The US private debt market is a good diversification tool for investors willing to accept its illiquidity.
The US private debt market is well established, having emerged in the 1950s following the creation of the Small Business Investment Company (SBIC) program by the US Congress. Since then, continued tightening of bank lending regulations has driven asset class growth. With around 200,000 companies, the SMB market in the United States now offers a sizeable array of investment opportunities.1
We believe that the increasingly stringent regulatory environment is leading to fewer funding opportunities for these companies and that private lenders are now taking action to fill this gap. However, in our view, most private lenders focus on private equity funded transactions or large corporate financing. This creates an opportunity for lenders who focus on complex, unsponsored opportunities or special situations in the smaller SME market.
The small SME market (companies with EBITDA between $ 5 million and $ 25 million) has historically enjoyed a performance premium of around 200 basis points over the traditional SME market (graph below), as well as a debt profile lower.2 We therefore believe that the combination of lower leverage and higher rates of return creates an attractive dynamic for investors.
The small SME market offers better returns than the main SME market
Source: “Mid-market leverage cash flow market at a glance” – SPP – January 1, 2015 to June 30, 2022. For illustrative purposes only.
Constant flow of offers, guide to growth, realization of value
The small SME market is poorly covered and yet can offer a wide range of potential opportunities for private lenders across a whole range of businesses. In particular for: (I) management teams / entrepreneurial investors (eg independent sponsors and family offices) who intend to acquire / consolidate a business; (ii) family businesses that consider investing in larger structures; (iii) public companies called “micro-caps” with specific capital needs and limited access to growth capital. The entrepreneurial spirit within the small SME market is omnipresent and constitutes a continuous reservoir of interesting opportunities.
However, investing in these companies still requires access to a wide range of procurement channels. Given the size of the investment universe, it is essential to pay close attention to fundamental research before making any investment decisions, but also to monitor and manage risks thereafter, in order to ensure good protection against the risk of a portfolio decline in end .
There are fewer lenders in this market as traditional players may consider these assets to be more risky. However, we believe these companies have good upside potential due to the significant impact of even modest growth initiatives and broader acquisition prospects. The segment of family businesses and businesses owned by their founders, for example, is less competitive and can therefore offer higher returns with less leverage. Additionally, independent sponsors who can demonstrate targeted execution and / or support from their portfolio companies tend to gain preferential access and more attractive purchase price multiples for potential investments.
In terms of investment instruments, US private lenders have several options that largely reflect broader European and US operations: senior / unitranche, mezzanine, preferred stock and common stock or a combination of debt and equity.
Public markets are affected by pressure on rates and high levels of volatility. Therefore, we believe this is a good time to consider a US private debt allocation as a diversification tool; floating rate loans offer protection against rising interest rates and limited volatility in terms of mark-to-market. The embedded illiquidity premium can enhance the performance of the portfolio.
2 S&P LCD “US Middle Market Quarterly 3Q21”. The most recent data available was used.
Muzinich & Co. mentioned herein is defined as Muzinich & Co., Inc. and its affiliates. This material has been produced for informational purposes only and as such the opinions contained herein should not be relied upon as investment advice. Opinions are current as of the date of publication and are subject to change without reference or notification to the user. Past performance is not a reliable indicator of current or future results and should not be the only factor to consider when selecting a product or strategy. The value of investments and the income from them can go down as well as up and are not guaranteed and investors may not get back the full amount invested. Exchange rates can cause the value of investments to rise or fall. Emerging markets can be riskier than more developed markets for a variety of reasons, including but not limited to greater political, social and economic instability; greater price volatility and reduced market liquidity.
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