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European Direct Lending III: Opportunities In The Lower Middle Market

6/11/2018

 
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RESEARCH PERSPECTIVE VOL.94
NOVEMBER 2018
Download Research Perspective
European Direct Lending III: Opportunities In The Lower Middle Market
Oliver Fochler
Managing Partner, CEO
Tel.: +44 79224 36360
Email: [email protected]

  
Alexandros Kyparissis
Analyst Hedge Funds
Tel.: +44 78431 44007
Email: [email protected]

  
Lending has always been the core banking business over centuries until the great financial crisis hit in 2008, which gave birth to a new asset class: private debt. For years, private markets were dominated by funds focusing on equity and banks on debt. The regulations that came into force in the aftermath of 2008 financial crisis created a funding gap for a specific market segment. Large corporates can finance themselves via debt and equity public issuance or bank lending, but funding middle market and SME corporates remains a challenge. The rise of debt funds together with fintech firms’ efforts to revolutionise alternative credit are shaping the current private debt environment, which is still enjoying a strong fundraising momentum. The 2023 forecast shows an increase for private debt AuM to $1.4 trillion, while assets have doubled since 2008.
Figure 1. Private Debt AuM, Forecast 2023, Source: Preqin
Figure 2. Private Debt AuM, 2013-3Q18, Source: Preqin

Banks have not exited the mid-market or SME space, but are following a different route to access this lucrative market segment. Banks provide private debt funds, fund of funds and fintech lenders with asset-backed facilities and warehousing lines. The leverage facilities are structured like private CLOs without tranching and include the setting up of an SPV with terms: advance rate, deployment and amortization periods, final maturity date, financial and performance-triggered covenants (performing loans and deployment percentage), eligibility of receivables, diversification requirements, regulatory trigger events and risk retention requirements. Interestingly enough, banks remain the main player for lending in Europe as shown in Figure 3, whereas alternative lenders have substituted banks on the other side of the Atlantic.
Figure 3. Proportion of Bank vs. Non-bank lending in Europe and US, Source: ECB, Bloomberg
 
The room for bank substitution compared to the US combined with the reduced lending activity from banks as shown in Figure 4, highlight an opportunity for alternative lenders to become the stepping stone for funding the mid-market, lower mid-market and SMEs. The European Union and European Commission are considering SMEs to be the backbone of the real economy and are focusing on funding this segment of market.
Figure 4. Loans to European Corporations Over €1m as of October 2018 Source: ECB Databank, Stone Mountain Capital Research
 
According to ICG data, European private companies’ fundamentals remained strong in 2Q18 with high interest coverage and senior debt rising as evidenced in Figure 5. Both senior debt and interest coverage are at all time high since the financial crisis, a statistic which is very supportive of the economy’s outlook despite the current late credit cycle. As we start to observe more defaults and delays in payments in the credit market, we need to stress the importance of seniority and experience in distressed situations. We expect senior lending and distressed debt closed-ended strategies to perform better during the current cycle in case funds are raised at this stage and capital deployment starts early in 2019.
Figure 5. Leverage and interest rate coverage of European corporates, 2008-2Q18 Source: ICG
 
Senior lending remains very attractive on a risk-return basis, providing institutional portfolios with uncorrelated sources of income compared to other private and public fixed income/credit strategies. There is embedded complexity and an illiquidity premium that investors can harvest with very low volatility and predictable cash flows. Lending funds have simpler and quicker credit and execution processes that justify higher pricing than banks and can invest across the capital structure. Senior secured and unitranche are the most common structure within debt funds, with unitranche being used by the same lender to enhance the returns with higher EBITDA multiples or higher LTV, but still being the most senior or sole lender in the capital structure.
Figure 6. Corporate Capital Stack Spectrum in US and EU, October 2018, Source: Barclays Research, Moody’s, Stone Mountain Capital Research
 
