FAIST ChemTec, a German maker of acoustic damping products for cars, is a big fish in a small pond. The Worms-based company’s revenue for the past fiscal year was just €150 million ($167 million), but its market share is close to 100 percent in Europe and about 80 percent in the U.S.
That commanding presence caught the attention of Pemberton Asset Management, a London-based specialist in direct lending to midmarket European companies. In April the firm made a seven-year loan to FAIST by drawing on capital from Legal & General Group, the U.K. insurer, which late last year gave Pemberton €100 million to set up a segregated fund.
There was a time when £715 billion ($1.083 trillion) L&G and other large international asset managers wouldn’t have bothered with companies like FAIST. But the fixed-income pickings are slim these days, with risk-free government bond yields so low in developed markets and only small premiums above those rates for investment-grade corporate bonds. The yield on benchmark ten-year German sovereign bonds, or Bunds, was just 0.6 percent in late September.
For their part, Europe’s midmarket companies — commonly defined as those with annual revenue of €75 million to €1 billion or so — face a struggle to secure financing as banks concentrate on shorter-dated loans to large, low-risk businesses. Asset managers have responded by filling the gap, lending at rates that exceed the yields on all investment-grade, and much high-yield, bond market debt.
FAIST took the loan from €1.2 billion Pemberton so it could expand its U.S. manufacturing capacity and build plants in China; in the same month it was acquired by L-GAM Advisers, a London-based investment firm. “The company is a market leader in what it does, has a very stable income stream, is relatively lowly geared and has performed well over the last ten years throughout the economic cycle,” says Symon Drake-Brockman, CEO of Pemberton. “It needed growth capital for the longer term, but banks increasingly prefer to do short-term financing.”
Drake-Brockman, who declined to comment on the pricing of the FAIST loan, notes that successful midsize businesses needing growth capital tend to borrow at about 5 or 6 percentage points over Libor. L&G, which bought a 40 percent stake in Pemberton last year, has also committed another €250 million to European midmarket loans through the firm’s European Mid-Market Debt Fund. That vehicle closed in July after raising €547 million, if the L&G segregated fund is included.
Trevor Castledine, deputy chief investment officer of the Lancashire County Pension Fund in Preston, England, which has invested heavily in direct lending in recent years, confirms the 5 to 6 percentage point estimate cited by Drake-Brockman. That translates into a premium of between 3 and 4 percentage points over investment-grade bonds, Castledine calculates.
Lancashire County has built up its direct-loan assets to just above 15 percent of its total £5.6 billion portfolio, after deciding in 2013 that investment-grade bonds weren’t worth investing in, he says. “They offer a very low yield for the risk involved and show significant volatility because of the high level of speculative trading,” he adds.
The pension fund slashed its bond portfolio and allocated to a variety of midmarket direct-lending funds. Its commitments include a €100 million investment in the Hayfin Direct Lending Fund run by €6 billion, London-based Hayfin Capital Management.
Some critics of high exposure to small and medium-size enterprises (SMEs), whether through the capital markets or loans, argue that such businesses are vulnerable during economic downturns. But Paul Stanworth, London-based managing director of Legal & General Capital, the £6.3 billion direct investment arm of L&G, thinks these companies often run into trouble not because of any inherent weaknesses but because of flaws in bank lending.
“The issue for SMEs when recession hits is that access to finance diminishes a lot more than it does for larger companies,” Stanworth says. Following this logic, he contends that well-managed midsize companies with access to loans are far safer than commonly believed by many investors.
Stanworth also asserts that recovery rates, the amount of money eventually reclaimed after a default, tend to be much higher for loans than for bonds, provided that strong covenants allow lenders to step in early and take some control over the company to stop it from using up all of its cash.
Growing institutional interest in European midmarket direct loans raises a question, though: Is the increasing supply of capital pushing down yields, as it has for most of the rest of the fixed-income market? “I see that every other man, and his dog, is out there trying to raise a fund, so it’s inevitable that some pricing pressure will come,” says Lancashire County’s Castledine. “But I don’t think the market is overbanked yet.”
