Headwinds and tailwinds

This article is sponsored by Kartesia.

Has the definition of the mid-market changed over time?

We look at companies with an EBITDA between €5 million and €20 million. In Spain, we tend to focus more on the smaller side of this range, when compared to more developed markets. On top of that, the true mid-market, where most mid-market lenders are, is anywhere between €15 million to €50 million. I think the definition has shifted somewhat and that the minimum amounts have increased. At the larger end of the spectrum some mid-market investors are doing deals with companies with an EBITDA of €70 million to €100 million.

Funds are getting bigger and so has the awareness of the advantages of direct lenders amongst mid-market companies. Also, CLOs are no longer participating in that bracket when compared to eight years ago. Meanwhile, the local banks are not as flexible as funds and are less willing to take on syndication risk, so they are leaving enough room. There is an intrinsic advantage for direct lenders who can move quicker. It is a legitimate trend driven by the overall market on the demand and supply side.

Is there more competition among direct lenders, and are deal terms still favourable?

Even though there are fewer banks and fewer CLO managers able to compete with private debt investors, this has been more than compensated by the emergence of direct lenders. This is obviously more the case with sponsored deals than with sponsorless deals since the former is much more easily intermediated. At the lower end of the mid-market, it is not economically viable to have such professional intermediation.

How do you structure your deals? Are you seeing more mezzanine or unitranche deals?

We do both unitranche and mezzanine. We also do senior debt alongside banks where the banks keep the amortising tranche and we can take the bullet tranche. We have built enough flexibility within the team to be able to customise solutions for each situation. What we try to do is structure the deals in a way that the customisation benefits us, as well as the company. So, we are increasingly doing sponsorless transactions where customisation is a lot more relevant than in a plain vanilla sponsored deal.

Has your risk appetite been impacted now we are later in the cycle?

We have evolved from doing more mezzanine from 2011 to 2014, when mezzanine and second lien was 40 percent of what we did. Today, mezzanine represents 10 percent of what we have done over the last five years. So, even in a relatively competitive environment, we have remained in the senior part of the capital structure. We don’t need to avoid mezzanine deals but there are very selective situations where we can take a comfortable position even if a downturn materialises. The most important aspect is maintaining discipline and building a diversified portfolio.

We focus on the nature of a business and the industries in which we invest and we maintain a very disciplined approach. We understand it may be interesting today to invest a large amount into a big company, but if that is at the expense of diversification we will not do it. We have the benefit of being in the lower end of the mid-market where the number of opportunities is greater. As a result, you can be selective: we had 52 deals in our third fund.

What is your view on Brexit, and what impact do you expect it will have on the European mid-market?

The general feeling is that we have passed the world of tailwinds, but the headwinds are still there. At different stages, that could be Brexit, the situation in Italy, Spain, oil and gas prices or global trade. I think we will constantly face headwinds and they will change in nature, but overall one should expect that. What we need to realise is that the small headwinds will keep coming and you need to build a portfolio that is resilient and selective.

As for Brexit, it has exacerbated and amplified the change in the cycle in the UK. When you look at specific sectors, such as retailers or restaurant chains, the evident negative impact has come through the increased cost of importing goods. Also, [in terms of] investment activity, Brexit has shaken confidence in the economy and that has led to lower M&A and lower direct lending activities. Some people argue that banks may leave further room to direct lenders. Frankly, I find it difficult to argue that there won’t be really good opportunities in the UK for direct lenders.

I think there will be an interesting opportunity when the market starts to show cracks. Those lenders that invested two to three years ago and have had a UK exposure of around 40 percent on average – or those lenders with greater exposure – will feel the pain when these companies go through heavy restructuring. They may have an appetite to reduce their exposure altogether and we can replace those lenders, which may be a great opportunity.

How much of your own activity is non-sponsored now? What are the main barriers to growth in this area?

Over 50 percent of our deals are non-sponsored. I think the reason we don’t see more is the unwillingness of managers to get their hands dirty. You need to be a lot more local to properly explain the benefit of going with you over a bank. So, the origination and structuring efforts revolve around having the capability on the ground to structure a solution that is a win-win for both parties.

For starters, you need to have the resilience to get the deal executed because it will not follow the same strict timings as a sponsored deal. Secondly, you need to be more patient and show more grit. Finally, you need to monitor those companies very closely. A level of reporting may be there but you cannot rely on a sponsor to improve it, so you need to lead that effort. Then you have to look at your exit and drive it if necessary.

Overall, there is more complexity, but with that complexity comes better risk-adjusted returns, and that doesn’t mean higher risk per se, it just means you need to think harder around the solution that is better than what you can get in the sponsored market. You need to invest in local teams to make sure they can drive penetration of direct lending in non-sponsored situations.

Hopefully, more direct lenders will look to sponsorless situations and build the capability to do those deals. It is really where the growth of the industry lies. We can’t only rely on private equity sponsors, that is not sufficient to fully exploit the potential of direct lending in Europe.

In terms of geography, where do think the biggest areas of growth are for European mid-market debt?

We are looking to increase our effort in the German market, because even though it remains very competitive with local banks, it is a vast market and our belief is that we need to put the effort in on the ground. We will be setting up our second office in Germany by the end of the year to make sure we are local enough to add value to these local companies.

On the fringe, I think there will be opportunities for us in Central Europe. Countries like Slovenia and Latvia have been very interesting because these companies are mainly selling to Western Europe.