Lending activity in Europe has peaked and 2Q18 was one of the most active since 2012, majority of which was originated in the UK. Since 2012, 1510 lending deals have been originated, 581 of which were based in the UK. Lending deals have increased significantly since 2017, showing signs of strong appetite for debt.
Figure 7. Lending Activity in Europe, Source: Deloitte Alternative Lender Deal Tracker Autumn 2018
 
There is an interesting distinction between funds that do sponsored deals and those who do exclusively non-sponsored. Investors usually prefer non-sponsored due to higher spread as they usually yield 100-200 basis points higher than sponsored. This premium is essentially the reduced risk as sponsored transactions have usually fully detailed due diligence reports and professional financial reporting systems. The management team should be diligently selected by the sponsor to execute a well-designed strategy. The above factors should be always considered based on the sponsor’s savviness and expertise in the industry. We believe that portfolios should have a mixture of both due to deal characteristics diversification but should be mainly non-sponsored with the credit team relying fully on their credit underwriting standards.
 
Stone Mountain Capital Partners is providing senior secured and unitranche European Direct Lending to the Lower Middle Market in Northern and Western Europe. In Stone Mountain Capital, we believe that comprehensive alternative investment advisory should reach across asset classes and interface between illiquid investments like real assets, infrastructure, venture capital, private equity, private debt, real estate and more liquid investments like absolute return strategies, hedge funds and fund of funds. Our main target is to achieve an optimal asset allocation for our clients in terms of performance, risk and liquidity under consideration of investment structure, size, and track record. Cross asset advisory implies an in-depth analysis of asset specific risk factors. Therefore, we provide the most sophisticated credit, market, operational, liquidity and integrated risk advisory.
 
This perspective is neither an offer to sell nor a solicitation of an offer to buy an interest in any investment or advisory service by Stone Mountain Capital LTD. For queries please contact Alexandros Kyparissis under email: [email protected] and Tel.: +447843144007. For further information around our research and advisory services please contact Oliver Fochler under Tel.: +447922436360 and email: [email protected]. 

The views expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to, Stone Mountain Capital LTD. Readers should refer to the Disclaimer.

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Stone Mountain Capital is an advisory boutique established in 2012 and headquartered in London. We are advising 30+ best in class single hedge fund and fund of fund managers across equity, credit, and tactical trading (global macro and CTAs). In private equity and private debt, we advise 10+ general partners across the sectors real estate, infrastructure / real assets and capital relief trades (CRT) by structuring funding vehicles, rating advisory and private placements. As per 19th July 2018, Stone Mountain Capital has total alternative Assets under Advisory (AuA) of US$ 52.3 billion. US$ 48.2 billion is mandated in hedge fund AuM and US$ 4.2 billion in private assets (private equity / private debt / real estate) and corporate finance. Stone Mountain Capital has arranged new capital commitments of US$ 1.28 billion across hedge fund, private asset and corporate finance mandates. Stone Mountain Capital has been awarded over 20 industry awards for research, structuring and placement of alternative investments.
 
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This research may contain forward-looking statements concerning business, operations and financial performance. Any statements that are not of historical facts may be deemed to be forward-looking statements. You can identify these forward-looking statements by words such as "believes", "estimates", "anticipates", "expects", "plans", "intends", "may", "could", "might", "will", "should", "aims", or other similar expressions that convey uncertainty of future events or outcomes. Forward-looking statements include statements regarding our intentions, beliefs, assumptions, projections, outlook, opinions, analyses or current expectations concerning, among other things, results of operations, financial condition, business outlook, the industry, sector or region in which we operate or for which we provide research and the trends that may affect the industry, sector or region or us. Although we believe that we have a reasonable basis for each forward-looking statement contained in this research, we caution you that forward-looking statements are not guarantees of future performance. All of our forward-looking statements are subject to known and unknown risks, uncertainties and other factors that are in some cases beyond our control and that may cause our actual or our research results to differ materially from our expectations. Except as required by law, Stone Mountain Capital LTD undertakes no obligation to publicly update any forward-looking statements for any reason after the date of publication in this research, our website, or on linked websites, whether as a result of new information, future events or otherwise.
 
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