Direct lenders in Europe’s lower middle market are sitting pretty going into 2024. While their peers wrangle over ever-larger deals amid the private credit boom, those at the small end of the market are spoilt for choice.
Notoriously difficult to define, the average loan size in the lower middle market is somewhere around €15mn, market players say. Lenders provide bespoke financing for sponsor-owned firms, plus funding for the sprawling and under-served community of non-sponsored borrowers. Some funds also venture into stressed lending for small companies.
“We are facing a perfect opportunity set. There are only a handful of credit funds in the DACH that service 14% of the economy,” said Matthias Mathieu, managing partner at Bright Capital. By contrast, he said, there are roughly 45 lenders in the DACH middle market focusing on just 1% of the region’s firms.
Banks are still the main lenders in the lower mid-market, but they have proved wary of small businesses as rates rise and economic uncertainty looms. According to the European Central Bank, there has been a “substantial” tightening in banks’ credit standards since early 2022, and risk perception has been a greater concern for SMEs than for larger firms, causing more loan applications to be rejected.
In the UK, banks are reluctant to lend to borrowers with high-growth strategies, particularly those trying to expand overseas, said Karun Dhir, managing director at AURELIUS Finance Company, an asset-based lender.
Meanwhile, money flowing into private credit funds has been focused on lending to mid-sized and large borrowers – witness the anticipated €20bn-plus fund for Ares. Despite the huge field of potential borrowers, there has been the least inflow into the lower middle market, say market participants.
Of course, the small number of players – and hence less competition and higher borrowing costs – can be attributed to the fact that many mid-market lenders perceive the dangers as too great. The view, as described by one manager, is that the businesses are less mature and carry higher risk, and it’s also harder to scale a direct lending fund at this end of the market.
To Markus Geiger, head of private debt at ODDO BHF, it’s a missed opportunity.
“The most active part of the direct lending market gets the lowest allocation; this disparity means there is a misallocation of capital to where opportunities exist,” he said.
Better insulated
The abundance of borrowers means lower mid-market lenders are less subject to the pressures that plague their peers further up the food chain, especially around sponsored-deals. On smaller deals, lenders can have better control over pricing, and remaining steadfast on terms is a must.
Described as a “Goldilocks” zone, deals between €5mn and €30mn are typically bilaterals so the lender can negotiate terms, documentation, and structure, according to Fidelity’s Direct Lending White Paper 2023.
“Deal terms have remained attractive and remarkably stable in the lower mid-market since we started investing in this opportunity back in 2015,” said Timo Hara, partner at Certior Capital.
Leverage for borrowers in the sponsorless lower mid-market is also “several turns lower than for larger sponsored transactions especially in recent years,” he added. “Across our portfolio of 400+ mostly senior credits, net debt to EBITDA has kept fairly steady at 3.5-4x,” Hara said.
Last year, spreads on large direct lending deals narrowed as credit funds competed with underwriting banks for a limited number of M&A transactions. Pricing for sought-after large-cap deals dropped below the E+600bps threshold and is expected to stay there for a while.
In the less transparent and more tailored smaller end of the market, deal pricing was maintained on average at E+700bps to E+1000bps for the less risky assets, while it can go north of E+1400bps in some cases, according to market participants.
Calling time
Looking at call protection, larger private-debt deals have shortened non-call periods to help compete with the syndicated market, but call protection remains more onerous overall.
UK-focused data shows 82% of mid-market deals had call protection, per DLA Piper’s European Debt Finance Intelligence 2023. Further, the protection on just over two-thirds of the deals it tracked expired after 24 months.
Source: DLA Piper UK
For London-based lender Beechbrook, which focuses on the lower mid-market, 36 months is the sweet spot.
“We usually secure call protection for three years, sometimes compromise at 2.5 years,” said Paul Shea, managing partner at Beechbrook, adding that the lender doesn’t “always need three years if we have an equity kicker”.
Trash and treasure
Delving deeper into the risk profile of the lower mid-market, some participants expect more calls for their capital as a result of the tight economic environment and the ensuing corporate pain.
“We are happy to lend to firms in special situations, like a turnaround or a transformation,” said Karun Dhir at AURELIUS.
Elevated interest rates, along with high energy and labour costs, have pressured operating costs – feeding the demand for loans from lenders that are open to higher-risk situations and stressed credit stories.
“When economic conditions become more uncertain, opportunities will be easier to win,” said Jens Jantzen, managing partner of Dexteritas, a Dutch lender offering facilities to firms with “non-perfect cash flows and liquidity issues”.
With roughly 60,000 firms in the Netherlands behind on COVID repayments and struggling to make their finances work, banks do not have the capacity to pick up the slack, Jantzen said.
Defaults more visible
Looking across the mid-market, the default experiences of the upper and lower tiers may develop quite differently over time, say sources, since maintenance covenants still prevail on smaller debt facilities and there is less flexibility around tests.
“I think default rates could be artificially low in the upper markets as covenant headroom is set wider and certain deals are covenant-lite. This is not the case with the lower middle market, where we have a full package of maintenance covenants with limited headroom,” Beechbrook’s Shea described the situation.
Lenders at the lower end tend to work even more closely with their borrowers, putting them in position to detect potential difficulties early on.
“Combined with regular information flow, such as board packs, this ensures we know what is going on and we have a seat at the table if there is a challenge or opportunity”, Shea added.
AURELIUS’s Dhir sees potential for a shake-out as defaults start to go up: “I worry that most of the alternative lenders have been set up because they see opportunity in the market to deploy, but it’s easier to deploy money – the hardest thing is to get money back.”
Stephan Roth
LevFin Insights
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