The merits of the mid-market

There are still pockets of opportunity in this late stage of the cycle – and direct lending in the middle market is one of the most attractive, writes Clark Coffee, head of Tyndaris Real Estate.

Regardless of profession, it is good to feel wanted. Following the global financial crisis, alternative lenders had such a feeling.

Across Europe, banks were constrained by the need to deleverage their balance sheets and conform to new regulatory pressures, while property owners faced significant refinancing needs and required capital to grow.

Eight-plus years into the cycle, the story is a bit different today. Traditional lenders have returned in scale and unprecedent amounts of private debt capital have been raised by alternative lenders in Europe as this segment of the market matures.

Despite increased liquidity in the sector, pockets of opportunity remain. One such area is the European middle market.

Real Capital Analytics estimates that 84 percent of all European commercial property transactions completed in 2017 were in lot sizes of less than €50 million, reflecting more than €85 billion in total transaction volume.

Despite this being the largest market segment by transaction count, it remains underserved by alternative lenders.

The reason for this is simple: the vast majority of private debt capital that has been raised for European strategies is concentrated with larger managers and in larger funds. These funds are incentivised to focus on larger loans, as ‘small’ transactions simply do not move the deployment needle, yet take a similar amount of internal resource and time to complete.

To the extent that such a transaction also requires underwriting a degree of complexity, this further deters large lenders from pursuing it strictly on a ‘profit-to-man-hours-worked’ basis.

By focusing on this less-crowded segment, mid-market lenders can not only benefit from increased negotiating power which can result in better protections and controls over the borrower but can also achieve more attractive risk-adjusted and absolute returns for their investors.

While the mid-market is an attractive playing field, it is not without its challenges.
For the same reasons that larger funds tend to focus on larger loans, market intermediaries and investment banks are also inclined to focus on larger transactions where fee revenue is most significant. As a result, it becomes more critical in the mid-market to have in-house origination teams to cover key jurisdictions and interact directly with counterparties to maintain a robust pipeline.

This comes at a cost to the platform and thus it is critical to pay close attention to the balance between the higher returns achieved in the mid-market and the increased burden and costs of running a direct origination platform.

Managers that drive standardisation of process and leverage technology in the origination, underwriting and risk management functions of a firm will be well placed to achieve success in the market segment.

In this late stage of the market cycle and in an environment of low interest rates, direct lending remains a highly attractive investment strategy, not least because it can offer investors material downside protection on their capital while producing a yield that is otherwise difficult to find in today’s fixed income markets.

Focusing on the middle market therefore presents a unique and attractive angle to capitalise on the direct lending opportunity in Europe.