Since the great financial crisis of 2008, direct private credit investments outside the banking system have grown exponentially. Both regulation and competition have forced the traditional regional banking model to consolidate and focus on larger borrowers, which are easier to service than smaller borrowers. This has left smaller borrowers without access to bank financing because of the higher costs and resources required for diligence and monitoring in servicing them.
The demand for capital by smaller borrowers is being met in the non-bank, private credit market (Figure 1). To support this market need, private debt funds in North America have raised more than $67 billion in the aggregate, according to Preqin. This market segment is likely to grow over the near term as the U.S. economy grows.
While private debt funds have emerged as a capital source for companies that banks are no longer financing, the vast majority of private debt funds are focused on sponsor lending. A smaller number of private debt funds have more specialized mandates, like non-sponsor direct lending, mezzanine lending, or distressed debt. Consequently, middle market companies that either do not have a traditional private equity sponsor or do not fit into a predefined mold often find it hard to access these pools of private credit.
Large cohorts of middle market borrowers either fail to fulfill a specific mandate or span multiple mandates and therefore aren’t a fit for any one private credit provider in particular. The borrowers’ rejections stem from structure, size, risk, or other situational factors. Known as “special opportunities,” these borrowers require potential lenders and investors that have specialized industry knowledge and are willing to perform added upfront diligence and invest resources devoted to enhanced monitoring.
Modern finance theory has validated the role of “efficient intermediaries” to monitor borrowers that banks do not have the capabilities or resources to monitor closely. This role has increasingly become the domain of special opportunity funds, particularly for middle market borrowers that rely on such funds to be transitional lenders or investors that can co-manage liquidity and operations when a business is facing an inflection point.
Large asset managers like Blackstone, PIMCO, Blackrock, and Fortress have dedicated special opportunity funds that invest globally across asset classes and industries. These funds are interested in situations that are time-sensitive, complex, or in dislocated markets across public and private credit. But they seldom focus on the middle market, where the demand for flexible capital and, more importantly, for involvement by sophisticated investors is significant and immediate. This has created the need for special opportunity lenders that provide access to capital as well as other tangible value-added services typically unavailable to the middle market.
The middle market-focused special opportunity investor can play a combined role that spans the functions of a relationship bank, a non-bank cash-flow lender, a subordinated lender, and a private equity investor by offering transitional but transformational capital. Such capital can be designed to achieve bespoke near-term objectives of a borrower.
When a business is at a strategic inflection point— whether that’s arrived at by adding infrastructure for growth, through operationally intensive execution, or via business plan changes—it is easier to rely on one sophisticated investor aligned with the success of the business rather than negotiate with multiple lenders. Each of those, after all, may seek to reduce risk by bluntly limiting the capital available to the business. Special opportunity investors typically help find a balanced outcome.
The special opportunity ecosystem offers the chance to design a financing plan in harmony with the borrower’s objectives, one that enables the company to invest added capital efficiently. Such approaches can help borrowers navigate transformative but turbulent periods for their businesses. Both transformation and turbulence may be driven by rapid growth, evolving business plans, or even distress. Middle market borrowers can benefit via increased access to capital, bespoke structuring, access to specialized industry contacts, and improved monitoring and governance (Figure 2).
Companies can involve a special opportunity firm at several inflection points in their life cycles, especially when there is no single traditional financing option that satisfies important strategic objectives. Successfully capitalizing on these inflection points has far-reaching consequences, because it can enable the company to achieve growth acceleration and strategic market refocus while avoiding dilution of control of the company via equity offerings. Figure 3 lists examples in which special opportunity capital was used in various phases of the life cycle of a company.
Borrowers should look for specific abilities before choosing a special opportunity investor as a capital source. There are high barriers to entry to be a successful special opportunity investor, and the following attributes are important considerations for middle market borrowers:
Borrowers needing access to capital can expect the right special opportunity investor to provide both one-stop capital and multidimensional expertise. At the same time, even though borrowers might need a comprehensive financing, they need not give up control. Traditional lenders are not suited to provide such options, especially when the borrower expects to undergo operational and strategic transformation and needs financial covenant flexibility to achieve stability. With the current surge in the use of debt financing across the middle market, the demand for special opportunity capital is expected to rise significantly over the near future.