Mezzanine finance is thriving in Europe’s lower mid-market. While other parts of the lending universe experience more fluctuation, the lower mid-market ticks along steadily. The continuing contraction in bank lending to SMEs (confirmed by the Bank of England’s “Trends in Lending” report in October and the ECB’s SME survey in November) appears to be structural rather than cyclical, with many excellent companies struggling to raise finance from their traditional sources.
As others have noted in Private Debt Investor, debt fund managers must be flexible. Whether they are running mezzanine funds, credit opportunities funds or other variations on the theme, they need to find bespoke lending opportunities away from the mainstream capital markets if they are to make attractive, unlevered returns on a sustained basis. Where do these opportunities arise? For some, they will be among stressed / distressed borrowers. Others will turn towards sponsorless lending and take significant minority equity stakes. And there are those of us who look towards the SME end of the corporate spectrum.
Our interest in the lower mid-market developed some years ago and sprang from two key observations. First, the large majority of companies lie in this category. Second, M&A activity here is less cyclical than it is for larger business, perhaps because it doesn’t depend on the capital markets. The case for operating in this area has since been reinforced. Bank appetite for lending to what would be B rated companies (not that they are rated) has diminished and is unlikely to recover fully in the medium-term. And the days of banks providing subordinated debt on their own balance sheets are over for now, saving the odd rogue banker who has chosen to ignore the head office memos about risk-adjusted return on capital.
As importantly, there are many companies of real quality in the SME space, with proven management teams and business models. We see many examples of strong earnings growth across our portfolio, whether organic or through acquisition-led build-outs. We are currently working with a growing UK SME, with an outstanding track record, that is trying to finance an acquisition. Its relationship bank will provide some backing, but at a much more modest level than would have been the case before the financial crisis and changes to bank regulatory capital rules. Beechbrook is topping up the senior debt with a mezzanine loan to enable the business to complete what could be a transformational acquisition.
Of course, the average investment quantum in this niche is modest: €5m-€10m is typical for Beechbrook. We raise funds that are sized to fit this opportunity. They have fairly short deployment periods and are structured to work with the illiquidity of our investments. There are not many managers with funds of this nature, so we find there is limited competition in our niche.
Flexibility, to which we have already alluded, is key. A willingness to adapt the finance offering to fit the needs of borrowers is important. One of the attractions for us of doing our own deals, usually on a bilateral basis, is that we don’t have to consider whether the products we design will be marketable. Provided we believe the risk is acceptable and the returns are commensurate, we can cut the structures up as we wish.
A final feature of this kind of niche activity is that the manager has a direct relationship with the borrower and has some ability to influence its direction, particularly when “events” arise, be they positive or otherwise.
This combination of bespoke products, hands-on portfolio management and attractive risk-return ratios is a potent one. Our experience is that it is attracting increasing interest from institutional investors that want exposure to growth businesses in Northern Europe’s lower mid-market.
Nick Fenn and Paul Shea are founding partners of Beechbrook Capital, a specialist fund manager providing debt and equity capital to small and medium-sized businesses in north-western Europe.