A Differentiated Lending Approach in the Lower Middle Market

Almost a year ago, Aberdeen Standard Investments (ASI) bought Hark Capital as part of its plan to invest in differentiated strategies within its global Private Markets business. Hark provides non-dilutive loans to portfolio companies in situations that would typically require equity.

MMR talked with Doug Cruikshank, head of fund financing and Hark Capital, about what role Hark is playing in the market,  today’s leverage lending environment in the lower middle market, and more. 

MMR: The credit market is crowded today. What market gap is Hark Capital filling and what is your investment strategy?

Doug: The credit markets are crowded, but what we do is different from most lenders. In short, we solve private equity portfolio company equity needs, but at the cost of debt. We do that by getting credit support based on the fund’s Net Asset Value (NAV), not its uncalled capital. This allows us to help the private equity fund continue to improve its portfolio, even out of its customary investment period. Rather than true end-of-life financing where there might be only a couple of portfolio companies left, we focus on what I like to call “robust middle-age” financings. The youthful days of capital call line borrowing may be over, but there’s still a healthy portfolio left to work with.

The gap between five and nine years into a fund life had traditionally not been well served by the debt markets, yet this is often a critical period for the GP to maximize the fund’s returns to its LPs and GP. Our strategy is to fill this need.

MMR: What do you think about today’s leverage lending environment for lower mid-market and middle market portfolio companies?

Doug: As has been widely noted, the leveraged lending markets continue to be extremely accommodating to borrowers, in some ways even more so than during the last peak. That reflects a number of factors, including a strong economy, low default rates, low interest rates, and a seemingly ever-increasing number of new debt funds being raised. For those who experienced the Global Financial Crisis starting in ’08, I think it also reflects the fact that most senior loan recoveries were quite good, as long as you didn’t sell in the midst of the crisis.  

Given the heightened competition in private equity, and sponsors’ temptation to maximize leverage to boost returns, there will undoubtedly be credit casualties when we hit some speed bumps. That said, most of the private equity sponsors we speak with are becoming more cautious despite the seeming invulnerability of the 10-year (and counting) bull market.

MMR: What should GPs do to prepare for the current and future macroenvironment? What is your biggest worry?

Doug: The next economic downturn has been around the corner for at least the past two years. Whenever there’s an extended upturn in the markets, the fear of not being prepared for a downturn fades and anxiety about missing out on the upside prevails. It’s hard to watch others make money while you’re crouched in your defensive bunker.

Nevertheless, we see private equity sponsors struggling with this dynamic and selectively taking actions to be prudent. Examples include steering to more defensive industries, when possible; giving at least a second thought to maximizing leverage; and running with extra liquidity, including extending out bank lines. On the offensive side, we see sponsors carefully considering exit timing and balancing the potential for increased upside against the risk of a potentially quick decline in multiples if the herd-mentality changes.

Downturns bring discipline back into the markets, whether that’s the lending market or others, and that’s healthy. Having worked through the global financial crisis, I certainly don’t wish for something that severe again, but a good, old-fashioned correction in the near future would be healthy for the market. We anticipate the need for Hark Capital’s strategy to increase when economic conditions start to deteriorate.

MMR: What are the opportunities you see for Hark Capital in the U.S. and Europe over the next two years?

Doug: We are starting to see a need for fund financing support in other parts of the world. As the first-mover in North America, we hope to use our deep experience in NAV loans to help sponsors abroad down the road, namely in the UK and Europe. In addition to geographic expansion, we are looking at the best ways to provide private equity firms multiple financing solutions along their natural lifecycle, ranging from capital call lines to end of life solutions. ASI’s global footprint and private markets platform provide a powerful springboard for this.