The case for small deals in emerging markets

Considering the large amounts of dry powder amassed by private debt GPs from their LPs, it is understandable that the focus is on finding large deals backed by private equity sponsors in established markets. Due diligence is straightforward and timely, and GPs can move quickly to the next deal. However, high competition has pushed internal rates of return down and has reduced covenants to symbolic status. Even excluding unforeseen factors (such as viruses) LPs should be comfortable that their investments can sail through downturns relatively unscathed.

The alternative of investing in debt funds focused on the smaller end of the market, especially in emerging markets, should be considered by LPs that allow this type of mandate. The advantages are several. To start with, competition is scarce, as bank penetration in emerging markets is substantially lower than in developed markets and, on top of this, capital markets are very thin. Multinational corporations in these geographies are usually relying on their owner’s credit or guarantee to access needed capital, but SMEs are in need of creative financing solutions which can only be provided by alternative investors.

Although having a high growth potential in their local (and sometimes regional) markets, SMEs are overlooked by banks, mostly for the lack of tangible guarantees that the bank regulator is imposing as a precondition for traditional bank financing. As a consequence, these smaller businesses, although well managed (usually by owners) and financially successful, are willing to borrow from private debt funds at a higher cost and fully accept standard covenants in their loan agreements.

They like it even more if the lender is of a hybrid type and happy to share the upside of their enterprise value growth, as they feel that their interest will be better aligned in the case of unforeseen (and temporary) hiccups in their cashflow. For the lender, this is significant upside potential for its IRR and an opportunity to closely supervise the management as a shareholder. These risk mitigators and levels of return cannot be achieved in the case of sponsored deals or bigger corporates with easy access to bank finance or syndicated loan markets.

On top of these competitive advantages for funds catering to the smaller end of the market, having smaller investments in many SMEs is, in itself, a mitigator through the distribution of risk.

The tricky part is, of course, the ability of GPs to understand the local corporate culture and jurisdiction and their capacity to manage risk on a daily basis. Many of these SMEs do not have sophisticated management information systems but these can be easily implemented through the digitalisation of their processes, which GPs can impose and make sure that, through their own risk management systems, they can keep a close eye on the daily business of their investees.

For LPs, the biggest issue should be the selection of the appropriate GP, especially because the big, established ones do not usually invest at this end of the deal size spectrum and in these geographies. New asset management teams, made up of people with solid knowledge of the local markets and a background in banking and corporate finance, are available, but, usually, have a limited track record in these new markets. Careful consideration should be given to the reputation of the members of the GP management team but, overall, the risk/reward ratio should encourage LPs to consider allocating capital to this yet untapped market.

Moreover, providing growth capital to SMEs in less developed markets has a strong “impact” flavour, as it supports local employment and ownership and, if GPs are taking on this mandate, should incentivise smaller corporates to implement ESG policies which they would otherwise not be too interested in.

Catalin Voloseniuc is a partner at SEE Credit Partners, a Bucharest-based debt advisory firm