European SME private credit: limited supply of capital and low levels of competition see local lenders generate attractive returns
At the recent Certior Capital European SME Private Credit Round Table at SuperReturn International in Berlin an audience of leading institutional investors and fund managers discussed the current dynamics of the market. As Ari Jauho, Chairman of Certior Capital, a leading fund-of-funds manager focused on SME private credit, and in seeding new managers, in particular, concluded:
“While in recent years a wall of capital has poured into mid-market direct lending funds targeting a limited pool of larger transactions, SME direct lending funds focusing on loans in the EUR 5-25m range have seen far less fundraising. According to Preqin, EUR 58bn has been raised for European direct lending opportunities since 2010 yet of this figure only around EUR 7bn is targeting smaller deals (with fund sizes of EUR 300m or less). Consequently, while returns and investor protections are starting to show some erosion for larger loans, SME direct lending still looks very attractive from a risk-adjusted basis. Smaller loans can offer investors a high cash yield, attractive all-in pricing with upside potential, conservative capital structures and lender friendly terms with full covenants”.
Paul Shea, a partner at London-based Beechbrook Capital, suggests that there may also be a misperception of the risks involved in SME direct lending on the part of investors. “For a senior loan in the UK we are typically targeting low double digit returns with some equity kickers. This doesn’t necessarily mean it is higher risk; the premium returns also reflect the illiquidity of the market, which allows us to structure our own risk and return. We use modest capital structures, employ covenants and get call protection. We also try to attach some kind of equity return to our deals which is a good mitigating factor for any potential losses”. He is upbeat about the future of the asset class. “There is a significant opportunity for direct lending. I see 10-15 years of growth ahead for alternative lenders”.
Banks continue to show little interest in lending to European SMEs
Patrimonium, based near Lausanne, is one investor which has benefited directly from the general withdrawal of banks from corporate lending to smaller companies. “In Germany there is a definite pricing dichotomy: if you make it through the strict ratings process at a bank you can obtain very cheap capital at maybe 120 bps”, comments Daniel Heine, a partner at the firm. “There is no way this is risk-adjusted or justifiable. That said, there are a lot of SME companies looking for capital and we invest in situations which just don’t make it through the banks credit systems”. Matthias Mathieu, a managing partner at Bright Capital in Frankfurt, concurs and sees little likelihood of banks reentering the space anytime soon. “I think banks in Germany will only get more restrictive in their activities. They are lending without covenants, far too cheaply and it will most likely end badly. Banks won’t be big players in the sector for a variety of technical and regulatory reasons and the first downturn will most likely hit them very hard”.
David Bateman, a senior managing director with Harbert European Growth Capital which provides specialty debt financing to businesses in the technology, life sciences and environmental sectors, also sees little competition from other sources of capital. “Typically, a VC might fund a company when it burns EUR 1m a month while we fund a company when it is burning EUR 150k a month – but still growing at 20%. That’s still a long way before a bank would ever get involved!”.
Local competition remains limited
“Interestingly, in 2004 the big players in Europe were ourselves and one other group and in 2018 it is still ourselves and the other firm”, continues Bateman, who has witnessed the evolution of the lending environment to European high growth businesses since the technology crash. “You need scale, reliability and real domain expertise to build a true pan-European platform and there are lots of obstacles under the water. There are a few smaller groups with funds in the EUR 50-80m range but there are no other big competitors. To be honest there is still lots of room in the market. Returns to date for us have been attractive at up to 20% IRR, made up of 12-14% in a contractual element plus fees and in all cases an equity kicker”.
The SME direct lending opportunity in Germany is here to stay, according to Daniel Heine. “The US market is 15-20 years ahead of the UK and the UK is in turn perhaps 5 years ahead of Germany”, he suggests. “Mid-sized pan-European players who have raised large funds recently are certainly lowering their deal thresholds. While we look at transactions up to EUR 50m we would expect to see competition from London for deals over around EUR 30m. Some new teams are also trying to raise capital but in the end the market is big enough for everyone.”
Spain, too, is often singled out as a market offering an attractive hunting ground for SME lenders yet with low levels of locally-based competition. Adriana Oller, founder and partner at Resilience Partners based in Madrid and Barcelona, underlines how new the idea of direct lending is in the Spanish market. “We might see some work-outs being done by particular teams or some special situations deals done by other groups with relevant experience but, in general, the market is very nascent. We know about investing in Spanish SMEs and completed 50 investments in the sector before forming Resilience. The investment opportunity is large – there are around 5,000 companies in which we can potentially invest – and to be honest we see little competition. We do see new investors flying in from London though but typically they are looking for sponsor-backed companies with EUR 50m in EBITDA – and there are very few such opportunities in Spain!”.
“There will always be the need for specialty credit capital and if you can act fast and provide flexibility there will always be deals”, adds Martin Pommier, a partner with Madrid-based asset-backed credit firm Incus Capital which has EUR 600m under management and offices in Madrid, Lisbon and Paris. “Sometimes, for example, it is a particular situation where a company cannot access traditional bank finance even though they have a great asset on their balance sheet. The alternative to coming to us is for the company simply not to do the deal. It can be tricky in the beginning of the negotiations but a lot of it is about perception: we target an IRR above 15% and may be viewed as expensive debt but not expensive as transitional capital”.
About Certior Capital
Certior Capital is a value-add focused private equity and private credit advisor and alternative investment fund manager. The firm’s core expertise is in European lower- and mid-market private equity and credit markets, where the team’s experience is one of the longest in Europe. Certior Capital currently manages three funds: Certior Credit Opportunities Fund invests in SME private credit funds and directly in loans while Certior Credit Investments invests in European mid-market direct lending transactions. Certior Private Equity Fund focuses on European small- and mid-market opportunities. Certior Capital is a registered AIFM and supervised by the Finnish FSA.
For further comments or additional information please contact Ari Jauho by email at email@example.com or by telephone on +358 50 3378 282