In the early years of a company’s life, identifying funding sources for organic growth or development is generally straightforward. But when that company reaches the stage where it is considering something ‘event driven’ (such as a bolt-on acquisition), they “often have no idea where to find appropriate funding”, says Grant Paul-Florence, head of intermediate capital at fund manager Octopus Investments.
Paul-Florence was one of five professionals operating in the SME financing market who gathered in London for a PDI roundtable recently to discuss trends in the market. One of the key ones was fund managers’ lack of visibility, which meant that borrowers seeking financing with an element of complexity were struggling to know where to turn.
“Some are literally searching on Google,” Paul-Florence added. “We have to go out and look for them – and, when we find them, it’s often a case of ‘This is great, this is the solution we wanted’.”
Moreover, it’s not just borrowers who are failing to appreciate the presence of small company-focused GPs. The opportunity is not well appreciated by investors either. Some LPs say due diligence is a struggle, partly because of a lack of relevant data, and it’s simply easier to back the bigger brand-name funds than a relatively new player in an obscure part of the market.
The danger in such a view is that investors may well be missing out on a compelling market opportunity. No reminder is needed here of the constraints on bank lending, but one may be required of the negative impact of EU state aid rules on the venture capital trust (VCT) and Enterprise Investment Scheme (EIS) sectors – meaning that growing companies find it harder to identify both debt and equity.
In theory, SME-focused debt funds can be a replacement for both. On the equity side, this may sound counterintuitive – but roundtable participant John Harrison of Harbert Management Corporation explained why borrowers may see debt as a preferable alternative to equity: “Some private owners may not want to sell control of their companies, but still need to raise capital for initiatives they are pursuing. We provide some kind of solution to companies that don’t want to relinquish control.”
Many characteristics of the SME market make it theoretically attractive. For example: unlike in larger deals, a full suite of covenants is still common; capital structures are generally conservative; and dealflow is likely to be proprietary. On top of this, returns are potentially eye-catching. Paul-Florence says his firm “aims for mid- to high-teens and we have achieved that historically through a combination of debt and equity”.
One thing the SME lending market cannot yet boast is visibility. Until it grows further, expect many more small company managers to turn to the highly visible Google instead.