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