There are many reasons to favour the smaller cap deals in times of economic uncertainty, argue Klaus Petersen and David Wilmot, founding partners, and Louis-Matthieu Heck, partner, at Apera Asset Management

You can read the article at PDI here, or download a PDF of the article here:

Q: Where do you currently see the most compelling investment opportunities for credit funds in Europe?

Klaus Petersen: We are looking at a unique investment environment because of the economic downturn. Rather than looking at any specific industry or geography, we are seeing that the normal providers of capital across Europe are going off risk, reducing their commitments and getting out of the market, which means the supply of capital is massively reduced. M&A volumes are down as well, but that creates a highly attractive environment to invest because the terms for debt transactions are improving, both with respect to credit structures and pricing.

The best time to invest a senior secured strategy is during these down-cycle periods, because you can reduce your risk through more conservative credit structure, and while credit terms are improving the supply dries up, which means you also can demand a premium. At the same time, only the strongest credits will come to the market, as weak credits will not find buyers or financing. Marginal deals will not be completed in a downcycle market where credit quality is one of the main concerns.

David Wilmot: In terms of execution of credit strategy, you need to be keeping to good credit fundamentals, which means businesses with non-discretionary demand and visible, recurring revenues that have limited correlation to downward economic cycles. You want to focus on businesses with limited non-controllable risks, with limited or no exposure to raw material input costs and energy costs, and where margins are not being squeezed.

Louis-Matthieu Heck: Private debt investments are predominantly float-ing rate instruments, which means that in a rising rate environment they will benefit from enhanced returns. Legal deal documentations and term sheets will see the reintroduction of substantial floor levels, which is something we have not seen for a while. They enhance returns, so are another positive development for lenders.

Q: What does Apera find particularly attractive about the lower mid-market opportunity?

KP: The reason why the lower mid-market – defined as transactions with less than €100 million and more than €15 million of debt – is so interesting is that it offers the largest pool of investment opportunities; around 700 per year. The ability to choose and select the best credits is a massive advantage, whereas in markets with lower transaction numbers you may be forced to finance marginal deals. In addition, the lower mid-market is structurally different from the upper mid-market because the main provider of financing is the banks, who have de-emphasised the space creating a de-mand-supply imbalance. There is more demand than private debt providers can supply, which means there are better credits in terms of leverage levels, lower loan-to-value and stronger covenants.

DW: These dynamics leave us with a long-term, structurally under-supplied market for debt transactions in the lower mid-market. That was one of the key reasons for us setting up Apera in the first place. Banks have been reducing their exposure and the larger cap funds have been compelled to move to the higher end of the market. There is an opportunity cost to big funds of trying to stay in lower mid-market deals because each deal doesn’t really enable them to deploy sufficient capital relative to the size of their funds. There is a broad scope of investment opportunities in the lower mid-market with no single dominant debt finance provider, which makes it a very positive environment for selective portfolio construction.

L-MH: The debt providers are also simply closer to the client and the borrower in this market than they are in the larger cap segment, both in the deal phase and during the life of the deal. In the large-cap market, lenders have limited say in term sheet discussions because there is so much competition between lenders. Across our portfolio, we have the opportunity to participate regularly in board meetings, which is something you don’t have in the larger cap space. In France, for example, we sit on the board of 90 per cent of our portfolio companies.

Q: How competitive are the banks in the lower mid-market?

L-MH: Banks are still there in the lower mid-cap space; in very national markets it takes just one bank to make a situation competitive. But we certainly see that they are retreating, largely because of increased regulatory costs.

KP: Originally, before the financial crisis, around 60 per cent of the leveraged loans that banks did in Europe were in the lower mid-market. Today, that is down to 8 per cent, so they have massively reduced their exposure and this year there has been almost no issuance. There is some variation across jurisdictions. In the UK, non-banks have been able to provide finance for a long time, whereas that has been different in the rest of the continent. France and Germany have the highest numbers of banks still active and non-banks were only allowed to provide direct lending in these countries from 2013 with the introduction of the Alternative Investment Fund Managers Regulation.

DW: The banks are under pressure and that is probably going to increase, because it is almost inevitable that they haven’t yet been able to fully reflect the impact of non-performing loans as the macroeconomic conditions worsen. Their provisioning does not cover their NPL exposures, instead covering only about 50 per cent of non-performing loans. That is only going to become more inadequate, because those port-folio pressures will likely intensify for them in the immediate term.

