Against a backdrop of unprecedented macro and geopolitical volatility and the mid-market lending space becoming ever more crowded, a group of debt funds, advisors and GPs discussed how lenders are differentiating themselves, providing specialised agreements to sponsors and also working amidst macro risk.

Speakers: 

Shaun Hyland, Director, Leonard Curtis

Ravi Anand, MD, ThinCats

Andrea Lennon, Director, Head of Fund Services, Ireland Crestbridge

Richard Williams, Partner, Tosca Debt

Jon Herbert, MD, Beechbrook Capital

Michael Butler Partner, ECI

Doug Wilson, Investment Director, Connection Capital

Moderated by: Simon Thompson, Real Deals

What is the panel’s assessment of the current position of the market? How are the macro headwinds (including war in Ukraine, supply chain disruption, rising energy prices and interest rates and inflation,) affecting the cost, availability, and appetite for debt?

Michael Butler: We're not seeing much of an impact on either appetite or terms. I think that while there’s been a number of headwinds in the market, it's particularly acute at the moment. At ECI, we've always focused on both growing businesses, but also resilient businesses that can manage through different cycles. The big thing now is cost inflation and the ability of businesses to maintain margins in that environment - it does feel slightly uncomfortable in that the macro backdrop is clearly not great. However, the businesses that we're looking to invest in are still super competitive, they're still moving very quickly and the availability of debt is incredibly strong. So, we’re not currently seeing any impact on terms. I think the market is probably quite polarised and everyone's gravitating towards the quality, resilient assets.

Jon Herbert: I broadly agree with that. Whilst there are lots of unhelpful macro headwinds that will have an impact on certain businesses, our experience in the lower mid-market is that the major influences on businesses are typically micro rather than macro. Quality of products/services, market positioning and strength of management are key. If we think about the financing sector, it is also in pretty good health at the moment, and while terms may not have shifted in a floating rate environment, returns are going up, which is good news, as long as they don’t go up too much. So generally, I think it's pretty positive for lenders at the moment, and there is still strong demand in our part of the market, which means we can be really selective.

Doug Wilson: I’m starting to see a weakening on the demand side for consumer facing businesses, which will likely feed into our investment appetite for, and credit committees’ view of opportunities in this space in the near term.

Richard Williams: Where 2021 was fairly busy in terms of activity due to a hangover period from 2020, I think that the energy crisis [and other macro factors] may lead to a quieter Q4 this year. Ravi Anand: We did a little survey of advisers recently to look at sentiment, and what was surprising was that 75 per cent of them were super positive for Q4, expecting peak volumes. Hardly anyone was super negative about their expectations for the remainder of the year. They expected that while there will be a quiet summer, there are a lot of processes taking place and will continue going forward. The M&A market is likely to continue to be as buoyant as it has been, but will be bifurcated by sector.

Andrea Lennon: From a more macro perspective, I think that given the increased volatility, rising interest rates and inflationary pressures, private debt can offer attractive returns especially relative to equity. However, central banks will be even more focused on factors such as systematic risk, opacity, circular funding, fiduciary responsibility and so on, which will impact the cost to launch new products. For both managers and investors, it is critical to have robust infrastructure to enable managers to operate as efficiently as possible and focus on optimal investor and investment outcomes.

Shaun Hyland: I think from a lender's perspective, what we're seeing is just a natural slowdown. People are saying: let's not get too excited, let's take our time, let's see; even down to the point of the M&A clients who are saying they will wait to see another month's worth of results first, or maybe see another quarter, and then they'll decide whether they sign up for a deal.

Anand: I agree completely. On average, a qualified deal where we have issued indicative terms, used to take about two months to close and now it is taking about four months. 

What are some examples of debt solutions that you have seen become more common in the market?

Hyland: We spoke with one private equity investor with a retail business where financial performance did not support standard import facilities the bank provided. They had an issue with logistics costs and timing, which lowered their margin for the year. As a result, the banks can get very nervous. What we did was put a credit insurance policy in place, made the bank a beneficiary and it gave them the confidence they needed.

Herbert: In the debate around banks versus funds, the banks are going to be quite cautious. Generally, the banking sector is very, very well funded at the moment, so, there's no issues like what they had to face back in the financial crisis, but that is still heavily in their memory. I think banks will adopt a very conservative approach, in my opinion, so for people who want to do business, then the bond market will get a bit of a boost.

