Why private capital is a smart tool for growth

Governments have been supportive in fostering the alternative investment markets to facilitate entrepreneurship

The private capital markets have always been labelled as an alternative financing tool for companies in comparison to the traditional funding avenues, especially banks. However, the global financial crisis in 2008 was a game changer for private capital markets. This can be broadly attributed to 2 factors, both driving the demand and supply for such alternative lending funds.

Firstly, the banking industry's thrust to become leaner and clean up legacy problems have forced banks to re-evaluate less profitable and high risk sectors coupled with the need to adhere with new capital requirements.

Secondly, central banks resorting to ultra loose monetary policies to stimulate economic activity reduces the attractiveness of the traditional asset classes. Both these factors resulted in private capital markets growing by record levels during the past decade.

According to latest data released by Preqin, total private capital fund-raising grew by 10.4 per cent in 2017 to cross the $800 billion mark for the first time as the industry remains attractive for investors. Within the private capital market, private equity (PE) and private debt witnessed double digit growth in fund raising during 2017.

According to Preqin, assets under management (AUM) in private capital markets have increased by 8.2 per cent CAGR from $3,061 billion in 2011 to $4,925 billion in 2017. PE represents around 60 per cent of the total AUMs of the private capital market as it has been the most preferred choice of capital for companies and promoters to fund growth across the globe. Although PE will continue to remain the most obvious choice for businesses going forward, the rise of private debt over the past decade as a suitable alternative funding stream without divesting equity has caught the attention of smart and sophisticated investors. According to Preqin, AUMs of private debt have increased threefold since 2007 to reach $638 billion at the end of 2017 and it is forecasted to grow to $2.5 trillion in another 10 years.

Private debt
Private debt has become an integral part of investment portfolios. It offers stable and predictable yield returns and downside protection compared to a typical PE investment. As the private debt market evolved, direct lending and distressed debt continued to remain the main form of instruments, but mezzanine financing emerged as one of the preferred instruments in recent times.

One of the main reasons for the growing prominence of mezzanine financing is that it not only generates return from interest payments but also offers equity kickers, which broadly depends on the deal structuring of each investment opportunity. As a result, a total of 32 funds was raised amounting to $11 billion in 2017, accounting for nearly 10 per cent of the total private debt fund raising activity.

The fund raising activity for private capital markets has been encouraging over the past decade as investors are hunting for stable returns and the opportunity to diversify into non-cyclical asset classes to minimise the overall risk of the investment portfolio. On the demand side, the private capital market activity is being driven by the fallout of the banking industry's thrust to adhere to changing regulatory environment. Hence, the changes in the lending landscape have emerged as a drag on growing SME businesses, bringing the alternative funding channels in the form of private capital to fill the incremental lending vacuum.

In addition to demand from global PE managers, demand for private debt is also increasing among pension funds, insurance companies and endowments who value high-yielding assets in which they can invest for the medium to long term. For pension funds and insurance companies, it provides a level of protection and return to meet their needs while startups and SMEs have easier access to finance for long-term investment and structuring.

The obstacles faced by startups and SMEs in Mena, such as stringent lending norms by the banks and cumbersome process and documentation, has led to the rise of private capital, especially in the form of PE in the region. The PE players have been rather selective in picking their targets, specifically targeting companies with sustainable business models and recurring profits, which means very few businesses might fall under these criteria not because they are not sustainable but have been rather constrained due to lack of availability of funding to foster growth.

As a result, regional SMEs are always exploring non-traditional financial sources, which have led to the emergence of alternative lending avenues over the past few years. One such lending avenue has been private debt, which has become an important funding vehicle for riskier models or distressed and cash-strapped companies.

One of the other important features of private debt is the flexibility and adaptability of structured deals, which are facilitated to support the growth of the companies. Within the private debt space, direct lending continues to dominate lending activity but mezzanine financing has become increasingly suitable for both companies and investors with flexible deal structure capabilities for each investment opportunity. The rate of return in such investments remains largely on the higher side, nearly in the range of 12 per cent to 15 per cent, and the debt portion can be converted to equity in case of default by the company.

In conclusion, the biggest barrier for the SME ecosystem to thrive has always been the availability of lack of capital to pursue expansion plans or to formalise creative ideas into actionable business models. Thus, bridging the financing gap has now taken various forms with the rise of private capital. Moreover, governments have been supportive in fostering the alternative investment markets (PE, VC, private debt, etc.) in order to facilitate entrepreneurship as well as encourage innovation. Hence, private debt, especially mezzanine financing, has the potential to become a dominant lending avenue for development of SMEs within the region.

However, the lack of appropriate regulations in some regional countries might be a deterrent for such investment vehicles going forward, but clearly there is a rising demand for smart financing vehicles to foster the long-term growth trajectory of regional companies.

The writer, a board member of Allied Investment Partners, is an active entrepreneur and fund manager. Views expressed are his own and do not reflect the newspaper's policy.