Partners highlights opportunity in ‘add-ons’ and complexity

A new report from the firm says direct loans in the mid and upper mid-market offer the most attractive return potential in the US.

In the private debt section of its 2018 Mid-Market Navigator report, private markets specialist Partners Group says the best returns in the US may be found in direct loans to the mid and upper mid-market.

In particular, the firm highlights add-on acquisitions in fragmented sub-sectors, such as business software services and clinical trial outsourcing. The report says that, due to a high level of fragmentation within these sub-sectors, market leaders can target a number of smaller companies with little financial or administrative infrastructure.

However, Partners confirms from first-hand experience a major talking point in private debt: increasing use of covenant-lite structures and looser documentation. It points to a deal where it was asked to provide subordinated capital for the acquisition of a medical software developer and device manufacturer.

After three rounds of due diligence, the deal was approved on a commercial basis. However, legal negotiations over the covenant package then led to “a mismatch in expectations as weak negative covenants were proposed as part of the terms”. Partners says it stepped away from the transaction.

In Europe, the firm highlights solutions for complex situations, such as its carve-out of Morpho from French conglomerate Safran and subsequent merger with Oberthur and its provision of holdco financing to an Italian payment services provider, which involved navigating a complex regulatory environment.

In Asia Pacific, the firm says it has increasingly focused on the demand for institutional debt from private equity sponsors in Australia, in particular for unitranche structures. Sponsors have found this kind of finance more flexible than that typically offered by the banks and was a part of Partners’ support for KKR’s recent acquisition of Laser Clinics Australia.

Overall, the report considers the private debt market to be “robust” in terms of investment activity and fundraising levels. The market is growing strongly on the back of private equity fundraising and private equity deals that need refinancing.

A summary of key points:

  • On the supply side, fundraising continues at a strong pace, particularly for senior debt;
  • In the US, the existing regulatory framework continues to favour non-bank institutional lenders; however, there is a regulatory discussion around a potential rollback of the current lending constraints on banks. Despite this, Partners does not expect banks’ market share to return to pre-crisis levels due to continued risk aversion, strong penetration of non-bank lenders and the unlikeliness of a full-scale rollback of Dodd-Frank regulatory protections. It continues to overweight large-cap second lien direct debt investments;
  • In Europe, direct senior loans and subordinated debt can be very attractive in the current market environment given banks’ ongoing reduction in market share and the overall risk-reward enhancement provided by original issue discounts, base rate floors and the option to participate in equity upside. Club transactions are particularly attractive;
  • In Asia-Pacific, Partners has seen a number of transactions which cater to non-bank institutional lenders in senior debt, particularly in the term loan B market. In Australia, an increase in institutional unitranche has been driven by demand from sponsors;
  • In general, Partners continues to focus on companies with three defining characteristics: recession resilience, stable recurring cash flows and high cash conversion levels.