Established in 2008, Beechbrook Capital provides private debt for small and medium-sized businesses in the UK and throughout Northern Europe. Currently deploying the capital from its second sponsor-led debt fund, the firm reached a first close at the end of last year, with over £100 million of commitments on its first fund that focuses exclusively on sponsorless debt financing, the UK SME Credit Fund.
How did you identify the need for a sponsorless fund?
PS: We have been investing in the lower mid-market since our inception in 2008, although the focus for our first two funds was on providing debt in buyout and other private equity-led situations.
However, we found ourselves frequently approached for financing by UK borrowers, or their advisers, who weren't private equity-backed, but who were looking to finance fast organic growth or seeking to make acquisitions. Unfortunately, we had to turn them down because we didn't have a mandate to fund deals that weren't led by private equity funds.
But we could see there was a great opportunity to establish a complementary fund to provide debt to similar-sized businesses (i.e., those with a turnover of between £10 million and £100 million and an EBITDA of at least £1 million) that were high quality but lacked a sponsor.
JH: We've seen a long period of sustained consolidation in the UK banking sector, as a result of which we now have just four main banks, plus two others, providing finance in this part of the market. There simply aren't enough banks to provide finance for the 40,000 or so companies within our size range.
Moreover, given the changes in regulatory requirements, banks are often now only looking to provide short-term, transactional finance, such as bank accounts, credit cards and, in some cases, asset-based lending. Five to ten-year term loans are no longer core to their business, especially not for event-driven activity, such as acquisitions, so we could see that there was, and is, a real need to support the growth plans of high quality lower mid-market companies with bespoke financing.
There are already funds targeting sponsorless companies. Why did you feel there was room for a Beechbrook fund?
PS: This part of the market is nascent and, while the credit fund market has deepened considerably, most funds still focus on private equity-backed deals and on providing financing of at least £20 million to £25 million. Our fund sits below that, offering between £5 million and £15 million. But it's not just about quantum; we see the sponsorless market as being quite distinct, and therefore an area that needs a specialist fund with a strong, specialist team.
JH: Success here depends greatly on our origination skills. Private equity firms obviously do a lot of sifting of opportunities. By backing a business, they are signalling to lenders their confidence in that business and their belief that the transaction has merit.
Origination is much harder in sponsorless deals – and that's possibly why there are so few funds actually doing them. We spend a lot of time with company intermediaries, so we need a high level of internal resource to develop good relationships with the networks of debt advisers, corporate finance advisers and banks to generate enough deal flow. We expect to complete between eight and ten deals a year, but we will analyse around 200 opportunities over that period. You just have to put a lot more resource into how you sift through opportunities than you do in sponsor-led deals.
This part of the market is also distinguished by its risk characteristics. We deal directly with owners and managers of businesses, who tend to have a lower appetite for risk than private equity owners. That means the leverage employed tends to be lower than in a business of comparable size that is backed by private equity. And that, in turn, means the risk-return characteristics can be attractive for many investors.
PS: Institutional investors are taking an increasing interest in the lower middle market. The larger institutions can allocate funds to our market through specialist advisers and funds of funds who know firms like us very well. That way they can invest large ticket sizes; that was how the private equity and hedge funds developed. But some big funds with specialist teams do invest direct – we have several pension and insurance investors in our funds.
Given that you have identified 40,000 businesses in your target space, what are you looking for in the companies you back?
JH: We only want to back high quality companies that are growing reasonably quickly and that need finance to support that growth. These are often family-owned, or owned by the managers of the business – the wealth of these individuals is often tied up in the business and that's an important criterion for us as lenders, as they have significant 'skin' in the game.
As credit specialists, providing senior, unitranche lending with a running cash flow yield and attractive, all-in risk-adjusted returns, we tend to concentrate on cash flow. In effect, that means we tend to focus on service-based companies, as opposed to industrial businesses where secured lending is already provided by many of the banks. That said, we can provide finance to all sectors across the UK. We are looking for a wide spread across the country and so we will be building out our team further and potentially expanding our own office network.
PS: We have already backed two businesses, with a third deal almost completed. One of these is Oxygen Free Jumping, a company operating trampoline centres in retail and former-warehouse sites. Run by a strong management team, with backing from high-net-worth individuals, it was looking to increase its number of sites from two to nine during 2016. The team could see that this was a rapidly growing market and we provided an £8 million loan. Already, the company is on the point of opening two new sites, in Wigan and Manchester.
So where would you say you fit within the overall funding landscape for SMEs?
JH: We want to provide the kind of old-school relationship lending that the banks used to offer. In other words, not so much a product, more a service. We can be very solution-oriented for our clients, in that we can provide flexible structures to match their financing needs.
We view each deal on an individual basis and work to develop a package that fits what the client is trying to achieve. While other funds look more to the junior end of the capital spectrum when they do sponsorless deals, we are typically in the senior unitranche space, seeking covenants and security.
PS: Also, I think borrowers perceive similarities between themselves and us, that we are an entrepreneurial business seeking to grow, just like them. We are also UK-owned and UK-based. That is an advantage for us because it means we are close to our customers, who like the fact that they are engaging with the people who make the decisions.
We support our customers in non-financial ways too, just as private equity does. Many of them are on a growth trajectory and are still shaping their business. We can help them with corporate governance and the make-up of their board, as well as assisting with reporting. We have observer rights on all the deals we do, sometimes taking a non-executive or chairman role on the board, which allows us to help entrepreneurs build out full teams where necessary.
We believe that the kind of discipline that private equity offers is healthy both for the business itself and for us as lenders.
And how do you see this part of the market developing?
PS: This is definitely an area of growth and I think we will see more funds entering this part of the market, although success will depend ultimately on building the relationships necessary to generate deal flow. I see it as complementary to bank financing and I expect to be working alongside the banks, as well as advisers.
Banks have already shown that they are willing to bring us deals where they can't provide medium-term financing themselves. Oxygen Free Jumping, where another lender and the debt adviser introduced us to the management team, is a case in point.
JH: I agree, especially as banking regulation seems to be encouraging this direction of travel – SME finance will increasingly come from funds rather than from banks. Our plan is to focus on UK sponsorless finance. There is a lot of opportunity here. It is an area where you need people on the ground to originate proprietary deal flow and where you need to keep decision-making close to your customers. And that is what we are doing.
This article is sponsored by Beechbrook Capital. It appeared in Private Debt Investor's Sponsorless Finance supplement, published June 2016.