Q: How is this part of the market likely to respond to a more challenging macroeconomic environment?

DW: The larger cap transactions will be suffering more from the downward correction that is going on in enterprise value levels in the M&A market. There is a bigger impact on larger cap port-folios because high leverage has driven high enterprise values there. There will also be more financial covenant issues arising in that part of the market.

We don’t think there is going to be the same impact in the lower mid-market, because there hasn’t been those debt-driven enterprise value levels, and traditionally the transactions have been financed prudently and consistently with lower loan-to-value and lower leverage levels.

On top of that, the structural features in the lower mid-market space mean you have maintenance financial covenants in transactions that enable you to react more quickly to worsening financial performance. That allows you to have a discussion with the management team and PE sponsor about how the situation can be dealt with at an earlier stage.

KP: In our portfolio, the normal lever-age level is around 3.5x, LTV is around 40 per cent, so there is an enterprise value multiple of roughly 8.75x. The leverage covenant would typically breach around 5.4x at a 35 per cent headroom, which represents 60 per cent of the enterprise value.

By contrast, in the upper market you typically have leverage of 5.5x and a loan-to-value of around 55 per cent and an enterprise value multiple of 10x. In this case, the leverage covenant typically will breach at around 9.2x at a 40 per cent headroom or circa 90 per cent of enterprise value, so you are really at the cusp of enterprise value when the covenant breaches and closer to a real problem where there is little value left in the business.
Overall, that explains why we expect lower defaults and better recovery rates in the lower mid-market.

L-MH: In the larger cap segment, higher enterprise value multiples and higher leverage multiples mean there are higher covenant levels, so once you get a decrease in the underlying enterprise value it feels like you are burning the candle at both ends. You can’t just wait until your covenant breaches because that is set at a very high level, but at the same time you can see asset prices are melting down. That is definitely a place you would like to avoid and that is less likely to happen in the lower mid-market. Generally, players in the lower mid-market have a more prudent approach, so the risk of asset price deflation is significantly lower.

Q: Which geographies are most appealing as you look across Europe?

L-MH: Globally, across the geographies in which we are operating, most countries tend to be impacted similarly by the economic backdrop. We see interesting opportunities across the board. At the end of the day, in shaky markets it is probably the better performing companies that are still coming to the market, and these companies will still be able to command good terms. However, even on these deals, private debt lenders should be able to achieve better yields.

DW: Looking at the geographies we focus on – the DACH region, the UK and Ireland, France and Benelux – we are looking to have a broad pool of opportunities to select from. It is critical to maintain a high level of selectivity in your deployment. So, the appeal is not so much about the location of the businesses, but the earnings visibility and stability of business models and a limited exposure to uncontrolled risks.

KP: We want to avoid the weaker countries and focus on the strongest economies, like Germany, France, the UK and the Nordics. These countries also have the strongest lender protections, which matters in a downturn. These four geographies represent circa 80 per cent of European dealflow, so they have the largest pool of assets, which is what we focus on.

Q: How can managers differentiate themselves to take advantage of the lower mid-market opportunity through a downturn?

DW: We are emphasising and continuing to prioritise the importance of prudent capital structures, low leverage, strong operating cashflows and strong equity support. These have not been features of all large-cap transactions. Having just raised our second fund at a total of €1.27 billion means we have capital to deploy in the lower mid-mar-ket in times like these, which is a great advantage and there are certainly good deals to be done.

History strongly indicates that in times of macro uncertainty it is overwhelmingly true that cash is king. That’s cash to enable businesses to trade through difficult times and cash for fund managers to deploy well in new investments.

L-MH: Another way that managers can differentiate is to have a sophisticated reporting system – a point where Apera has a significant advantage. It is really important to closely monitor the portfolio in a downturn, both to make sure there are no challenges creeping up that you’re not aware of and to price and structure new transactions accurately. You need a system that works and allows you to really monitor companies and detect any deviations early on – managers without those strong reporting systems will struggle to keep track.

KP: What matters most is experience. The three of us have each been in this market for more than 20 years, and to be able to demonstrate that you have invested through these market cycles provides reassurance and support to those seeking finance.

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