When the broadly syndicated loan market recorded a resurgence in 2024, competition increased for mid-market and upper mid-market deals. Private Debt Investor sat down with Investec’s head of direct lending Callum Bell and co-head of UK origination Greg Betz to get their thoughts on how the firm’s dedication to the lower mid-market opportunity, a segment they say is insulated from the wider competitive intensity, has borne fruit as it continues to invest and build out its direct lending franchise.
Looking ahead through 2025, the lower mid-market is getting more interest from private debt investors - why do you think this is?
Callum Bell: A lot of money has flowed into direct lending in recent years, and the increasing size of funds has forced many of them to focus on larger deals.
That has left the lower mid-market relatively underserved and, from a relative value perspective, it offers very attractive risk-adjusted returns and a clear illiquidity premium. Our strategy is dedicated to this segment by design, so we have leveraged that positioning to provide investors a differentiated access point to direct lending.
Greg Betz: M&A volumes have been resilient in the lower mid-market because the underlying growth potential of companies in this segment are attractive to investors, which means that opportunity flow has remained robust.
At Investec we see as many as 600 opportunities annually, allowing us to be very selective and construct highly granular portfolio’s delivering attractive returns through the cycle. This feature of the lower mid-market is a particularly attractive to allocators.
What are the benefits of including lower mid-market opportunities in a private debt portfolio?
CB: Given the favourable supply and demand characteristics of this segment, managers can build a much more diversified portfolio which helps to reduce idiosyncratic risk without simultaneously diminishing alpha, which you see in the upper mid-market. You can also capture the illiquidity premium, which is something that has nearly disappeared now at the upper end.
In addition to this diversification benefit, managers can deliver more certainty – and therefore less volatility – around returns in this segment. That is compelling for private debt investors. Pricing and terms tend to be a more secondary factor for borrowers looking for a financing partner to support their next phase of growth.
GB: Some of the trends we have observed in the upper mid-market over the last couple of years, for example spread compression and a general loosening of lender protections in loan documentation, have been much less prevalent when lending to small and mid-sized companies. You can structure transactions to give you tight protections and provide the ability to get around the table early in an underperformance scenario, while at the same time generating compelling returns.
Typically, the leverage profile is substantially lower, loan-to-value ratios are lower (typically under 30 percent) and there is material equity investment from shareholders sitting behind you in the capital structure.
Direct lenders in the lower mid-market are really partnering with the business’ management team and shareholders. Our role goes beyond purely the provision of financing, and we build collaborative relationships with management teams who are in many cases significant shareholders in the business.
What is required in the lower mid-market to successfully access opportunities?
GB: Scale is key given the high volume of opportunities, and you need deep sourcing channels to source and execute these opportunities. You need to have well mapped-out relationships and extensive execution capabilities, which comes from tenure in the market and a proven track record of delivery. Over the past 15 years, Investec has deployed €9.5 billion into over 330 individual transactions, with over 90 PE sponsors.
Lower mid-market companies tend to be on a growth trajectory and therefore require more flexible debt facilities. Direct lenders will generally be better placed than traditional banks to offer this flexibility, and to provide the follow-on capital growing companies often require.
What are some of the key considerations investors should be aware of with the lower mid-market? Are there any misconceptions?
CB: Many investors looking at the lower mid-market for the first time have a natural pre-conception that because the investment companies are smaller, they must be riskier. That’s not the case in our experience, and that view is further mitigated by portfolio granularity, the more conservative capital structures and the thoroughness of the research conducted in the underwriting process.
Our capital preservation philosophy is at the core of all our investments. We also typically take part in transactions with significant sponsor backing, which means you have a supportive shareholder who can step in if needed. That provides a helpful security blanket for the business. The management teams also like to deal with lenders who are aligned and supportive. Our whole business is dedicated to the lower mid-market, and entrepreneurs and sponsors like the fact that we are just as invested in their businesses as they are.
Looking ahead, what do see you see as the main opportunities - and challenges - facing the lower mid-market and its investors in 2025?
GB: The backdrop for deal activity should continue to improve in 2025 given high levels of dry powder across both private debt and private equity and as interest rates and inflation have been on a steady downward trajectory.
While base interest rates are coming down they are still much higher than where they were a few years ago so lenders still need to assess debt serviceability very carefully when structuring transactions. Geopolitical uncertainty has the potential to reignite some inflationary pressures and weigh on economic growth, which will be something to keep a close eye on this year.
CB: One medium term opportunity is that there is a structural need for sponsors to seek exits and recycle investor capital. We have been actively positioning for this uptick over the past 12-18 months with key hires to ensure capacity is there to capitalise on the opportunity as it comes.
We are increasingly in an environment where uncertainty is becoming an evergreen backdrop for the private markets. While that presents challenges, we believe it can suit long-established managers like Investec with a focus on the lower mid-market. These managers have the requisite infrastructure to navigate increased complexity and consequently are a longer-term and more sustainable option for allocators.
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