This article is sponsored by Investec Direct Lending
Your strategy is heavily focused on the lower mid-market. What is the lower mid-market opportunity in the current European climate?
Callum Bell: We believe the lower mid-market is the most underserved segment of the direct lending market. Many funds have significantly grown AUM and, as a result, drifted into larger deals while banks have continued to retreat. Across our core European lending markets, banks’ market share has more than halved over the last five years.
Combined, these structural trends present a large opportunity for experienced managers dedicated to the lower mid-market like Investec.
The lower mid-market is also the volume segment – there is a wide selection of borrowers and sectors to source the best investments and construct the most attractive and granular portfolios.
This segment presents opportunities to back entrepreneurial businesses and management teams, who are typically not as “leverage” driven but do require more bespoke finance structuring to meet their growth needs. We typically find our ability to support future growth, to deliver capital solutions quickly and offer a high service approach is valued more highly than day-one leverage and borrowers are willing to pay a premium for this.
Megan Sachs: The lower mid-market certainly offers the most conservative debt structures and terms but, importantly, comes hand-in-hand with strong returns.
This allows us to capture better risk-adjusted returns when compared with competitors operating in the larger and more transactional segment of the market where competitive dynamics are less favourable. For example, in our current fund, all our investments have at least a leverage covenant and nearly two-thirds have more than two covenants.
We find enhanced covenant protection allows us to engage early, put our heads together with the business and find proactive solutions well in advance of any financial stress. These attributes provide the opportunity for investors, but in the current economic climate, importantly, also provide enhanced downside protection.
How does Investec differentiate itself in the market?
CB: We have an exceptional team of people that are committed to investing in our target market – this is our key asset and differentiator. Over 12 years, we have built a large team of over 40 investment professionals, which provides us the scale needed to source investments across Europe and to manage them actively to realisation. Combining a clear investment philosophy centred around capital preservation – with great people – is what sets us apart.
Through this approach, we source over 500 opportunities a year and transact on around 50. With these volumes we are not motivated either by winning deals or delivering deployment numbers but rather by financing the highest quality investments. We have an unrelenting focus on delivering superior risk-adjusted returns for our investors and, importantly, the market presence and discipline to support that approach.
MS: For me, it comes down to our partnership approach. Our leadership team has worked together since 2014 and within the wider team we have developed real sector and lending expertise in the lower mid-market. Across this time, we have built strong and trusted partnerships with sponsors and over 200 unique borrowers. We look to back growing businesses and we deploy finance alongside them by structuring flexible solutions that cater for this active expansion from the outset.
Looking forward, what key trends and opportunities are you seeing?
CB: This market presents a lot of opportunities that will favour managers that have been disciplined over the last few years. If your portfolio is in good shape, the opportunities will far outweigh the risks because the lending environment is so much stronger – pricing is up by over 100bps on average for us and terms have tightened.
Based on our recent deployment and current pipeline, the next few years will likely be the best vintages we have seen for a long time for debt investment strategies. As far as trends, we are seeing a shift to more flexibility with capabilities like asset-based lending, for example, being increasingly sought as borrowers look to try to manage the cost of capital lower. We currently see a strong pipeline of opportunities with quality businesses in the lower mid-market, which creates a really positive outlook for our franchise.
What are the advantages of a more differentiated manager over the larger, more generic players?
CB: We have seen significant growth in direct lending in recent years and I think it is quite natural that as markets develop and get bigger you start to see more differentiated strategies bubbling up. That is great for the market and investors as it provides increased investment choice. To increasingly talk to investors about more diverse investment strategies like growth, ESG/impact and integrating asset-based investment alternatives is now much more prevalent than a few years ago which is exciting for innovative managers like us.
Going forward, we believe that there is a real advantage for the nimble and innovative to differentiate their offering as a way of maintaining a competitive advantage. For example, one of our differentiators is that we can provide both revolving and term lending from a single provider which removes the complexity of super-senior structuring and complex inter-creditors.
MS: Differentiation comes in various forms but the most measurable for investors is returns. With the current economic uncertainty there will be increased visibility and scrutiny around a manager’s ability to generate superior risk-adjusted returns relative to the market. We believe this will reinforce appetite for deployment into the lower mid-market.
For example, since our inception we have consistently generated IRRs per turn of leverage (a proxy for risk-adjustment) well over 2.0 percent compared with the broadly syndicated loan market that is typically less than 1.0 percent. We have been able to deliver this because of the compelling structural attractions of the lower mid-market, our unique sourcing capabilities and our disciplined focus on capital preservation.
In more challenging economic conditions, is there more risk associated with backing smaller companies?
MS: The current macroeconomic climate is certainly more challenging. With base rates having increased over 3 percent in the last 12 months, businesses have had to adjust quickly, and highly leveraged structures have come under pressure. In our experience lower mid-market borrowers tend to have more conservative capital structures which provides a tangible safety margin.
To illustrate the point, Investec’s average leverage has been around 3.5x whereas the wider market leverage is in excess of 5.5x – a full 2.0x more leveraged. We have found that this low attachment point significantly reduces loss rates to negligible levels over the long term which is a key consideration for investor returns.
Callum Bell is head of Investec Direct Lending and Megan Sachs is portfolio manager for Investec Private Debt Fund I