Mid-market lending: Niche v Generalist funds

The meteoric rise of the private debt fund market in recent years is reshaping the way companies source and use finance both in the US and in Europe. It’s also changing the way investors allocate their capital, with private debt fund commitments now increasingly either adding to alternative asset strategies or replacing some fixed income investments. Indeed, PDI figures show that over the five years to the end of 2016, private debt fund managers globally have raised a total of $462 billion, a sizeable increase over the $395 billion five-year total to 2015.

To date, much of this capital has been concentrated in larger funds, the likes of Ares, for example, which raised €2.5 billion for European private debt in 2016, and Hayfin, which raised over €3.5 billion earlier this year, up from €2 billion in its 2014 fund. And then there is a swathe of new entrants targeting similar areas of the market, such as Pemberton’s €1.2 billion European mid-market fund raised last year, while Canadian pension plan- backed Northleaf earlier this year raised $1.4 billion for its first private debt fund.

Yet behind these mega-funds comes a trail of smaller funds seeking capital. “There are some large funds that domi- nate the European market,” says Fenton Burgin, head of the UK debt advisory team at Deloitte. “Then there is a long tail of newer entrants that are struggling to differentiate themselves, especially to borrowers, in what is becoming a commoditised market.”

Some of these new entrants are starting to seek out niches, as Tavneet Bakshi, partner at First Avenue explains. “Two to three years ago in Europe, we had mid- sized groups who were the go-to names in private debt and these have managed to raise significant funds over recent times. But as these groups move up in scale, space for smaller and more niche players is expanding.”

Duncan Riefler, senior advisor at Arbour Partners, agrees. “The mid-market has become very crowded,” he says. “Newer firms really need to tell a story if they are to get traction in the market.”

Groups are looking to specialise, both to make themselves attractive to borrowers and to tap a growing desire among some investors to fine-tune their private debt allocations particularly in the US where the market is more mature.

“We are seeing more niche strategies emerge as the asset class becomes better known and people recognise that there were lots of niches which banks dominated but no longer play in,” says Gregg Disdale, head of illiquid credit at Willis Towers Watson. “Some of the areas we are seeing develop are ABL, lending to specialty financing companies, MPLs as an alternative to these players seeking securitisations, transitional (change of use) real estate and some smaller specialist distressed funds, which are filling the space vacated by some of the larger players.”

Added to this are some other areas, says Justin Mallis, principal at First Avenue. “Niches we are seeing emerge include real estate debt, which has developed into a more mature area, energy debt, retail and consumer, healthcare, enterprise software and ABL,” he says.

The US is clearly leading the charge here, given its more mature market and more experienced investor base when it comes to private debt. What might we expect in Europe? Country-focused funds is one trend – Italy’s Quadrivio and France’s Capzanine are among those pursuing geographic focus – and sector-based strategies may be another.

“We’re not there yet, but as the market matures, we will see more funds gravitate to more of a sector focus,” says Burgin. “That will help funds secure deal flow, deploy capital as well as presenting a scalable opportunity.” Yet many believe it’s unlikely we’ll see quite the range of funds available in the US. “I’m not sure that Europe will naturally go the way the US market is heading, with a lot more specialist strategies emerging, although clearly there will be some,” says Disdale. “If you look at how private equity has developed in Europe, the different market dynamics in each country and the difficulty of transacting across the whole of Europe has meant that specific sector focus funds, for example, are far less common in Europe.

Dealflow

Generalist

Positive

Many of the larger groups have built strong relationships with private equity sponsors that can help generate deals. Companies also like the deep pools of capital these funds can offer. “The larger funds are attractive to many borrowers, not just because of the quantum they can provide, but also because their larger size now means they are able to provide a sole financing solution with follow-on financing potential, which banks can’t,” says Mallis.

Negative

The crowding of the market means that many funds are chasing similar deals and an over-reliance on sponsor-led transactions, which could present issues if the market takes a downturn. 

Niche

Positive  

There is arguably less competition with a niche strategy and managers will be able to build a strong network. “Sector focus will be attractive to borrowers,” says Burgin. “If they can gain comfort that the fund understands their business and strategy, they will feel more affinity and alignment with this type of fund.” Many are also looking to partner with banks, which can provide some off the beaten track opportunities.

Negative

Origination in some strategies may be an uphill struggle, requir- ing a lot of shoe leather to identify opportunities, plus an effort to educate parts of the market that are not yet accustomed to private debt fund investment.

