Direct Lending Funds – Are the Needs of Mid-Market Companies Being Met?

by Michael Romanek of Rise Partners Limited, 10/19/17

In a recent discussion with one of Europe’s largest banks, the bank declined to proceed with what was a quite plain-vanilla corporate lending transaction of EUR 100 million. Historically this deal would have been a “bread & butter” transaction for this desk (good ticket size, stable company revenues and EBITDA, non-cyclical sector and based in Northern/Western Europe), so owing to the obvious, the desk head felt obliged to give open feedback and said “Michael, off the record, we don’t really consider corporate lending as a business line of the bank at present; I wish the situation were different”. I thanked him for his openness, but the statement really reinforced the fact that years after the financial crisis, banks are not actively supporting mid-market businesses. In a separate discussion with a large direct lending fund during the same week, I asked where they were seeing their deal flow sourced, they replied “We’re probably seeing about 75% from banks and the other 25% from guys like you”.

Against this anecdotal backdrop, the market has experienced substantial growth in both the number and sizes of private debt and direct lending funds lending to small and mid-size enterprises (SMEs). We’re experiencing strong and growing institutional investor appetite for the sector and many managers are making light work of raising/closing new funds. However, we must address and monitor the core metric which ultimately gauges the success of this sector: Are the needs of mid-market companies being met?

In my initial discussions with European SME clients, I note to them that my sources of debt capital are mainly comprised of private debt and direct lending funds, institutions and family offices (the latter two groups doing deals directly). As SME corporate clients are generally not familiar with direct lending funds, my brief explanation to the client is that the margin cost will generally be higher than what they may have seen from banks in prior years, but with this added cost there is generally much more flexibility in deal structure. Benefits of private debt and direct lending funds in comparison to bank lending may include:

less restrictive covenants
choice of cash-pay or PIK interest (payment-in-kind / rolled-up)
non-amortising or non-standard amortisation schedules
flexibility to structure around the plans/needs of the company
ability to “toggle” on or off some features during the loan term
ability to structure hybrid solutions across the company’s capital structure

PRICING & TRANSACTION SIZE

Regarding pricing, there is a “hole” in the pricing spectrum; few financing transactions are being funded from +350 to +500 margin (3.5% to 5.0% over LIBOR). This is resultant of banks not pricing risk and debt funds having higher minimum return targets. To clarify, we see banks pricing deals up to around +350 over; should the risk level warrant higher pricing, they merely decline the deal. On the other side, most lending funds have minimum target thresholds of around 6%. Certain funds may have return targets that can facilitate lower rates, but these are presently more outliers than the norm. This combination results in far fewer deals being transacted between +350 to +600. Oddly, risk is often not the main driver in pricing deals; ticket size often plays an outsize role. This is resultant of the majority of the larger funds generally having minimum ticket sizes of 20-25 million (currency roughly interchangeable between (GBP, USD or EUR) with “sweet spots” between 25-100 million. This leaves a corporate client seeking 15 million of lending having a smaller subset of lending funds which can accommodate their need. Smaller deals are usually accommodated by funds who either by their size (sub 300 million) or by design (they specifically target sub 25 million size lending tickets). This has manifested a situation where larger funds are seeing compression in margins due to competition while smaller deals will be priced at up to 300 basis points higher for the same risk.

MATURITY

Excepting a small percentage of funds with “evergreen” capital, most are structured as private equity type vehicles, so have fund life spans of around seven years. Working within this constraint, funds seek to deploy capital over the early years of the fund and roll deals off toward the end (maybe putting in some short two-year deals from the mid-point of the fund’s life cycle). This manifests as most funds being active in lending of tenors of 2 to 5 years. Seven years is usually the longest maturity and 8 to 10-year money is seldom found. This liability matching to the fund structure may also lead to maturities being longer than what the corporate client ideally seeks as there is widespread use of make-whole or non-call provisions often of up to 3 or 4 years.

STRUCTURE

Whereas the practices regarding pricing and maturity can be viewed as negatives for direct lending funds; flexibility of structure is a positive that will often outweigh the prospect of paying higher margin rates or having longer non-call periods. It is the level of flexibility of structure that doesn’t just make direct lending a replacement for bank lending, but something altogether “new” that will continue even if banks return to more aggressive lending. Private debt (for sponsored deals) and direct lending (for non-sponsored deals) have provided companies with both a level of flexibility and speed of execution that is both welcome and now integral to their plans.

STATUS & UPDATE

Direct lending is today’s “darling” of institutional investors; fund raising has been stellar in the past two years. However, now some in the industry are pointing to excesses of “dry powder” and are foreseeing problems believing that funds will become more lax in underwriting and covenants. However, I believe the real driver to watch is the collective “risk appetite” of the institutional money going to alternative debt – in brief, their risk appetite “trickles down” and we now see many large funds chasing the same trade. The real risk is not of excesses of money pushing funds to become covenant-light, but of large amounts of institutional money going into funds to chase the exact same risk which will cause specific problems by sector, geography or size of corporate – i.e. if everyone is chasing non-cyclical western European corporates with 50 million revenues and 10 million EBITDA, we could see isolated “bubbles” in companies that fit that parameter. The direct lending space will best develop with groups having more diverse approaches and appetites; not just investors throwing more money at the sector.

I believe SMEs will be best served if alternative lending continues as the label implies – be alternative; not just grow larger and morph into being big-bank surrogates.

www.risepartners.com

Direct Lending Funds – Are the Needs of Mid-Market Companies Being Met?

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