The founding partners at Kartesia have been investing as a team in the European corporate credit market for over 11 years. During this period we have witnessed a number of cycles, typical of the credit market, in which the availability (or lack thereof) of financing has resulted in an additional strain and volatility to businesses.
These cycles-turned-into-crisis have, however, resulted in a number of structural changes which are re-shaping the provision of financing to companies, at least for the next few years. The main change is the retrenching of banks, which have become more risk averse and focused on their core markets. But for banks, with loans to thousands of borrowers, a reduction in risk can only be achieved by applying strict risk criteria that leave little ground for interpretation, let alone adaptation to each of those borrowers’ needs.
The retrenching of banks towards more standardised financing packages to “standard” performing companies has created the need for institutional credit investors that can provide highly-bespoke financing solutions tailor made to the requirements of each business, which we’ve come to name “unitranche”. In fact, a growing number of regulators across Europe are driving changes that welcome the emergence of credit funds as an alternative source of financing for their economies.
The main advantage of unitranche lies in the ability of its provider, the credit fund, to understand the underlying risks and adapt its terms to those risks and also to the needs of the company and its shareholders. However, the advantages go beyond the structure, as the company will find in the credit fund a long-term partner, one that can and may need to adapt to the evolution of the company. It is this capacity to provide solutions when things don’t go as expected that will also differentiate unitranche providers from one another, and also from banks, which are driven by stricter technical constraints.
At Kartesia we have chosen to dedicate our attention and efforts to the smaller end of the mid-market (“smidcap”) segment, in which we believe the unitranche can be most useful. The smidcap segment is populated by companies that have financing needs of €10 million to €50 million.
A LARGE AND DIVERSE SEGMENT
The suitability of unitranche for this segment lies in the combination of i) the vast number and ii) the diversity of the opportunities it presents.
With respect to the first driver, it is essential for any credit investor to diversify and discriminate. Therefore, the vast number of situations in the smidcap segment is a great starting point since it gives the credit fund the ability to discriminate and select those situations to which it can bring most value and therefore capture return, and also to reject those in which risks cannot be absorbed. It also means that there are fewer periods with little or no deal flow, which helps maintain the credit discipline across the cycle.
The second driver is diversity or deviation from the norm, as this results in a broad spectrum of situations that need to be addressed with tailor-made solutions. When we look at the larger end of the market, the differentiation in pricing or terms between financing packages is more limited, and in fact, credit investors prefer to rely on credit ratings that help standardise their reflections on risk and pricing.
In the smidcap segment you can obviously find measurements that indicate the average risk of the segment, and it is commonly accepted that the segment is marginally riskier than the larger cap “on average”. However, the appeal of the smidcap segment is precisely its diversity, as the diversity of requirements is central to the suitability of unitranche facilities. In markets in which the population is very close to the average, the winner is the cost leader for the size-that-fits-all, whereas there is more potential for personal tailors in population segments which show more deviation from the average.
THE SUPPLY OF CREDIT CYCLE
Despite the inherent suitability of this segment to unitranche, we see it as the most under-served one. This is partly explained by the higher “costs” to access these small individual opportunities that require similar efforts to those required in mid-cap deals in which a credit fund can invest over €75 million per deal.
It is therefore not surprising that most of the capital raised by direct lending funds has been captured by large alternative asset managers that have traditionally invested in the mid-market segment and whose teams are inclined to dedicate their precious time to a large transaction in which they may deploy the equivalent of three investments in the smidcap segment. The differential in return and risk does not appear to be a sufficiently motivating factor for the larger fund managers to choose the smaller investment.
Finally, the smidcap segment is less exposed to the cyclical nature of the credit markets, since the main two alternatives are banks and credit funds with long-term capital. It is a segment that is less influenced by more cyclical sources of financing (high-yield bonds, CLOs, international banks).
Our experience in the smidcap space over the last 11 years shows that this ability to discriminate both on risks and returns results in superior risk-adjusted returns to our investors. On the last four investments we have made, the expected returns on our unitranche facilities are above 12 percent p.a., which need to be compared to an entry leverage level below 4x Ebitda.
Obviously, the existing conditions may and inevitably will evolve, but the structural attractiveness of the smidcap segment for unitranche is solidly supported by the diversity of situations that require an instrument that stands out for its ability to provide tailor-made solutions.
CASE STUDY: APPETITE FOR AN UNUSUAL FINANCING
How an Iberian casual dining chain digested a unitranche loan with some unorthodox features
Kartesia arranged & underwrote a €26 million unitranche loan financing towards the acquisition by H.I.G. Europe of Café y Té and Panaria, thereby creating the leading Iberian operator of casual dining.
The entity resulting from the merger of both companies, Compañía del Trópico, operates a network of 247 outlets, circa 50 percent of which are directly operated and the remaining are franchises.
The company operates bakeries, coffee houses and tapas bars located in shopping centres, premium on-street spots and city hotels. The portfolio of brands include Café y Té, Panaria, Café y Tapas, Charlotte Café, Caffé di Roma, Bocados Café, Sky Madrid, etc. Compañía del Trópico is based in Barcelona and employs around 700 people.
The financing includes a few features that were atypical:
– No amortisation until maturity of the Unitranche;
– Additional capex facility to fund the rollout of the store network over the next four years;
– Committed recap facility allowing the sponsor to recover 25 percent of its investment within 12 months;
– Approval to repay a junior vendor loan ahead of the unitranche;
– Kartesia delivered the final documentation and funding within two weeks of the signing of the term sheet.
By the end of 2015, 18 months after closing, EBITDA had progressed by over 60 percent and the company delivered from 3.5x at closing to 2.8x (including the additional drawdowns in the capex and recap facilities, and the planned repayments on the vendor loan).
Overall, Kartesia contributed to a transaction that resulted in a positive outcome for the company, the sellers, the buyers and Kartesia itself.
This article is sponsored by Kartesia. It appeared in the May 2016 issue of Private Debt Investor.