Smaller deal sizes continue to provide the opportunity of outsized returns for private debt funds focused on the lower mid-market. While many credit managers have gravitated up to larger deals during the buoyant activity of the last few years, those that have stuck around report an attractive opportunity set that defies outdated perceptions.

Nicolas Nedelec, managing director in private debt at French fund manager Eurazeo, says that many wrongly believe smaller deals come with more risk. “There is no evidence that there are more defaults or losses among smaller businesses,” he says. “There is this perception that smaller businesses are more fragile, but that is not true. Maybe you need to pay more attention to management and do proper due diligence, but even where there are defaults, recovery values are in line with larger deals.

“The lower mid-market offers outsized returns primarily because you have fewer competitors in that space, which means you get to decide the deal you want and you get to drive the price and the returns. Right now, we are doing deals at 8.0 percent-plus margin. And there are lots of buy-and-build strategies, creating opportunities to do additional business further down the road.”

A wider pool

Andreas Klein, head of private debt at Pictet Asset Management, agrees that smaller deals offer compelling attractions. “There are fewer competitors but also structurally there are more small companies than large so there is a wider pool to fish in,” he says. 

“At this stage of the cycle, asset selectivity is key in the small-cap segment. Local presence is also critical because when you’re working with smaller companies you are often working with less international management teams, so the cultural elements of understanding the borrower are very important.”

Sourcing deals also requires a completely different skillset and network, according to Klein: “The networks to find these opportunities are different because these are not necessarily companies that can afford to work with large debt or M&A advisers. That means having a local network and being plugged into regional industry experts plays a big part in identifying the best deals.”