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Special Opportunity Investing in the Middle Market

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.

Figure 1


A Specialized Lending Niche

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).

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.

Figure 3

(Click to enlarge)

A Borrower’s Checklist

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:

  1. Flexibility with Capital Structure. Special opportunity investors can provide deep, patient, and flexible capital to manage through inflection points, whether those are arrived at via high growth potential or through distress. A special opportunity investor has the flexibility to approach transactions with a more agnostic view of capital structure requirements. As a result, investments can take the form of debt, equity, or both to create alignment with the long-term goals of the business and its management team. Growth is often accompanied by investments in infrastructure and causes periods of negative EBITDA or cash flow. Typically, traditional lenders require that during such periods companies must be financed with an equity investment. Special opportunity investors recognize good growth and consistently use capital structuring—including the creation of off-balance-sheet facilities—to provide borrowers with the ability to scale beyond what their existing credit capacity can allow without having to raise dilutive equity.

  2. Nimble and Responsive. For companies facing a crossroads, time is of the essence, and a capital source’s ability to move quickly is an important factor to consider. Special opportunity investors are built to move quickly, with dedicated deal teams working with company managers to understand the business, its near-term financing need, and its long-term objectives. For future financing needs, a special opportunity investor with a large capital base can continue funding capital needs without requiring the borrower to start the entire financing process over.

  3. Access to Industry Veterans. Special opportunity investors recognize the importance of letting management teams exercise their strengths. But when it is helpful, their operating partners can provide industry expertise and ongoing support for management teams. Leveraging a network of industry veterans helps special opportunity investors understand and take part in a wide range of industries and asset classes. Unlike banks or control equity investors which, respectively, take either a hands-off or complete control approach, special opportunity investors can leverage appropriate operating partners across diverse situations. These introductions may be particularly important for family-owned or closely held businesses because operating partners can provide unique insights without impeding day-to-day operations or disturbing company culture.

  4. Performance Metrics. Special opportunity capital may be governed by nontraditional covenants and bespoke performance measurement metrics that are true indicators of business progress. It is critically important that the capital provider understand the bottom-up fundamentals of the business in harmony with the management team’s perspective regarding business objectives. That allows the investor to focus on helping the management team achieve its objectives without being shackled with metrics that might not reflect the ultimate drivers of long-term value.

  5. Migration to Lower Cost Capital. Graduation to lower cost, long-term capital is an objective shared by special opportunity investors. More-efficient financing may be sourced within a special opportunity investor’s capital base, saving on the upfront costs associated with capital raising. Alternatively, a special opportunity fund’s network of niche capital providers can generate introductions for companies. Finding a special opportunity investor with a high-quality network or a diverse capital base from which they can allocate funding can help companies find the right capital at the right time.

  6. Alignment of Interests. Relative to a controlled private equity investment, special opportunity investors can allow the management team and business owners to keep a disproportionate share of the upside created by structuring investments in a way that recognizes and rewards continuity of ownership and management at middle market companies and seeks to foster an alignment of interests so that everyone rows in the same direction.

Rising Demand

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.

Sachin Sarnobat

Sachin Sarnobat

Atalaya Capital Management

Sachin Sarnobat is a managing director with Atalaya and has extensive experience investing in private credit. He previously worked with Prospect Capital Management, a multibillion-dollar credit and private equity fund. Sarnobat began his career at a technology start-up that provided advanced analytics to the consumer credit risk industry and was awarded a U.S. patent related to data mining. He holds bachelor’s and master’s degrees in chemical engineering from the University of Mumbai and the University of Tennessee, Knoxville, respectively, and an MBA with honors from Columbia University Business School.

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