Why aiming small has its advantages

With increasing allocation towards private debt, the mid-market appears crowded in a period where deal activity is lower and commercial terms have drifted away from those in the post global financial crisis era. With limited partners increasing allocations towards established larger credit funds aimed at disrupting traditional loan syndication and bank club structures, there appears a sound opportunity to capture lower market opportunities – defined as debt facilities up to £30 million (€35 million; $38 million), for guidance.

Along with a potential margin advantage of up to 1.5 percent depending on deal specifics, there is an added advantage of lessons learned from the pre-GFC era in terms of structural changes to business models (eg, online retail vs brick and mortar or healthcare models heavily reliant on government spend); the impact of various unforeseen macro and economic events such as the pandemic and supply chain crisis on SMEs over the last decade; and the consequences of too much leverage on small-cap deals – both from pressures for lenders to compete and the increasing gulf between actual and adjusted earnings.

Some banks have since naturally pared back on risk levels, leaving room for private lenders to offer more debt (stretch senior) to justify the higher margins. Some banks have opted to manage risk by focusing on lower-risk tranches such as revolving facilities and often a small amortising tranche senior to funds alongside capturing ancillary clearing revenues.

In the lower markets, primary buyouts and buy-and-build themes continue to remain one of the key drivers for growth, providing lenders scope to increase exposure to borrowers gradually. There is also a historically less bank-friendly carveout and operational improvement strategy that can be lucrative for credit managers that have the skillset to conduct deeper due diligence and structure tailored debt packages.

As a new subset of private equity managers, deal-by-deal funders backed by family offices or single LP vehicles also offer the scope for lenders to co-invest in the equity or offer other more remunerative forms of junior debt to provide extra acquisition fire power. Banks are typically shy of considering such strategies, providing flexible credit managers with a golden opportunity.

Lack of access

Another fillip is the sponsorless segment, where the lack of access to a committed equity fund is seen as a credit risk or impediment in the event of underperformance or unforeseen shocks (eg regulation, loss of a material contract or pandemic) to the business. Again, experienced credit managers that have worked with both subsets of entrepreneurs and private equity can draw on their experience of previous transactions where loan agreements have been in breach and the respective remedies were offered and stances were taken by each cohort.

Many sectors, especially those linked to software, technology and digitalization, were not well understood relative to more traditional sectors such as industrial, healthcare, services and retail pre-GFC. Today, the former sectors have SMEs with very large markets to operate within and grow organically or via acquisitions without holding a top ten market share position.

Similarly, more traditional sector SMEs have embraced technology to become tech-enabled and build a moat in terms of customer retention and operating profit margin enhancement. Inspection and testing, insurance broking, digital consulting and customer engagement software are just a few examples of SMEs benefitting from this transformation. Other sectors such as healthcare and education are experiencing positive headwinds from increasing undercurrents of need for some privatisation or upskilling for a more productive and inclusive work force.

Other possible upsides include longer duration in these markets and therefore an increase in the absolute yield earned by credit managers compared to the mid- and large-cap markets where assets can be churned, or debt structures swapped from private to public markets quicker depending on the wider sentiment across listed equity and fixed income markets.

In order to effectively harness lower-market opportunities, however, there is a greater need for focused origination and client coverage, as these deals are not as highly visible as mid-market deals with an auction mechanism and far-reaching sell side processes, which build awareness. For a pan-European manager, each country will have its own idiosyncrasies in terms of sector influences and the local competitive landscape. Credit managers which are agnostic about originating and more focused on accessing a slice of the loans can potentially scale through partnerships with banks or other like-minded credit managers.

Rising interest rates are significantly influencing the overall cost of borrowing for SMEs, which means that sponsors and entrepreneurs are starting to scrutinise all funding options more closely, forcing private debt funds to offer compelling structures and terms relative to banks to win the day.

In a sense, moving towards the lower-cap markets can offer a defensive strategy for certain credit managers, just like moving into the jumbo deal space is a defensive move by others.

Viral Patel is a private debt professional and founder and managing director of Prime Lead Partners, which provides strategic consulting and debt advisory services