Mid-market lending report: EQT on Europe

Paul Johnson, a partner at EQT Partners, investment advisor to funds within the EQT Credit platform, talks to PDI about mid-market private debt opportunities in Europe, and his outlook on the current credit cycle.

How does EQT Credit define the ‘mid-market’ in Europe, is there an industry consensus on the definition?

For the purposes of EQT Credit’s direct lending strategy, we define the mid-market as between €10 million and €50 million EBITDA, and that has been consistent across the last few credit funds, but that is not a hard and fast rule. There is no consensus in the industry, and everybody defines the mid-market slightly differently.

There’s no doubt that part of the growth in direct lending is coming from firms targeting much larger deal sizes than that, and we have seen growth in that particular segment. But our deal introductions in 2017 were significantly higher than in previous years, so we also see considerable growth in the segment that EQT Credit is targeting.

What pleases me is that the healthy growth of the product is purely driven by borrower demand. The private equity firms now consider this a mainstream product; the growth is certainly not because banks are not willing to lend, because they are.

What is driving LP appetite for mid-market debt opportunities?

If you invest well, this is a really attractive asset class whose investors are smarter than ever before, having invested in the asset class for several years now and often with several managers. They can cut across the headline statistics, and they are really starting to focus in on differentiation.

They will often immediately focus not only on the investments you’ve made, but also on the opportunities you haven’t invested in, which is what ultimately defines the returns in credit. Having access to EQT’s unique network of over 250 industrial advisors gives us huge insight into different sectors and businesses, ensuring our due diligence process is as water-tight as possible.

Investor appetite is clearly growing, and the focus has turned to picking the manager rather than the asset class. New investors are coming in, US investors are moving into Europe, and existing investors are increasing allocations.

What is your typical investment size per deal, and has this changed with the latest EQT Credit fund?

The typical investment size has increased, to a median lend of €80 million to €100 million. That is a bit larger than the last fund, but that’s mainly a function not of the size of the businesses, but of EQT Credit being sole lender more frequently on deals.

“Investor appetite is clearly growing, and the focus has turned to picking the manager rather than the asset class”

EQT Credit has been the sole lender in six of the last seven direct lending transactions, whereas in the past it was closer to a 50/50 split. Some sponsors in M&A processes look for two or three lenders, but if it’s a portfolio investment or an investment where there is a very short window of exclusivity, having the ability to act as a sole lender is very powerful. The preference is always to be sole lender, and EQT Credit’s investment strategy is entirely consistent across the two funds, in terms of product, geographical focus, sector focus and size of deal.

Is the amount of dry powder in the market putting pressure on deal terms in a borrower-friendly environment?

The amount of dry powder is definitely growing, but we don’t have particular concerns. Really, it’s about how much competition there is for each deal – dealflow is so strong that you have to be selective and pick the deals you want to work on and where you have a strong angle. There are transactions where debt advisors will go wide and look only for the lowest cost of capital or the quickest process, and we are not going to spend a great deal of time there.

When we look at the deals the funds have completed, EQT Credit has usually only been in competition with a handful of direct lenders. The market is moving towards building stronger relationships, where sponsors have worked with particular lenders before and know how they think and act. That helps them select lenders for new transactions. Everybody can source deals, but not everybody can convert them – you need to focus on relationships with decision-makers.

Deal terms are actually pretty consistent across the industry. Maybe there should be more differentiation. They are 50-75 basis points tighter than they were a few years ago, but still highly attractive and well within the range we have always been talking to investors about.

Do you think the barriers to entry are getting higher in this industry? How can the largest managers differentiate themselves?

Yes, the barriers to entry are definitely higher. EQT Credit has a well-established track record and investors can do their due diligence and see what has been established in the last decade. The growth is coming from existing firms, and it’s hard for new entrants to establish a track record. I don’t observe the number of players increasing – we might actually be at the peak in the number of credit managers.

“We are clearly late in the cycle and have been for quite a while, so preparing for the worst is certainly a healthy approach”

Differentiation means allowing investors greater flexibility, allowing them to pick their managers based on geography, size criteria and so on. Being part of a global platform with competencies from multiple different asset classes allows EQT Credit to be smarter and better investors. But ultimately performance is a critical differentiator. It’s getting easier for investors to see the good managers that have avoided problem investments, which at the minimum absorb management time and impact new investments, and at worst see managers struggling to get principal back.

What is your outlook with regards to the current credit cycle, and how do you mitigate the risks associated with a potential downturn?

We are clearly late in the cycle and have been for quite a while, so preparing for the worst is certainly a healthy approach. Direct lending is an excellent product in a downturn and lends itself to a lot of downside protection. What is important to us in our due diligence is not actually the multiple in a valuation, but who will be the next buyer of the business. If the business has a reason to exist, and is needed in its value chain, then someone will look to acquire it.

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.

EQT Credit has no retail exposure and only limited industrial exposure in the direct lending portfolios. Historically around 75 percent of the fund’s deals have been in business services, TMT and healthcare. Those have similar characteristics in terms of stability through cycles, with highly connected customers who stay with the businesses. That approach has been taken for several years, and I see no reason to go more cyclical.

We do hear of some deals struggling, and direct lenders having to take control of businesses, and we expect that to increase. Investors will increasingly look at loss rates on deals that didn’t go to plan.