Anand: We've seen a lot more aggressive competition from challenger banks. These banks have come back aggressively, with credit structures on leverage terms right at the top end of where leverage should be for sponsor-backed deals. I don't think that will carry on too much longer, because I think books are going to get bigger, too big, even. And of course, higher interest rates are overlaying that in terms of impact on existing borrowers, which is going to distract banks. This is where we will come in and can be more flexible and focused on new business.

How competitive is mid-market lending today? What are the differentiating factors between funds and banks?

Butler: It is super competitive. We’ve done three deals this year and we’ve had multiple lenders with very similar terms on very tight timescales. We only have a view of our own activity, however, and it is difficult for us to say that things have moved in different sectors, lenders and leverage levels, but the gut feel is that it's as competitive as it's ever been.

Herbert: I agree that the mid market is very competitive, although not as competitive as it was in 2007! Most decisions at the moment are still quite reasonable in my view, but there is lots of competition. There is lots of choice for private equity and there's still plenty of money out there, so it's not a lack of liquidity issue. As a result of this, lenders have to try and find ways of competing, and not just on price. That’s why we focus on the lower end of the market, where there is significantly less competition, a better balance between borrower and lender and Beechbrook can be a price maker not a price taker.

Anand: You win deals on flexibility where you like something. Also, good sponsors want two or three lenders on their panel; they want to work with people who they know can deliver because the problem with dealing with the clearing banks is that there’s no certainty that it’s going to happen at any point in time. What we can compete on is that certainty and flexibility. We will likely be more expensive than a clearer, and some of the challenger banks, but they have inconsistency around appetite, particularly in this environment.

Williams: It’s that certainty factor that’s also really important for sponsors. Sponsors and management teams are looking to execute transactions within a defined timeline and need to know that they are not going to be let down. That’s where debt funds really come into their own. Debt funds focus on relationships and adopt a collaborative approach to transacting.

What are the biggest changes that have been seen in terms of sourcing finance over the past 12 months? How easy has it been to secure funding?

Hyland: There was a brief period last year where we were actually starting to see terms coming out without term debt covenants, which is pretty interesting in the SME market in particular.

In regards to rates, they have kind of drifted up, but not very quickly. This is partly down to the fact that there is so much competition. Despite what we tell our clients, the first question they ask is what’s the price and it’s a constant fixation. We say to clients that values are a complex calculation and price is only one factor in it, and I think that people need to understand that.

The important thing around relationships is that no deal is going to go completely as forecast and it’s about having an understanding and appreciation of how that lender is likely to react when the road gets a little bit rocky. Wilson: I’ve not seen any specific changes over the last few months, but I think there has been gradual change over the years. There is now such a range of different options and solutions and there are different ways that lenders are differentiating themselves. This can be very interesting from a borrower or investees’ perspective, because there are so many more options on the table now.

Anand: One of the big changes was around the CBILS loans and the sheer amount of debt that is out there. A lot of that is not going to get recovered, because it’s not worth the money and effort to recover it. Additionally, insolvencies are going to be an issue coming out of CBILs, and more importantly coming out of the macro environment that’s going to hit us in the next 18 months. Credit appetite is going to wane because there will be huge amounts of excess losses and the headline insolvency stats will spook a lot of people. 

How is the macro environment affecting fundraising? To what extent has investor sentiment shifted in the face of inflation and rising interest rates? How are investors allocating to private debt?

Lennon: The observation I would make here is the growth in access to non-bank funding and yield has contributed to managers now offering both equity and debt funding and has led to significant increase in the deal size and a quicker deal turnaround.

I would add that more regulatory obligations may increase the cost to launch regulated investment fund products, which may impact small and mid-managers. I do think that non-bank lenders are playing a pivotal role in funding SMEs, and new regulation in Europe introduces new prudential and capital requirements to large MiFID firms which may in time, extend to different classes of investment firms.

Williams: Fundraising is definitely going to be a challenge for private debt. Specifically, I think first time funds will be at an all time low because it will be really difficult to raise a fund without a track record especially against the macro backdrop.

Herbert: Another trend is that whilst there will be general caution, we’re seeing a lot of volatility in the equity markets, whereas actually in a floating rate interest environment, debt becomes more attractive to equity. As a result, the investing institutions have got to invest somewhere and so I think the dial will move slightly in favour of credit, away from equity, simply because of the floating rate nature of the product.

