Kartesia’s Credit Opportunities (KCO) Funds III and IV have received The Hedge Fund Journal’s Alternative and Private Credit Award 2021 for Best Performing 2013 and 2018 Vintages in the Direct Lending – Senior/European strategy category. Awards for closed end funds were based on IRR data reported to Preqin.
KCO V, which closed at EUR 1.5 billion in May 2021, and the inaugural senior debt fund, Kartesia Senior Opportunities (KSO I) launched with EUR 1 billion in March 2021, are too new for Preqin to report the data, but the early indications are of strong pricing: spread per turn of leverage of 380 basis points across the 36 investments so far made in KCO V offers an attractive risk adjusted return.
KCO is active in primary and secondary direct lending, investing across first lien, mezzanine, and CLO liabilities. Firm assets in CLOs, including a dedicated vehicle, are EUR 300 to 400 million, or around 10% of Kartesia assets of circa EUR 4 billion.
We can offer more leverage than a bank but will normally be less dilutive than private equity.
Laurent Bouvier, Founding Partner, Kartesia
Kartesia’s direct lending approach is distinguished by its growing origination; preference for sponsor-less, bespoke deals using local law and language; maintaining a board presence and catalysing growth; generating returns from equity exposure; and increasingly nuanced and tailored ESG policies.
Since inception, Kartesia has deployed EUR 3.3 billion into 162 deals, across the primary and secondary spectrum. Kartesia pioneered lower middle market direct lending in Europe, to companies with enterprise values of EUR 30 to 250 million.
Kartesia started investing in secondaries in its first two funds in 2009 and 2013. “We started sourcing secondaries from CLO managers but now it is mainly from banks, who need to monetise their balance sheets, and restructure or sell loans. We also expect to find more deals from direct lenders as they start to underperform,” says Laurent Bouvier, founding partner of Kartesia.
More recently, Kartesia has been growing its share of primaries from about 30% of KCO III to 50% of KCO IV and possibly 80% of KCO V. KSO has a higher share of primary deals, which as of today represent 100% of total investments. Kartesia funds 100% of deals in most cases but between 5 and 10% of Kartesia assets are in co-investments, and “We also very selectively syndicate with “co-petitors” who have a similar DNA on deal making and monitoring,” says Bouvier.
Over 90% of Kartesia’s deal-flow is sourced through “off market” or limited competition deals and the Covid crisis has provided abundant deal-flow. “We never invest in club deals and aim to be the sole lender and sparring partner on the primary side, where everything is bespoke,” says Bouvier. Some 70% of loans do not have a private equity sponsor. “Sponsor-less deals offer more friendly terms as we often have an exclusivity agreement in the due diligence phase. On average, sponsor-less deals extract 400-500 basis points of extra returns, but they do take longer to originate: 3-9 months getting to know company management and markets, with a higher level of due diligence.”
Over 90% of Kartesia’s deal-flow is sourced through “off market” or limited competition deals
Some direct lenders insist on English law documents in all jurisdictions, but Kartesia uses local law and language: “The philosophy is “glocal”. We are a global firm but apply local business models in Europe. We find this makes us more relevant and better at originating and monitoring. We like to be a local and long-term player, and our seven local offices have been helpful for sourcing, monitoring and site visits throughout the Covid crisis, despite travel bans. We have not slowed down at all,” says Bouvier. The firm is active in the Benelux, France, Germany, Italy, UK, Spain, and occasionally, in the CEE.
For 92 exited deals across 18 European countries since inception, the average realized gross return was 16.4% IRR and 1.4x multiple. Around 30% of returns have come from cash or PIK (payment in kind) yields and 30% from secondary market discounts to par. “Ten years ago, the contractual share of returns was higher, but the overall IRR was similar at around 15%; average leverage has actually decreased,” says Bouvier.
Equity kickers have contributed a growing share of returns, averaging around 40% of historical performance, and appeal to Kartesia’s borrowers: “Family entrepreneurs are focused on value creation and equity-linked instruments are at the heart of their business models. This creates a win-win situation. Our business model is halfway between banks and private equity. Banks may offer plain vanilla, low leverage at low margins but they are becoming less relevant for the lower middle market, of companies with less than 10 million EBITDA. Majority or minority private equity offer more cash but more dilution. We can offer more leverage than a bank but will normally be less dilutive than private equity,” says Bouvier.
“Dilution” includes both equity stakes and governance. “We have a board presence – either as observers or members – 60% of the time for senior loans, and 80% of the time for KCO. We always ask for a board presence because as sole lender we want to be a sparring partner. We might not get it in two main cases: when we are a minority lender, or in the UK where private equity sponsors push back,” says Bouvier.
Kartesia relishes its active involvement and often acts as a catalyst for growth, supporting companies as a partner to the management team: “We invested in Benelux and US based SPI and encouraged a strategic buy and build approach, acquiring a competitor in 2019, which more than doubled the size of the firm. They are now a global leader in digital sales and training for large companies,” says Bouvier. “In Austria, we lent to a manufacturer of apparel linen woven menswear, after a private equity fund needed to exit. We did a dividend recapitalization, distributing a first return to investors, and extended the fund by two years, after which the firm’s EV valuation multiple increased from 5 to 7 times.”
Kartesia’s activism is quite selective in relation to special and distressed situations: “If the capital structure is oversized versus profitability, we might convert part of the debt into equity so there is no cash strain on the firm. A full operational turnaround is not our preference however, and we would not go for a lossmaking distressed situation,” says Bouvier.
We are declining more and more deals each year for ESG reasons, based on discussions with investors.
Laurent Bouvier, Founding Partner, Kartesia
Kartesia might sometimes accept a loss and exit where the time and effort needed to turn a company around is excessive. Kartesia reports close to 0% loss rate across the last three funds but has made a profit across all defaulted deals. “Though two situations lost money, others where we did debt for equity swaps made multiples so that the overall return was positive across these deals,” says Bouvier.
Seniority and asset backing are other risk mitigants. Over 70% of KCO deals are first lien while all KSO I is first lien and secured. Kartesia is a cashflow lender, but it can have recourse to various types of assets: “They could be land, buildings or equipment; inventory such as gold; or brands such as Pyrex,” says Bouvier.
Kartesia lends in Europe, but its investors are increasingly global: “Our investor base 10 years ago was mainly French, but we have been raising assets throughout Europe and the UK and in the Middle East, in Israel and UAE. The recent strategic partnership with Candriam and New York Life helps with distribution, particularly in the US and Asia,” says Bouvier.
“It also helps to anchor and seed new funds and strategies and is also designed to assist with due diligence in launching the new SFDR article 9 impact investing strategy,” says Bouvier. All Kartesia’s other funds are now classified as article 8 under SFDR (apart from a small, segregated mandate in structured credit that is category 6 to match the client’s preference).
At Kartesia, sustainability and engagement have always been core for both the firm and its investments. Examples are ongoing discussions with management and sponsors, ESG reporting, carbon reductions and offsets at corporate level, carbon assessment at portfolio level, and IT security and data protection at both levels.
The philosophy is to integrate ESG into the investment process: “We don’t want ESG to be treated as a side activity, we want it fully integrated with our investment strategy and processes. The investment team is responsible for ESG engagement with companies, though they are supported by ESG specialists,” says Kartesia’s Head of CSR and ESG, