A UK-based company approached its bank – a large institution with a pan-European brand – to finance a receivable from a top-tier Italian telco. The bank liked the deal but informed the borrower that it could not finance an Italian asset. The borrower was duly referred to the Italian unit of the same lender.
However, the company then found itself in a catch-22 situation when that unit said that it could not finance a UK-based company.
It’s a familiar and frustrating story across Europe and as Raoul Stein, one of Kreos Capital’s six partners tells it, he rolls his eyes at the situation. But the story is also incomplete – because what happened next was that Kreos Capital stepped in.
Comparing it with the US where there is a more sophisticated range of financing solutions as well as a truly single market, Stein says: “In Europe there’s not really a yield curve, a growing company can either get [financing] cheaply from a bank, or it is challenging to get it at all.”
Situations like the one described above are Kreos Capital’s sweet spot. The firm actively hunts out the companies that have fallen through the cracks of Europe’s shattered financing market.
The firm has a focus on high-growth, mainly European companies, though it is also active in Israel. Borrowers are generally pan-European in outlook and in need of cash to finance expansion. Financing is flexible, according to the partners, meaning the firm foregoes covenant protections to allow borrowers the elbow room to grow.
The loans often include structured equity or other forms of share-capital upside, offering reward alongside the risk and aligning the interests of Kreos and the borrower, says Stein.
The four founders of Kreos Capital – Ross Ahlgren, Maurizio Petit Bon, Raoul Stein and Marten Vading – formed the firm in 1998. Ahlgren and Petit Bon spun their first fund out of the growth finance business of previous employer, Dresdner Kleinwort Benson, after it was bought by Allianz. European Venture Partners was its initial incarnation, but with so many similar three letter acronyms around, the firm rebranded as Kreos – which means ‘debt’ in Greek – in 2007.
A number of the partners spend most of their time in the markets where they have particular expertise. Stein commutes between Tel Aviv and London while Vading can often be found in Stockholm.
But they all meet at least once a month in their Mayfair office in London. And that is where Private Debt Investor sat down with the whole team.
Eight years ago, when it was forming its third fund, the firm took on two other partners, deal-maker Luca Colciago and Simon Hirtzel, who joined as chief operating officer.
But the team don’t want to concentrate on their roots. It’s all ancient history as far as they are concerned and the funds they’ve raised and the deals they’ve done tell the real story.
On the subject of funds, Kreos has raised four so far with a fifth in the pipeline, PDI understands. The €240 million Kreos IV Fund is 75 percent invested across 38 facilities and, across the vehicle’s investment period, the firm has lent €355 million into 88 facilities.
Those deals included transactions for a broad range of companies ranging from the familiar to firms that most people will never have come across.
If Google’s algorithms have detected any sign of an appetite for purchasing homewares, you’ll be familiar with online retailer, Achica, which Kreos has financed.
But unless you’ve recently had heart surgery, it’s unlikely that you will have come across Symetis, another of Kreos’ borrowers, which develops coronary valve replacement devices.
Net internal rate of return (IRR) to LPs has been in the range of 15 percent, the partners explain, declining to break the figures down by fund.
Kreos is exiting all the time, they add, pointing to the amortising structure that returns interest payments and principal to the fund consistently. Down the line, they also look forward to potential equity-style upside.
In August last year, the equity upside built into a deal done in 2010 paid off when Vero, a software design company, was bought by Swedish firm Hexagon from Battery Ventures, the venture capital firm that took the company private four years earlier.
Battery, with a debt facility from Kreos, bought Vero and supported the company as it bought three other businesses in three years.
But Kreos doesn’t rely on home runs, adds Vading. By doing around 100 deals per fund, it can rely on the underlying debt returns to meet its targets.
THE ART OF STRUCTURING
At first glance, Kreos’ deals do not offer the kind of risk profile which is comfortable for pension-holders nearing retirement. For example: They have few or no covenants; Kreos partners don’t sit on company boards (though they will take observer seats); most of the companies that the firm lends to can’t demonstrate the track-record of profitability that any standard credit process demands; and Kreos writes the biggest tickets in the growth finance space (according to both the company itself and others with long tenure in the market).
But with regular amortisation payments, the deals are continually being de-risked, and as Ahlgren notes, they avoid exotic or over-processed structures.
“We are very focused on amortisation, cash coupon, we don’t do PIK [payment-in-kind] or balloon structures. We don’t make money from financial engineering,” explains Ahlgren.
The firm doesn’t use personal guarantees, and instead maintains a focus on monthly cash amortisation and senior security to eliminate deal risk. And when targeting deals, the firm tries to position itself as sole lender, which means the full senior security that it insists upon is meaningful.
The firm also only works with sponsor-backed companies. It has strong relationships with a range of private equity and growth capital firms which are the main source of its deals.
THE REAL FINANCING GAP
Furthermore, the businesses it lends to are not focused on a single market. They may be based in Ireland but the borrower will not be reliant on selling into a small, peripheral European nation; it will be multinational in outlook, says Hirtzel.
This is where the true European mid-market financing gap lies, says Stein. Fast-growing businesses without the balance sheet strength to access traditional (or even any) lending but which do not want to go the more expensive equity route, are not serviced by Europe’s fractured debt market.
And just like in the example given at the outset, companies seeking opportunities beyond their home market are not even served by the so-called pan-European banks, which apply different credit criteria across the different countries that make up the continent.
Stein is emphatic: “Today the European market does not provide much financing for companies that grow quickly at the cusp of profitability at this stage [€20 million to €150 million in revenues].”
