Private debt investment

A niche opportunity

Small companies are the lifeblood of the European economy. The region is home to some 23 million small and medium-sized enterprises (SMEs), providing nearly two-thirds of its jobs and adding EUR3.4 trillion of economic value a yearEurostat. For those that are able to invest in alternative assets, the dynamism of such businesses makes for a potentially attractive investment opportunity. That has been especially true for private equity in recent years but in this new era of higher rates, higher inflation and low to negative earnings growth it should be credit’s turn to shine.

Yet, for investors in private debt (direct lending), smaller and medium-sized companies curiously do not form part of the investment universe.  Due to economies of scale and the fee benefits, most private debt funds prefer to lend to larger companies – where deal tickets are bigger, but where competition is also much fiercer. We believe this is a missed opportunity as the commercial effervescence of Europe's small and medium-sized businesses is impossible to ignore.

A common refrain is that lending directly to smaller companies is a high risk and complex endeavour, requiring greater due diligence. There is some truth to this but the rewards on offer more than offset those risks, many of which can be controlled in any case. Many smaller companies are disruptive in the niches in which they operate, offering significant potential for development and growth above and beyond their more mainstream, publicly-listed peers. Our approach at Pictet Asset Management is to invest in businesses that have reached a crucial stage in their evolution, providing what we would describe as bespoke growth capital to allow them to reach their next milestone in their lifecycle.

Whatever the size of the deal under consideration, however, each potential investment requires thorough due diligence. Complicating matters is the fact that smaller companies often have less established reporting processes and information systems, requiring the funds to roll up their sleeves and put in the hard work.

Therein, though, lies the opportunity. An investor with the skill and capacity to carry out the necessary due diligence on smaller firms can unearth investment opportunities that most others would overlook due to the amount of work involved. These are the types of investment we are targeting in our private debt strategy.

Attractive risk-return balance

Conventional wisdom holds that lending to smaller companies involves taking on much more risk. But because the European business landscape is so rich, and the lending options available are wide, such risks can be mitigated through bespoke capital structures, robust loan documentation, and precise credit selection.

With effective due diligence, debt managers can select companies that have a much stronger credit profile and lower risk than the average small business. Such analysis is vital as many of these firms are not rated by credit agencies, so all the research is the responsibility of the investor. We believe the most important determinants of a company's long-term investment appeal are its underlying credit fundamentals and the nature of the market it operates in. Visible, recurring revenues are important as are high profit margins and a flexible operating cost-base. To this end, we tend to prefer asset-light companies with high cashflows and cash conversion ratios.

Physical assets – such as cranes or factory equipment – are often perceived to offer capital protection for lenders on the assumption that they can be sold if times get tough. But our experience shows this is not always the case. Under certain economic conditions, these assets can become surplus to requirements with few buyers, if any. Furthermore, physical assets need servicing to retain value and functionality, which is a cash drain on the business. Therefore, far from being a positive, these assets could become a hinderance.

In addition to narrowing our range of investment candidates to companies that exhibit strong credit fundamentals, we believe there are three other routes to reducing risk and maximising returns: the choice of industry sectors, regional diversification and defensive deal structuring.

In an environment characterised by potential economic and financial instability, we are focussing our investments on defensive sectors. Those that we prefer – healthcare, education, business services, and tech & software – are home to companies that are naturally cash-rich and low beta. These defensive attributes put them in a stronger position to deliver profits, even in uncertain times.

Diversification is another way in which direct lending can control risk. By spreading investments across countries, investors can diversify the portfolio. This route isn't open to all. It is only viable for larger investment firms with deeper infrastructure. Private debt is a very much a 'hands-on' asset class: to secure attractive deals, portfolio managers need a local presence with local connections and an in-depth understanding of the cultural and legislative nuances of each region. Our main focus is on Germany, France, UK and Benelux, which together account for around 80 per cent of all private credit deals in EuropeBased on data for 2011-21. Sources: Deloitte Alternative Lender Deal Tracker Spring 2022; Pictet Asset Management, 31.12.2022. These geographies offer deep product penetration and a robust creditor framework that allows us to protect value in the downside.

Notwithstanding, all investments have some element of residual risk. We currently believe that rising operating expenses, including wage inflation are yet to fully filter their way into the system. Lower real disposable consumer income will exert pressure on many corporates’ top-lines. Add in rising funding costs that eat away cashflows and we are likely to see higher default rates in legacy deals, particularly those from 2021 and 2022. This offers a real opportunity for new vintages to capitalise on investments into sound companies with imperfect balance sheets. The ability to find, select and structure these opportunities will filter the winners from the losers.

Secure structures

When it comes to designing the deals, we favour defensive loan structures that embed protection. At a time when interest rates are rising, the marginal benefit of chasing extra yield is disproportionate to the incremental risk.

Protection for investors can include contractual restrictions and covenants on the borrower with limits on interest coverage, maximum leverage and/or fixed charge coverage. These are typically tested every quarter. In case of a breach, or even the threat of an eventual breach, lenders can get involved more directly in the business to protect their investments. Furthermore, the lower competitive tension among lenders in Europe’s lower-mid-market facilitates the inclusion of such strong protection measures into all of our loans.

If the worst happens, investing in senior secured loans gives us a priority positioning with numerous avenues of recourse to protect our investment. In extreme cases, we are able to step in as shareholders and control the board to protect our interests.

A growing market

The range of investment opportunities in the Europe's private debt is growing as the region's smaller companies are becoming increasingly receptive to this form of funding.

Typically owned by families or individual entrepreneurs, such businesses have historically relied on either bank loans or private equity capital. The former is relatively cheap but comes with little or no flexibility. Nor does it come with the support to enable business growth. Private equity, by comparison, does potentially offer a lot of value but the cost is a loss of independence and control. Private debt, therefore, can be seen as the perfect middle ground between the two – something a new generation of business owners is starting to appreciate.

Direct lending funds can offer strategic and operational guidance (including, in our case, on environmental, social and governance matters) but they don’t run companies or dictate what they should do. They can also offer the requisite flexibility and support to transform smaller companies into industry leaders. From investors, such involvement can bring a degree of “operational alpha” – further boosting returns by helping to nurture the business you’ve invested in.

Niche opportunities are hard to come by in a financial market where information is commoditised. Yet direct lending to lower mid-market European companies is an attractive proposition with a highly compelling risk return profile, particularly in today’s market conditions. Backed by managers with the right knowledge, expertise and local presence, investors can access a low-risk asset class with strong underlying yields in an uncertain macro environment. We believe credit, and particularly private credit, is now in its golden age.

Our approach