Small is beautiful – for LPs, at least

Over the dozen or so years since the GFC, the private-debt universe has evolved into a rich ecosystem that supports all manner of strategies – direct lending, infrastructure, real estate, special situations, venture and so on. Within each segment, the question for LPs is where the best risk-adjusted returns are to be had – single-country or pan-european funds, large cap or mid-market, PE-sponsored or non-sponsored? These are not straightforward questions in a relatively young market that has not had time to produce long-run data over multiple cycles.

Fortunately, a recent report from the British Business Bank (The UK Private Debt Research Report 2020 – click here) shines some light on this important question as regards the area in which Prefequity is most active – the mid-market segment of the UK private-debt market. The report features data for 55 funds, managed by 37 UK fund managers, and 934 individual deals. It is the first time such primary data has been collected and analysed for this part of the market.

A key finding of the report (page 23) is that size matters – specifically, the average net IRR for funds of less than £200m is about 200 basis points higher than for funds of greater than £200m.

That’s a significant premium and needs some explanation. In our view, the best explanation is one of competition and incentives – namely, there are very few competitors at the lower end of the mid-market because new entrants either raise larger funds or do so as soon as they are able. The economics to the manager are compelling – the management fee on a fund of more than £200m is no lower in percentage terms than on a fund of less than £200m, but the work involved in investing and managing the investments is approximately the same. The deals are just bigger. The incentive to grow AUM is even greater in private debt than in private equity or venture capital, where management fees and carried interest are typically higher and support a lower AUM base.

The lower mid-market in private debt therefore remains something of an orphan niche – which is just the way we like it, as it means we do not have to participate in price-competitive auctions or any of the other horrors of the larger end of the mid-market. LPs may wish to bear this in mind when they consider where to allocate their capital.