Mid-market credit continues to represent a central part of the asset class’s ecosystem as LPs – facing lacklustre returns elsewhere in their portfolio – turn to private debt managers in search of greener pastures. As various species of manager look to adapt and stand out in an increasingly crowded market, PDI highlights some of the key trends in private debt’s most dynamic sector.
1. Competition is FIERCE
With a record-breaking $187.5 billion raised last year, and another $35.7 billion raised globally in the first quarter of 2018, there is more money chasing deals than ever. Not only that, there are more managers in the market. With the supply of capital currently outstripping demand, private equity sponsors can afford to pick and choose who wins the debt mandate.
More than anything, PE firms want to be able to manage the business in any way they see fit, especially if it runs into trouble. Hence, when it comes to deciding who wins the deal, the lender offering the fewest covenants will most likely be in the stronger position.
Immediately post-crisis, the inclusion of a full package of four covenants was common. The rules relating to a business’s leverage, cashflow, liquidity and net worth were early warning systems, with any breach bringing sponsor and lender together to discuss the issue. Until recently, cov-lite deals had been largely the preserve of the larger deal end of the market. A decade on from the GFC, however, more and more mid-market deals are now ‘loose’ or ‘lite’.
2. …but dealflow remains strong
Plenty of managers are chasing transactions, but that does not mean there is a dearth of good deals. Not everyone feels the competition felt across the broader private debt market is as acute in the mid-market – particularly at the lower-end of the market. Many lenders have exited the space, while others are capital constrained and the barriers to entry are high.
“This is a relationship business, and you can’t build relationships overnight,” says Ted Goldthorpe, managing partner at US-headquartered BC Partners Credit. “People also need technical knowledge, including an understanding of loan documentation.” Meanwhile, the more nascent European market saw a bumper year for private credit transactions in 2017. The Deloitte Alternative Lender Deal Tracker recorded 359 European mid-market deals, far surpassing 2016’s 271, making it the biggest year since 2013, when the report was first published.
3. Bigger players are making their mark…
Many of the “new” entrants in the mid-market private debt space are established asset managers – particularly traditional private equity firms – who have seen the opportunity and are now bringing their considerable resources and networks to bear in order to tap the mid-market. BC Partners (interviewed on p. 24) is a prime example, but there are many others.
“So many private equity fund complexes at this point have an associated debt strategy that it’s clearly more than just a trend,” says Tim Houghton, managing director of fund administrator Cortland. “I think it’s fair to assume the advantages to a PE firm of having a lending structure outweigh any disadvantages. The advantages are straightforward: growth in assets under management, providing the existing LP base with access to this highly desired asset class, and flexibility to shift up and down the capital structure, to name a few.”
4. …but so are the niche specialists
As the asset class has matured over the past decade, many players are growing their expertise within niche sectors, strategies or jurisdictions. These managers are arguably in a stronger position to differentiate themselves from the competition, while providing LPs with some diversification in their portfolio. On p. 26 we look at some of the sectors where managers are honing their specialisms.
There are also those seeking to tap new sources of dealflow in relatively neglected areas of the market by leveraging a local presence. Madrid-based Kartesia (interviewed on p. 28), for example, is targeting non-sponsored deals in Southern Europe.
“LPs are getting more interested in non-sponsored, they can feel the competitive environment and know that in sponsored deals there are some funds that are taking on too much risk for too little return,” says the firm’s managing partner Jaime Prieto. “There is a general feeling that non-sponsored is riskier, and that is broadly true, but the market is so big with so many businesses in it that a good management team should be able to mitigate those risks.”
5. Everyone is wary that fortunes may change
Throughout 2017 there was talk about when the cycle might end. This year will likely be no different. Some warning signs are there but not everyone is convinced the current environment is immediately comparable with the situations that existed pre-2008.
Christopher Taylor, managing director at Madison Capital, notes in his interview with PDI that any future correction will be less severe, but likely drawn out over a longer period. “The future correction would be more of a U-shape and will require a heightened focus on borrower liquidity,” he says. “The last financial crisis was very sector driven in terms of housing, construction and weakness in the financial sector. I don’t think the next correction will be driven by the same factors.”
Meanwhile, Paul Johnson, a partner at EQT Partners, notes that preparing for the worst is healthy at this stage in the cycle. This is where due diligence comes in. “If the business has a reason to exist, and is needed in its value chain, then someone will look to acquire it,” he says. “You can build more defensive portfolios ahead of a downturn, and certainly have a senior secured first-lien instrument that gives you a real buffer to the valuation.”