Mid-market lending report: BC Partners on dealflow

Just over a year after launching BC Partners’ debt arm, Ted Goldthorpe, managing partner of BC Partners Credit, offers insight on the US mid-market deal-making landscape.

BC Partners Credit, launched in 2017 by private equity firm BC Partners, pursues two primary strategies with a global remit. It operates as a direct lender making unitranche and first/second lien loans to mid-market companies, but also as an opportunistic investor, making loans to stressed and distressed businesses, and to other companies in more complex situations. Ted Goldthorpe, managing partner, talks about market conditions in the US and Europe.

Where are you making deals in the mid-market right now?
In terms of dealflow, there is a definite skew towards direct lending at the moment. To give you an idea of this, last week we sourced 11 deals for our direct lending strategy. This is where we are hiring people the moment. Our direct lending business is really growing.

Do you feel the space is becoming increasingly overcrowded?
Not in the middle market, where we operate. Everyone talks about how crowded it is, but many firms have exited this space, and others are fairly capital-constrained.
One reason why this market still offers attractive risk-return characteristics is that the barriers to entry are reasonably high. This is a relationship business, and you can’t build relationships overnight. People also need technical knowledge, including an understanding of loan documentation.

Is there any concern about larger lenders encroaching on the mid-market?
It doesn’t make sense for them. Some of the larger firms have $100 billion-plus. For this reason, they want to do larger deals of $200 million-$400 million in the upper middle-market. It would take them the same amount of work to do a
$30 million deal as a $200 million deal, but the $30 million deal wouldn’t move the dial for them. But if we do a $30 million deal, we get excited about it.

What’s the supply of deals like for alternative lenders in the mid-market as a whole?
In the US, the combined market share of alternative lenders is very stable, having grown so much over the past 10 or 15 years as traditional lenders retreated. However, the opportunity set is huge, because of the number of companies out there. If looked at on a standalone basis, US middle market companies would be the third biggest economy in the world. In Europe, the supply of deals is growing massively because so many more middle market companies are willing to consider borrowing from alternative lenders rather than banks.

If the mid-market isn’t too crowded, this must be favourable for returns?
Returns are still good. It’s possible to generate 8 percent on first-lien assets right now. That’s much more than for large and liquid leveraged loans or high-yield bonds in the US or Europe. In the US, for example, the S&P/LSTA Leveraged Loan 100 Index shows a yield of Libor plus 325 basis points, with 6 percent for US high-yield – and that 6 percent is riskier, because it comes with no covenants or controls. Unlike for bonds, moreover, we’re not exposed to the risk of market interest rates rising, because we’re making floating rate loans.

Is the dealflow small for your opportunistic strategy at the moment?
It’s true that we’re not in the middle of a broad-based credit downturn, but there are always opportunities to lend to companies because they don’t fit banks’ notion of what a good borrower is.

Let me give you an example. We’re looking at a deal with a datacentre company with high leverage based on relatively low trailing EBITDA. However, it is only at 15 percent capacity and it will ramp up its capacity over the next 12 months by securing lease agreements. That deal would not fit in our direct lending strategy but works for our opportunistic business.

There are also about seven or eight sectors in the US that are suffering stress, for a number of idiosyncratic reasons. For example, oil and gas has been hit by lower prices, power by the rise of renewables, and pharmaceuticals by pressure on drug prices. These present opportunities to invest selectively.

Moreover, the broader credit market does experience volatility quite regularly, which enhance opportunities for distressed investors. The downturns seem to be getting shorter, however. The last one, in 2015-16, lasted only three or four months. This means that the window of time in which investors have to react is becoming shorter.

BC Partners Credit is quite new, but BC Partners is more than 30 years old. Is it an advantage to be part of a long-established private equity outfit?
Having private equity colleagues gives us a big advantage in sourcing, executing and monitoring investments.

Firstly, they introduce us to a lot of good business. Our private equity team might see 200 deals each year and ultimately close five. Many of the 195 plus companies may not fit our private equity mandate, but they are good businesses that need access to capital for a variety of reasons, such as to make acquisitions, fund capital expenditures or to facilitate succession from one generation of the family to the next.

Secondly, our private equity colleagues, and the firms they have invested in, can lend us their expertise. Consider again the example of the datacentre deal we’re working on. BC Partners owns two datacentre companies, and we were able to ask engineers at one of these companies to assist in engineering due diligence on the potential borrower. This expertise extends across industries and geographies.

“One reason why this market still offers attractive risk-return characteristics is that the barriers to entry are reasonably high. This is a relationship business, and you can’t build relationships overnight”

Finally, our ability to act as a value-added lender is enhanced by the resources of the broader platform. This includes access to operations professionals, who focus on value creation initiatives and day-to-day business improvements across portfolio companies. These individuals have direct managerial experience (all have acted as either CEO, COO or business unit heads) and a majority have also worked as management consultants. As a lender, this allows us to identify and offer best practices to our borrowers throughout the life of the loan.

You recently filed paperwork for a BDC. Why did you choose this structure for your direct lending strategy?
BDCs are beneficial for foreign and tax-exempt investors because investors generally are not subject to US withholding tax and BDCs act as a corporate blocker for Unrelated Business Taxable Income and Effectively Connected Income. There are some restrictions that come along with the BDC structure, but we think the benefits far outweigh them. BDCs have become even more attractive with the recent legislative changes that increase allowable leverage from a 1:1 debt-to-equity ratio to 2:1. We think this will, counterintuitively, make BDCs less, rather than more, risky, because they will be able to lend to lower-risk companies and compensate for the lower yield through incremental leverage.