Institutional investors turn to alternative credit to boost risk adjusted returns

By Daniel Lanyon on Thursday 30 March 2017

Alternative Lending

European SME private debt is an emerging niche for those institutional investors looking for low volatility income.

Institutional investors are increasingly looking to broaden their private credit exposure away from the large cap segment which has become increasingly overheated and competitive, according to Ari Jauho, chairman of Certior Capital, and instead opting for more SME loans.

The fund-of-funds manager – which is focused on SME alternative credit – says demand is rising as the as it offers attractive returns to investors with significant downside protection that comes with being a senior lender.

“The size of the opportunity across Europe is enormous - in the UK alone there are some 40,000 companies with £5-50m of revenues - and yet to date relatively little institutional money has focused on it.”

Institutional money in Europe has been slow to focus on SME alternative credit, however, although many say this situation is now changing.

Returns available to investors in the SME private credit sector compare favourably to many other private and public asset classes. Johan Kampe, a Senior Managing Director at Harbert Management.

He says originators can safely lend rapidly growing to businesses which are but not yet profitable, and in doing so achieve strong, risk-adjusted returns.

"Our typical investee companies have raised one or two rounds of venture capital funding but they are not yet being targeted by the banks. Revenues are typically in the €5-50m range and our funding is often a bridge between rounds of venture funding.

He says returns to date have been attractive at up to 20 per cent IRR. “This is made up of 12-14 per cent in a contractual element plus fees and in all cases an equity kicker".

Beechbrook Capital, another firm active in the alternative credit space, has taken advantage of the lack of bank lending available to smaller European businesses.

"Our original focus was on mezzanine, unitranche or subordinated loans in private equity sponsored buyouts in Northern Europe where typically there might be a €5-10m gap in the capital structure", said Paul Shea, Co-Founder and Managing Partner at the firm.

However, he says they were soon inundated with enquiries from companies in the UK who wanted to borrow £5-10m. They rapidly raised £150m for a new fund offering unitranche or senior loans to family businesses.

“Most banks are reluctant to provide five year bullet loans but that is exactly what many growing companies are looking for. For a senior loan we are typically targeting a 10-12 per cent contractual IRR plus around half of the deals we execute involve equity kickers," he said.

Incus Capital, which manages €600m across several strategies, focuses more on asset-based lending to the Iberian SME sector with local offices in Madrid and Lisbon and aims to offer an alternative to banks, based on speed and flexibility.

While the common assumption is that investing and lending to smaller companies involves higher risks than dealing with larger companies, risks can be significantly lower than what investors perceive. David Bateman, a Senior Managing Director at Harbert Management, is clear on this point. "If you are operating in this niche most deals are a result of bilateral negotiations.

“If you are a venture capital business there is a lot more competition for capital but in debt there is only one senior lender and they really hold the reins. Being the senior lender in a bilaterally negotiated deal is a great place to be".

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