Prefequity sponsors LGPS roundtable in Birmingham
We recently sponsored a roundtable in Birmingham organised by Room 151 with senior participants from across the LGPS community. Please find the full report here.
As part of the event, Theo Dickens, Prefequity’s Managing Partner, sat down with Room 151 to discussed why smaller UK businesses face a persistent shortage of growth capital, creating opportunities for institutional investors to support economic development while generating attractive returns, and how combining private debt with equity participation can help bridge the gap.
Why does a funding gap persist in the UK lower mid-market, and what opportunities does this create?
It goes back to the financial crisis and the tougher capital requirements imposed on banks. That reduced lending, particularly to businesses without substantial hard assets. We make cash-flow loans to companies that typically can't raise the capital they need from asset-based lenders.
But there's more to it than banks. The key is the minimum efficient scale of investing. Managers are typically paid as a percentage of assets under management, so there's an incentive to raise larger funds and do bigger deals.
It's just as much work to do a £10 million investment as a £100 million. Meanwhile, there's quite a lot of policy-driven capital targeting very small deals.
So there is capital available for small amounts and plenty for larger transactions, but relatively few investors operating in that £5 million to £20 million gap.
How does combining senior secured lending with equity warrants change the risk-return proposition?
It's nice being a senior secured lender because it puts you in a strong position under our legal system – but it caps your return.
We like the asymmetric payoff from combining the fixed return of a senior secured loan with an equity warrant. If things go well, we participate in the upside. If they're disappointing, we still receive our contractual interest and fees, assuming the company can pay. And if things go severely wrong, we're in a position to step in and take control.
Smaller companies undoubtedly carry more business risk, so we have to be particularly careful with due diligence. But we take considerably less financial risk than larger buyouts. Average leverage in our first fund was 2.5 times EBITDA.
There's also less refinancing risk because companies can often generate enough cash over the five-year term to repay our loans. Our warrants include put options allowing us to sell them back to the company at a fixed EBITDA multiple.
Roughly two-thirds of our target return comes from contractual interest and fees, with one-third from equity warrants. We're targeting low-teens contractual yields and high-teens returns including warrants.
Private credit has become increasingly competitive. Has the lower mid-market escaped this pressure?
We're relatively insulated because there aren't many investors operating in our segment. We negotiate bilaterally with companies rather than participating in auctions.
The difficult part is origination. We've spent more than 10 years developing a network of approximately 350 regional corporate finance boutiques around the UK. They understand our criteria and bring us suitable opportunities.
That network is a significant barrier to entry, so we haven't experienced the same compression of yields and deterioration in terms seen in larger private credit markets.
But there's a limit to how far the strategy can scale. I think we could invest a fund of £200 million to £250 million without compromising our terms. Beyond that, we'd increasingly encounter competitors with large amounts of capital to deploy.
One problem investors should consider is that private credit managers are often paid fees on invested rather than committed capital. That creates pressure to deploy, potentially producing conflicts between managers and their investors.
How closely do you work with portfolio companies, given that you're principally a lender?
We don’t work with private equity so we're effectively our own sponsor. We originate our deals, conduct due diligence, sit on company boards and manage investments through to exit. It's private credit with a private equity hat on.
We're long-term partners to the businesses we invest in, although we're not controlling shareholders. We receive monthly accounts and attend board meetings at least quarterly, sometimes monthly.
The relationship is often most intensive immediately after investment, when management teams or operating processes might need strengthening. Later, our involvement can shift towards supporting acquisitions, additional financing and planning exits.
Can you give an example of how that involvement has improved a business?
One of the biggest weaknesses we often encounter is the finance function. In probably half the companies we've invested in, we've required management to recruit a new finance director or make other changes to the finance team.
At Central Group, a roofing business, finance was largely regarded as a scorekeeping function. Management wasn't using financial information to identify the most profitable work and didn't fully understand the gross margins on individual contracts.
We helped strengthen that capability through an internal appointment. The company can now establish target gross margins for each project based on the labour and materials required.
It's made the business much sharper in how it approaches contracts. At this scale, companies often need to become more professional in the way they're operated, and we can help because we know what good looks like.
What happens when an investment performs badly, and how do you protect against economic downturns?
We had one investment in our first fund where we discovered a fraud. The company had been reporting profits when it was actually loss-making.
We took control, replaced management and spent several years restoring the business towards break-even. We're now looking to exit and recover as much of our investment as possible.
Fraud is a significant risk in smaller companies because so much responsibility can rest with a limited number of people. However, gains from equity warrants on other investments have helped offset the impact on the fund.
More generally, we diversify across sectors and favour businesses providing non-discretionary products and services. We tend to avoid retail, consumer businesses and highly cyclical activities.
Our companies are UK-based, but many generate overseas revenues, providing some additional diversification.
What makes this strategy attractive to institutional investors, particularly local government pension schemes?
For our local authority pension fund investors, the cash yield is important. Unlike private equity, where investors typically have to wait for exits, we return the majority of our interest and fee income to LPs quarterly.
There's also the opportunity to make an impact by influencing how smaller businesses operate. For example, ESG considerations are part of our due diligence, and we ask companies to report regularly on their progress.
We can't instruct them because we're not the owners. But discussing these issues, asking for information and encouraging improvements can change behaviour.
Perhaps most importantly, we’re providing growth capital to underserved regional SMEs, which form the backbone of local economies. In today’s climate that’s highly relevant to LGPS investors concerned with local employment and the wider contribution of their investments to society.