How are lenders differentiating themselves beyond pricing and documentation?

Herbert: In 2018, we built a fund performance team that provides portfolio management and value add services to our portfolios. The team is staffed with seasoned professionals who are not just experienced in protecting our downside but also professionalising investee companies. For example, in our sponsorless investments, they introduce corporate governance structures and policies, upgrade financial reporting and work on 100 day plans with management. This in-depth knowledge provides value add support and helps de-risk any new investment for our funds.

One of the other things we always include in our funds is a bucket for equity. It could be synthetic equity warrants and similar, or performance fees, but we also have a bucket where we can actually spend money on co-investing alongside the shareholders. Particularly for the high net worth investor groups, for example, having a lender who can put in a million of equity alongside them is an added value.

Hyland: It’s quite useful in that private part of the market where if you’re providing debt and a manager is going to take your debt to buy a business and potentially make themself a pot of cash, it only makes sense that you get a share in that upside. Most of our clients will eventually see the reasoning in that. Without that, it’s sometimes not quite a doable deal.

Wilson: I think another thing that using an element of equity allows us to do is that we can enter into some equity processes as well. Where an advisor is pursuing only an equity solution that’s significantly dilutive from the investees’ perspective, you can convert them into a borrower that is giving away less dilution. So, you can insert yourself into different processes and move across the equity spectrum.

Anand: We did some research on the tech space and there's clearly a gap between venture and senior debt. What I mean by that is if you have got a business coming up the J curve, it's not going to attract senior debt, because it's still a loss making business, but it's deliberately loss making because it wants to invest in growth and it's typically an annual recurring revenue business, where the option generally at the moment is venture debt. Venture debt is highly competitive and relatively expensive, particularly for businesses that have visibility on profitability. So, we're going to provide capital that is somewhere in between venture and senior debt as a bridge for those tech businesses. The key there is that you've got to understand the tech, you've got to understand what's driving ARR and you've got to understand the dynamics of the sector. There's certain sub sectors that can do that well and not others. We see this as an opportunity.

Are ESG-linked ratchets becoming commonplace? How are sustainability metrics being included in decision making around deal terms?

Lennon: Generally and from a governance perspective, I would say by and large ESG data is now commonplace and widely incorporated across the alternative assets spectrum. Around 63 per cent of European assets already incorporate sustainability principles within the investment decision making process. So my view would be that ESG is basically becoming integral to the whole process. It's a bit like tech a few years ago, where you had it as a differentiator, and now it's just core to the value proposition.

ESG is also likely to become a big source of mis-selling in the years to come. So, ensuring ESG is integrated into the risk and governance framework, will be key to avoiding the pitfalls we are seeing around greenwashing and the fines being given out.

Anand: I think it is crazy to try to bucket ESG altogether. The three elements need to be separated and defined, and we need an industry standard to assist in our reporting against each of these areas.

Williams: We can challenge our investors, some of the bigger players and it's not like they've got a ready made template to say what we should be doing. We have been proactive to raise an impact fund to support small businesses. This has been our interpretation that is tangible, quantifiable and socially driven and also there’s employment KPIs that are linked to this. This was our response to showing we’re taking ESG seriously.

Herbert: It's really important that we take ESG seriously. Fundamentally, what are we doing? We're backing growth companies providing capital, and if they're growing, they're making more employment. So by definition, that's good for the “S”.

We have started introducing ratchets into some term sheets where appropriate. However, we expect these to evolve and be finessed overtime. We as lenders are much more akin to the private equity style of influence at board level and that can help with the “G”. So by far the most difficult one in the SME world is the “E”, in my opinion. But, as fund based and credit based lenders, I think we make a massive difference to the “S” and “G”, and we should be really proud of what we're doing in those areas.

Butler: We did our first ESG ratchet in the portfolio recently, and it’s there to drive improvement rather than just saying the business has a great ESG angle to it. We set KPIs early on and it is these that assist with driving better returns, which is incentivising us as a private equity house and incentivising the management team to continue to drive improvement.

Nonetheless, I do wonder whether the market will just accept the ESG position of businesses today. It's actually all about improvement and if you can show improvement regardless of the starting point, then we will reward that. I think there are some businesses that are on the wrong side of ESG, which, to be honest, just make them quite hard to invest in at the moment.