No covenant worries here

More attractive deal terms and the ability to be highly selective are among the reasons why investors are increasingly tempted to diversify into the smaller end of the market, maintains Jaime Prieto of Kartesia

What explains the attractiveness of senior strategies in the lower mid-market?

The first element is the sheer size of the market. We look at companies with EBITDA of €5 million to €20 million and that is clearly the largest segment of the market in Europe. Visibility of deals is very significant. You are in a position to be selective and to build a well-diversified portfolio.

The return potential is also strong. In the lower mid-market there are only two traditional liquidity options for sponsorless companies – bank finance, which is standardised and constrained, or private equity companies, which want majority control. In between the two, you have direct lenders that can offer bespoke solutions with more flexibility than the banks and without the need to take majority control. When it comes to returns, you are paid for the flexibility you can offer as you are the only alternative to the traditional sources of capital.

From a risk point of view this part of the market is favourable because the banks are the reference source of capital and they still require full covenant packages and have a traditional definition of EBITDA.

How does the upper and mid-cap end of the market compare and contrast with the lower mid-market?

I think the first element to consider is how the markets are structured. In the larger and mid-markets, opportunities generally come through intermediation networks and differentiating yourself is very difficult. On top of that, at the larger end it’s more competitive, there is less alpha and the risk-adjusted return is lower. There is a lot of capital coming from direct lending but also from CLOs, the high-yield market and banks.

It’s also the case that the reference lenders at the upper end of the market are investment banks rather than the traditional lenders and they will normally syndicate. They are not obliged to have full covenant packages and will take judgments on how to calculate EBITDA figures. Loose legal documents are more commonly found at the higher end of the market.

The high-yield and CLO players have increasingly moved into the mid-market and in the US you even find looser terms at the lower end. But Europe is still mainly reliant on the banks, so you don’t feel the pinch as much. At the lower end, companies can be less stable and the argument is made that this makes them riskier. But because it’s a less intermediated and diverse universe, you can apply selectivity in building your portfolio and that allows you to deviate from the average.

By using that selectivity, you can compensate for a slightly higher loss rate. According to Fitch, the recovery rate of defaulted deals in the US is around 66 percent in covenanted deals and 54 percent in covenant-lite deals where you only learn about the problem when capital is urgently needed. There are a bunch of deals with CLO investors where no one is in a position to take active ownership of any problem and implement a solution. So the larger end may have more stable companies but the recovery rate is typically lower.

How is it possible to build an effective deal sourcing network to cover the smaller end?

It’s a much more fragmented market and many firms don’t have the resources to find opportunities in particular industry segments. You need to be closer to fragmented markets as they are less intermediated. Being local is key. We’re in six countries and that means a big investment in building the firm’s infrastructure that you simply have to make.

You also need to trust all the elements in the organisation. For five years, we had all our directors in London and Brussels and, at the end of those five years, they went out and filled the spots in the local markets. It ensured that we had the same DNA everywhere in terms of our risk evaluation and deal-doing processes, which made our approach effective and coherent.

As mentioned earlier, the lower end is less homogenous and there are fewer intermediaries, so you need to spend a lot of time getting to know companies and building deals from scratch. You need to limit the downside and capture the upside and all this requires skill and experience at the deal-building stage. Another important factor is extending your network as widely as possible, as you can’t rely on any single sponsor. In our case, 50 percent of our deals are sponsorless and we expect that to grow even further in the future.

What are investors looking for now, and what might they want in the future?

I think over the last six years LPs have been looking to get acquainted with private debt and have deployed a lot of capital to obtain beta from larger managers. Over the last year or two, that beta has diminished due to the level of competition and some investors now want to complement their core exposures through more active niche players looking at particular markets, or which focus on asset-backed lending or sponsorless deals.

Today, there is a big concern around downside protection. To some LPs it doesn’t matter whether they get 6.5 percent or 8 percent; what they want above all is resilience in a downturn. They want you to be adept at financial restructuring and corporate governance and be able to work through a downturn before eventually capturing the upcycle. They are also keen to know that you have the know-how and resources to restructure businesses across Europe rather than in just one country.

Why does there appear to be a particularly strong appetite for senior debt from German investors at present?

It comes down to German investors being traditionally more conservative and also to triggers in the financial system. Pension funds have been given more flexibility to invest and have been increasing their exposure to private debt in recent years. Now it’s the turn of insurance companies, which have been given better risk treatment from the regulators and can now go out and seek better returns. For these types of investors recurrent income of 6.5 percent with little volatility and strong diversification is very appealing in today’s market environment. They can get very little yield elsewhere. n

Jaime Prieto is a founding partner of Kartesia, a provider of credit solutions to small and mid-cap companies in Europe

This article is sponsored by Kartesia