After its formation late last year, Epsilon Direct Lending, a boutique manager focusing on a particular part of the burgeoning private debt asset class – the under-served $70 billion mid-market growth and event-driven financing space – is ready to go to the investment market with an institutional and wholesale fund.
The three founders of the business – Mick Wright-Smith, Joe Millward and Paul Nagy – expect to raise about $500 million with their initial offering. The trio worked together at CBA until last year, where they had set up a similar business for the bank.
One reason that the private debt market is growing rapidly both for investors and borrowers (customers) is the increasing difficulty the major banks have had in both satisfying those customers and coming to terms with the new regulatory restrictions of capital adequacy, such as through the adoption of the global Basel III requirements. Another is that big banks are not well suited to providing bespoke services to these customers. Plus, banks tend to love real estate as collateral. Epsilon is prepared to deal with its customers on the basis of a company’s projected cashflows, its market value and history as a sound going concern.
The word ‘Epsilon’ is the name for the fifth letter of the Greek alphabet, which roughly translates to an ‘e’ in English. But like many Greek letters, it is often used as a symbol, with broad application including to mean elasticity or resilience in economics. It is also the name of the fifth star on the Australian flag – the only five-pointer star which is the one not also on the New Zealand flag.
The three founders each has more than 20 years of experience in originating, structuring and managing borrowing facilities for mid-size companies. Those companies will have an average annual revenue of $25-500 million and an average borrowing requirement of about $30 million. With a $500 million fund, Epsilon believes it will be able to comfortably handle 15-20 loans in its start-up phase.
Will Morgan, COO at third-party marketing firm Shed Enterprises, which is representing Epsilon, says there are several key differentiators between Epsilon and other private credit providers. The banks and most others participate in syndicated lending, where various lenders participate in the one loan. Typically, a bank or banks will package the loans and fund managers or other banks buy in. Syndicated loans can be lower returning for the investor, while bilateral mid-market loans often require real estate or other fixed assets for banks to back the loan, Morgan says.
“Banks look backwards, but private debt managers look forwards,” he says. “Epsilon looks for well-established businesses and lends against future cashflows. It is a bilateral (one lender one borrower) arrangement which doesn’t inherit someone else’s credit process. This is where the founders’ experience and contacts are very important.”
The Australian corporate loan market is worth about $1 trillion, according to statistics compiled by Epsilon. This is still a largely bank-controlled market, although non-bank lenders are taking market share in the real estate, SME, and Large Cap syndicated loan market segments. Epsilon’s target market is the under-served middle-market growth and event-driven finance segment (estimated at $70 billion). Epsilon’s specialties are: bilateral loans, middle market companies, Australia-only, and with no other credit strategies (such as real estate or infrastructure) in its portfolio.
Mick Wright-Smith, who spent 11 years at the CBA, says that, perhaps surprisingly, most of the loans generated in this segment came from personal relationships held by himself and his partners Joe Millward and Paul Nagy, rather than referrals from within the bank. “I came from the UK to CBA in 2009, after the credit crunch had hit,” he says. “At CBA we had this market pretty much to ourselves. Then from 2012 the other banks came back and started to be competitive again. Then Basel III made it more difficult for the banks… But the demand hasn’t gone away. It’s that the supply of this segment of loans has shrunk.”
Nagy says that “close to 80 per cent” of the opportunities he and his co-founders had looked at in the past were originated through direct contacts. “They tend to be sophisticated and repeat borrowers… Relationships are the key in this business. Our primary competitors are the Aussie commercial banks, not the big offshore players.”
The borrowers tend to be privately owned companies, which, in the mid-market range, are harder to access than either their generally larger listed brethren or those at the small end of the market,” according to Joe Millward. “Public companies can get pretty big and transact quite often, so the investment banks are always hanging around them. And they can get publicly available information easily. You don’t need to have a relationship to lend with companies at the big end of town, just with the syndicate desk. And at the other end, the small companies, there are a lot of brokers dealing with the non-banks. The middle market is harder to access and we have a more diverse range of companies with which we lend and more diverse types of transactions… We are really rolling our sleeves up. It’s hard work. We are offering better risk-adjusted returns for our investors than the other segments.”
Wright-Smith and Nagy are both based on Melbourne, while Millward is in Sydney. Both fund administration and loans operational management are outsourced. Millward says: “We want to be asset managers, not administrators. We’re focused on being an Institutional grade business, and just like the largest and most successful offshore managers, we have no interest in attempting to run a range of non-investment focused activities ourselves just to try to capture a little more margin”. Fund admin will be handled by global private credit specialist firm Alter Domus, which has an Australian operation, and loans admin by IHS Markit who administers over $1 trillion of loans for banks and funds globally. The manager targets an average annual net return of 6 per cent, which puts it between investment grade corporate debt and higher risk SME lending and special situations lending.