Australian middle market continues to power ahead as the engine room of economy

The Australian middle market is a large, diverse, and dynamic set of operating businesses. It’s often referred to as the engine room of the nation’s economy, employing nearly a quarter of all Australians, and responsible for almost 40 percent of Australia’s business revenue.

To be clear, this is where the action is. These are growing businesses, dynamic, fast-moving, entrepreneurial in nature, exploring new regions and new markets, and embracing technology.

Middle market companies form a critical part of the Australian economy. According to the ABS (2019), there are about 2,300 businesses that are considered large companies (more than 200 employees). By contrast, there are close to 35,000 businesses within the Australian middle market (companies with annual revenues over $10 million but less than 200 employees). It’s a big segment.

Additionally, the mid-market is where much of the M&A action is in Australia with medium sized companies accounting for around 80% of all M&A transactions.

But being mid-sized is not always an advantage.

In surveys of middle market companies, the greatest barrier to growth and innovation nominated by business owners is a lack of access to capital. Conversely, large companies place access to capital as the least of their concerns when it comes to building their revenue and earnings. This is evident when the big end of town can attract funding relatively easy with many having open access to the listed markets, and Banks (both local and offshore) eager to lend.

Whilst corporate lending in Australia is dominated by traditional bank lenders, structural change has occurred and banks face several key challenges in lending to middle market companies which will continue to restrict their lending activities, and accordingly, limit the supply of capital to these companies, including:

• Capital requirements and regulatory change: Tightening of capital adequacy requirements by the Australian Prudential Regulation Authority mean banks are more inclined to lend to businesses who can offer substantial physical assets as security, thereby embedding a bias away from intangible assets which in today’s economy are crucial pillars of productivity;
• Poor customer experience: For the last four consecutive years to June 2020, the Net Promoter Score for Business customers (a measure of customer advocacy) at each of the four major banks has been negative, reflecting a largely unhappy customer base;
• Inability to provide loan product innovation: Australian banks are seeking to standardise loan products in order to digitalise lending processes and reduce their cost base;
• Resourcing: Specialist teams are difficult to retain and incentivise and typically gravitate towards Large Cap transactions, an issue that is exacerbated with banks shifting to standardised products and tightening credit appetite.

These factors contribute to a rich environment for agile direct lenders to present as a compelling alternative for borrowers and achieve attractive loan economics.

Loans will remain as a primary source of funding growth. Most senior loans typically provide for company owners to maintain control of their businesses as they grow. This is an important factor as many middle market companies are generally family-owned or closely held and are therefore reluctant to dilute control and decision-making to private equity (PE) sponsors and third-party equity investors.

However, many of these companies typically do not have meaningful access to debt capital from offshore or onshore bond markets or the broadly syndicated loan markets, because they lack the scale in earnings, public profile, track record and/or bond issuance size (generally required to be greater than $100-150 million).

Add to this funding problem a generation of business owners that are getting older and face real succession issues. 70% of middle market business owners are currently planning to sell or pass on their business, and the capital to facilitate that transition, as well as to grow the business under new owners, has never been harder to access.

We have observed these trends play out firsthand in middle market Australia over the last decade.

Nonetheless, we continue to be enthusiastic and excited by this group of growing companies. They remain distinctive as they are large enough operationally to make a meaningful impact on the economy and are often small enough to be entrepreneurial in nature, hold leadership positions in market niches, and adjust quickly to prevailing market conditions.

While access to capital is the biggest impediment to growth for these 35,000 Australian middle sized companies, we see this as an enormous opportunity.

Middle market direct lending opportunity is a large, stable segment worth AUD70 billion. This is not distressed lending, but lending for growth and event-driven financing including leveraged buyouts and acquisitions. It’s a very stable segment, which has much lower volatility embedded than real estate lending or special situations lending.

With many banks underserving the middle market, we see an opportunity here – and Epsilon is the only Australian fund manager that focusses purely on performing companies in this space.

With material constraints on the supply of capital to medium sized businesses, combined with strong demand, great lending conditions and structural product advantages, middle market direct lending presents a highly compelling risk adjusted reward opportunity for investors and borrowers today.