CAN’T TOUCH THIS
A wave of disruptive technology companies and the high-profile initial public offerings that accompanied their rise has focused a lot of people’s attention on the high-growth sector. Huge brands like Google and Facebook were supported with debt facilities that carried equity upside which has drawn the attention of investors.
Inevitably, others are trying to get in on the action and several funds and banks have established growth finance strategies.
Ask Kreos about the competition though, and the firm will likely reply that there isn’t anyone competing directly across its entire region or deal spectrum. Says Hirtzel: “We do see competition from smaller, sector-specialist and single-geography-focused lenders, but they are at the smaller end of our deal size and tend to be different people in different deals.”
Other names in the area include Metric Capital and US-based Harbert Management Corporation. The latter reached a second close of €93 million last year on its debut European Growth Capital Fund, a debt strategy which is targeting €200 million.
On the bank side, Clydesdale Bank and Silicon Valley Bank have growth finance franchises while UK lender Barclays has recently moved into the area.
The partners acknowledge that from time to time, some of these names will be competitors for a mandate, but say that none of them can match Kreos in terms of flexibility or scale across the same range of sectors and jurisdictions.
Petit Bon is especially exercised by the suggestion that banks can compete in the market.
When PDI points out that with cheap central bank funding behind their balance sheets, banks can and have offered lower margins in the space, he tells an illustrative tale.
The firm was courting a company that was also offered bank financing. A UK-based lender offered the borrower 15 percent of the total they were seeking, structured with full security and seniority on top of very tight covenants. The margin was lower than what Kreos would charge (on average low teens), but with a hefty upfront fee and substantial interest coverage ratio, the deal totally failed to meet the needs of the business, says Petit Bon.
Stein chimes in, pointing out that when you borrow €2 million from a bank, and they ask you to keep half of it on deposit, the six percent margin isn’t really that cheap.
“We have examples of where we lost deals to banks, but six months later they [the company] come back to us because the structure the banks put in place doesn’t allow them to operate,” adds Colciago.
HERE TODAY, GONE TOMORROW
The Kreos team are united in predicting that many of the names active in the market at the moment will not be found down the line.
With 16 years behind them, they have seen more than one attempt by a bank to tap the seam they mine so successfully, only to under-perform when some assets struggle and become weighed down by big capital charges. Not to mention that assets are sometimes moved to another part of the lender to be worked out by a different team, rather than supported by one team through the process, says Stein.
Ahlgren explains that over their 16 years of deal-making, they have seen many other players emerge, only to disappear when the going gets tough.
The team point to hedge funds which started looking at illiquid credit in 2007. But they had a fundamental mismatch with liquid investor cash poured into illiquid assets.
Inevitably it is losses or a failure to produce the required return that has driven other credit providers out of the space. Kreos has a tried and tested model but the risks remain substantial.
On managing risk, the partners agree that their flexible approach often sees them through. When a credit struggles, they can offer payment holidays or ask the sponsor to stump up some equity.
When they do have a default, the firm focuses on high recovery rates and the situation is helped by the amortisation payments helping them de-risk.
But the very last thing that Kreos will do is seize assets in an attempt to recover capital. Alienating sponsor partners is bad for business and interests must be fully aligned, the team explains.
“More important than selling the assets is selling the business as a going concern,” explains Hirtzel. “And that’s really one of the key things we would look for if it gets to that stage because for everybody concerned – the remaining value for sponsors, us getting our money out, management team – everyone prefers to have a success.”
SQUEAKY BUM TIME
The businesses that Kreos Capital lend to have lofty ambitions, but not all meet their targets and the equity upside built into Kreos’ loans is never guaranteed, no matter how good things look initially.
In mid-2012, UK-based payday lender, Wonga.com, was on the cusp of launching an IPO with a potential market capitalisation of around $1.5 billion. But headwinds including a series of difficulties with the UK’s Office of Fair Trading and public criticism of the firm by the Church of England meant the offering faltered.
Wonga.com has not performed badly. It is profitable and successfully operates in South Africa, Poland, Canada and Spain as well as the UK, but the IPO exit time-frame has certainly slipped as has the equity upside Kreos anticipated as the listing loomed.
These equity yield-enhancers are a ‘nice to have’ rather than the key business driver. And when a fast growing company stumbles, the real risks of growth finance are clear.
Crytek is a Frankfurt-based online computer game developer that has borrowed from Kreos. After strong success with some of its early titles, the company expanded quickly. But last year it came close to insolvency with employees complaining to trade press that they had not been paid.
The company sold the rights to one of its games and shut down the development side of its office in Austin, Texas and found a source of fresh capital, though it declined to comment on where the injection came from.
The company’s recent woes have not hit Kreos though. It lent to the company a few years ago and has already been repaid and did not lend further to Crytek, explains Hirtzel.
A reminder that the difference between success and failure is very often timing.
The Kreos credit model is very different from standard bank or debt fund criteria, the team explain. It is geared towards business fundamentals rather than balance sheets and the firm has produced new iterations down the years, bringing their deal experience to bear.
There are hairy moments, but the team say they have clearly demonstrated that they can navigate their way through whatever the market throws at them.
“The model has been resilient in different environments. In 2001, there was a technology crash, in 2008 there was [the start of] a credit crunch. If you then look at what we’ve done over the past 16 years, you’ll see that our results have stayed pretty stable, they’re not volatile,” asserts Stein.
Private Debt Investor recognises the potential riches of niche strategies but as ever, this niche is not going to be for everyone.
With fund V looming, though, the partners of Kreos Capital are in it for the long-haul.