Kartesia: The need for liquidity drives sponsorless deals

The lower mid-market remains very active but there are signs that inflation is having an impact, says Laurent Bouvier, managing partner at Kartesia.

This article is sponsored by Kartesia

Laurent Bouvier

How would you describe the current state of the private credit markets in Europe, particularly in the lower mid-market?

It is a mixed landscape depending on where you look. This year has been a very active year – we all headed into 2022 with a good market outlook for both fundraising and dealmaking. What has happened since has been more challenging, first the energy crisis and now the rising interest rate momentum.

Companies that have been able to deal with the issues around inflation and energy costs are now clearly starting to “feel the pinch” of the rise of the base rate and the overall increasing cost of liquidity. We see many situations where there are early signs of clients reaching the cut-off point at year-end and starting to postpone payments as they begin to feel that pressure. Little by little, the impact that everyone feared of this inflationary environment is starting to materialise.

As a direct lender, we are looking at  a market where we need to shift from an era where liquidity was really high to a time where the fundraising outlook will be, if not difficult, then certainly time-consuming. Many LPs are delaying their allocation decisions for various reasons, a key one being the impact of the “denominator effect”.

While that is out of the control of direct lenders, the two things that could happen to trigger some relief from that constraint are either a decrease in interest rates allowing the fixed income asset class to reprice, or a strong increase in listed equity prices. As we do not expect any major shift in either any time soon, private equity and direct lenders will need to keep returning significant capital to LPs to ease that ratio so that re-ups can occur.

We have adapted our approach to dealmaking in terms of selectivity, we believe the dry powder we have is valuable and we need to select the right opportunities: companies with pricing power and with the ability to withstand rising inflation.

As for the lower mid-market, you have the private equity-driven part of that market and the sponsorless deals. The sponsorless deals are not driven by M&A activity but rather come from companies that are in need of liquidity for expansion or re-investment. We have been very busy in that segment where we see no signs of deceleration.

Private equity-driven transactions were still very dynamic until the end of Q4 2022, but there are clear constraints in that space as sponsors find it difficult to raise debt for deals. While still active, we do see M&A reducing and pipeline visibility beyond Q1 2023 decreasing with valuations under pressure. The big issue is the increasing bid-ask gap between buyers and sellers – if that readjusts we should still have an M&A market, but we will need to see what happens.

What impact is accelerated bank retrenchment having on direct lenders, and how do you expect that to change through 2023?

Bank retrenchment has clearly continued throughout the past year, but it is not at all a homogenous trend across Europe and can really vary across markets. In France, for example, banks have remained very much open for business, as opposed to the UK where the banks have been extremely prudent. In the Benelux region and in Germany they are more prudent, but still open for business.

While bank retrenchment has some impact on direct lending, the decision to select a direct lender has more to do with a borrower needing flexible financing in a world that is highly volatile, versus going with a lender that is more rigid in its approach. For private equity sponsors, it is a balance between certainty of deal execution and certainty of funds, as opposed to leverage or pricing. We do not expect to see that change massively in the year ahead. We also don’t expect the behaviour of the banks to change significantly, unless there is a major wave of defaults that causes them to re-evaluate their risk appetite.

What are the opportunities and challenges for lenders to sponsorless transactions?

Sponsorless transactions are mostly non-M&A-driven. As such, it is a good market segment to be involved in during more challenging times. One big challenge for lenders in the sponsorless segment is the overall fatigue of management teams that we see today. The level of turnover in finance teams, the fatigue of CEOs, CFOs and other executives who had to weather unprecedented times in early 2020, and that have now seen almost three years of high volatility, puts the people risk on these deals at a significant level.

Lenders need to focus much more on the individuals, because the last thing you want to face is low-quality financial reporting or absence of a management team in the middle of the next storm.

Then, of course, the other challenge is to find the appropriate advisory teams to make sure you can support companies properly. These succession challenges are difficult conversations to have with management teams, but lenders need to focus on what happens if they lose an important element of the C-suite. That has been our focus for the past semester and it will certainly be the case for the next semester, and likely throughout the coming year.

What do you expect to be the most challenging parts of the private credit markets in Europe this year, and where will we see the most activity?

I would say one of the biggest challenges will be asset retention. If one thinks about a decelerating M&A market, particularly at the lower end of the market, that means overall asset retention in the portfolio will be higher. Additional human capital is thus required to deal with more intense portfolio management, also implying managers need to raise additional money from LPs in order to grow. If you are not returning capital at the speed you had expected to, it will impact your ability to raise new capital.

Another challenge, given we do not see inflation or interest rates reducing significantly in the next year, is the overall geopolitical threat, particularly in relation to China and Taiwan. With Russia and Ukraine as an example, we need to anticipate two or three years ahead during which the “China threat” materialises, and to avoid timing an exit on a deal hitting that risk. We need to start talking to management teams with that in mind.

We are having many discussions in the portfolio about companies’ level of exposure to China and how they can mitigate that risk. We are seeing a lot of onshoring and relocation of sourcing out of China to other Asian countries. The risk of sanctions being imposed on China in the event that anything happens with Taiwan is something we want to avoid causing us issues down the line. The lower mid-market is slightly more immune but, higher up, that is certainly a risk that is more acute.

In terms of where we will see the strongest activity, the UK market is still very active. We also see an increased number of opportunities in the Benelux region and in Germany. We hope to see more opportunities coming through in Spain and Italy, with Italy having been subdued in terms of dealflow but home to a good network of mid-market companies.

Central and Eastern European countries are really interesting today, with the onshoring and near-shoring of supply chains. The lower labour costs in economies like Poland, which also has access to cheaper energy prices and very talented management teams, is creating opportunities. We have a couple of deals already where production has been relocated to Poland. This has strongly enhanced profitability and fast-forwarded access to Western European consumers and end-markets.

Overall, this is a good environment for private credit to prove its strengths across Europe, as well as a good test to see who has done the right deals and who can actually work through any issues that arise in the portfolio. For managers, there is a balance between identifying new deals and making sure they spend enough time on their portfolio to cope with any issues managers might face.

What are the attractions of lower mid-market senior debt for private credit managers and their investors right now?

For those solely focused on sponsored deals, 2022 was an active year. As we head into 2023, however, that M&A-driven market is likely to be slower as deal activity declines. If fundraising becomes more difficult for private equity, there is a question over dry powder; without access to sponsorless deals, direct lenders are going to be forced to focus on a smaller number of transactions.

As far as the sponsorless market is concerned, given it is not M&A-driven we do not expect a deceleration of dealflow. To be pan-European, managers need to identify and select the best opportunities. By doing so, we are able to achieve stronger risk-adjusted returns by identifying opportunities with lower leverage and substantially increased returns. Today, in the UK, with a margin of 7-9 percent on the typical senior loan, plus a base rate of over 3 percent, you are effectively lending at almost 11-12 percent on the senior debt. The risk-adjusted returns remain very attractive compared to all other asset classes.

The biggest challenge is that you need to finance businesses that can afford to pay such a high cash price on that capital structure. This being said, we are not seeing any shortage of opportunities to do those deals right now.