Advocates of lower mid-market lending in Europe say it solves a problem faced by those funds that concentrate on larger deals – the intense competition that has forced them to take on much more risk for the same return.
“It’s a more attractive segment compared with the larger end of the market, because you still get decent terms, including covenants that offer good downside protection, rather than the take-it or leave-it deals for larger transactions,” says Matthias Unser, Munich-based member of the executive board at Yielco Investments. The alternative investment fund of funds manager has invested in larger deals in the past but is, as Unser puts it, “more focused these days on lower mid-market strategies”.
But while it is hard to find outright critics of lending in the lower mid-market, plenty of people advise caution. “Companies at the smaller end of the middle market will have a more limited market themselves, and will be subject to country risk, political risk and so on,” says David Waxman, New York-based managing director at Azla Advisors, which guides general partners on fundraising and limited partners on divesting assets in the secondaries market.
“An auto parts manufacturer in Germany that exports 100 percent of its product to the UK is dependent on what happens with Brexit. Obviously a larger company wouldn’t have that kind of risk: it would be more diversified.”
Fans of lower mid-market lending argue if there is a problem, they at least have good protection. Unser says in the lower mid-market, which he defines as loans to companies with an EBITDA of up to €25 million, lenders can usually secure between two and four covenants, rather than just one or even none for many larger deals. He also estimates that leverage, at typically around three times EBITDA and rarely above 4.5, is lower than for larger deals.
He also notes that transactions with non-sponsored companies in the lower mid-market offer a premium, relative to larger sponsored deals, of one or two percentage points. Lenders note that private equity sponsors are extremely good at playing off potential lenders against each other.
But if spreads are higher, logic suggests that the risks of lending must also be greater, if the market is operating efficiently.
Paul Watters, S&P Global Ratings head of corporate research in London, says smaller borrowers are often family businesses, which may as a result have less comprehensive expertise than larger borrowers. For example, “IT systems or general governance may be less sophisticated”.
Waxman makes a similar point: “I wouldn’t be concerned about governance for a lower middle-market sponsored loan, but for a non-sponsored loan there may be some concerns. If the company is 100 percent owned by one family, which has all the seats on the board, there is no outsider to check decisions.”
Unser acknowledges the “slightly higher operating risk” of lower mid-market firms but argues that this is compensated for by lower financing risk: EBITDA might fluctuate more because the customer base is less diversified, but leverage tends to be 1 to 1.5 turns lower. Moreover, the strict covenants and concentration of the entire loan is in most cases in the hands of a small number of lenders, perhaps as little as one, making recovery rates better than for larger deals. This is because the covenants warn the lenders of problems, and the concentration of the debt ownership makes an appropriate response less prone to being blocked by dissension, as well as making it quicker and more effective.
However, some lenders argue that even the upper reaches of the lower mid-market have become too competitive. Their response is to go lower still. One such fund manager is London-based Octopus Investments, which has its tentacles on debt investments of £5 million ($6.5 million; €5.7 million)-£10 million across the UK, mainly to fund leveraged buyouts. Octopus also often invests equity.
“One of the things we really like about this size of deal is that the dynamics are very different to the mainstream mid-market,” says Grant Paul-Florence, the firm’s investment director, who used to work on private equity mid-market deals for another manager until 2014. “The mainstream mid-market is a crowded space, in terms of the number of private credit funds, and also of the appetite of banks to lend.
“That drives certain behaviours and dynamics around pricing and terms. A lot of the deals we did when I was doing mid-market buyout deals involved contract races”, where potential equity investors and their debt partners were compelled to race against the clock, doing due diligence in as little as six weeks. “That’s one of the reasons why I moved away from it, and I think it’s got worse.”
By contrast, Octopus’s negotiating power in this less competitive part of the market is so great that it can insist on a seat on the board of borrowing companies – giving it ultimate visibility over incipient corporate problems.
Blu Family Office, a London wealth manager, goes even lower than this, making short-term loans of up to 18 months and between $1 million and $5 million around the world. Nick Rees, chief executive, describes this as “the sweet spot”. His explanation: above that, businesses have a wider range of financing options; below that, at the level of mass-market lending platforms, such as Funding Circle, the loans tend to be unsecured and more exposed to market cycles and concentration risk.
But if some observers worry about gaps in managerial expertise even for much larger mid-market deals than these, what about managerial competence at this very low end of the market?
Paul-Florence is relatively sanguine about the risks posed by managerial mediocrity for the type of company that his firm lends to: well-established businesses with at least 10 years’ trading. “We will always want to back a strong management team, but because these businesses have a sufficiently strong offering and a sufficiently diverse customer base, if we discover that the chief executive isn’t really the right guy for the job, it’s a nuisance but not a killer.”