Fundraising 

Generalist

Positive

Many investors have still to scale up their private debt exposure and so welcome the diversification generalist funds can offer as well as the ability to deploy larger amounts of capital. “There has been a lot of capital raised in the mid-market space, with some significant funds raised over recent times,” says Paul Shea,co-founder of Beechbrook. “This is because there are many large investors looking to deploy capital in private debt strategies and they need to write large ticket sizes to shift the needle in terms of overall exposure and risk-return characteristics.They also have limits on how much they can invest in each fund as a percentage of total capital raised.”

Negative

It’s possible to argue that many longstanding investors now have enough exposure to mid-market strategies and may be look- ing to limit new commitments to what has become a crowded space. It may also be that some of the larger funds don’t in practice provide the diversification investors are seeking. “Typically, 50 percent to 70 percent of pan-European private debt fund investments are to UK-based businesses and I think we’re starting to see some fatigue around plain vanilla funds,” says Mallis. “This means that many are starting to think about how to access individual countries or sub-regions.”

Niche

Positive 

Increasing sophistication of investors, particularly in the US, means that some are now actively seeking out differentiated managers to back in a bid to fine-tune their exposure and give them greater control over how and where their capital is deployed. “In the US, we’re starting to see the emergence of core-satellite or core-complementary strategies that enable LPs to have an anchor allocation to a moderate risk-return strategy which targets around 5 percent to 6 percent return, complemented with other more specialist funds that can provide higher risk-return profiles,” says Mallis.

Negative

It’s still early days, particularly in Europe, where investors are still building out portfolios and so convincing them to back a niche could be an uphill struggle. “More niche strategies will emerge,” says Shea. “The issue is whether LP demand keeps up with this. There are some investors who have been investing in private debt strategies for some time now and know exactly which parts of the market they want to be in and how to access them. However,there are still many that are still mapping the market and getting investment committee approval for private debt – their first step is likely to be in larger, more diversified funds.”

Talent

Generalist

Positive 

 
There is now a deep pool of expertise in the generalist funds that have built up track records managing third-party capital, including some with some very specific expertise. “US firms are often resourced with a good mix of skills,” says Burgin. “They range from financial to industry and sector backgrounds. That means they can also target specific niches.”

Negative

As the industry matures, we may start to see spin-outs, much as we did with the private equity industry as generalist firms move up the fund size spectrum, with some talent moving out of the larger groups.

Niche 

Positive 

There should be no shortage of people with specific expertise as banks have scaled back their activities. “Where niche players are emerging, they tend to be led and staffed by people who have been lending in these areas for some time – there is a deep pool of talent coming out of banks, hedge funds and other credit groups,” says Bakshi.

Negative

They may lack one vital ingredient as far as LPs are concerned. “The issue is that they lack the track record LPs may be looking for and they don’t have experience of managing third-party capital through fund structures,” adds Bakshi.

Resources

Generalist

Positive

The more established generalist firms will already have the right resources largely in place and can benefit from efficiencies of scale, enabling the management fee to stretch further.

Negative

As funds creep up in size, greater scrutiny and the requirement for more institutionalised processes requires more intensive back office resourcing.

Niche

Positive

Smaller firms are both nimble and more able to draw from outside resources. “You’ve now got organisations that can provide several services for you, much like in the hedge fund business, where they will help you set up, find a COO, do your accounting, give you an operating platform,” says Rie?er. “This obviates the need for investment upfront in resources as well as providing comfortto LPs, who will be familiar with many of these firms already.”

Negative

Many strategies can be resource intensive. “Our sponsorless SME strategy requires more resources than a more generalist fund would,” explains Shea. “We need to be close to our com- panies and be more hands-on, particularly as we can’t rely on private equity backers to manage issues and ensure corporate governance is appropriate.

Risk and returns

Generalist

Positive

With longer track records and experienced team members, LPs will be reassured that firms are capable of generating the returns they are seeking at the appropriate risk level. “The large funds have real scale and diversity,” says Burgin. “This means they are not concentrated in single areas and can provide a relatively stable return profile for LPs.”

Negative

As more entrants come into the market, terms and conditions and yields are being supressed. “The sheer volume of money trying to find a home is having an effect either on returnsor on the risk profile of the investments being made in some cases,” says Burgin. 

Niche

Positive

“Niche players can offer investors something different in terms of risk-adjusted returns and increased demand from specific types of borrower in areas that are less competitive,” says Shea. Disdale adds: “If you have a particular skill in more complex areas and/or less scalable strategies, we believe there are opportunities to be quite handsomely paid for the effort as a private debt player.”

Negative

Concentration risk is an issue, notably with country funds.. “We’re a little sceptical of country-focused private debt funds if you’re going to be doing sponsor-backed M&A-type lending as this relies too heavily on the market conditions being right in a given country so we prefer the ?exibility to rotate across them,” says Disdale. “More specialist strategies, such as spon- sorless SME, however, may require more of a country focus as networks are more challenging to create.”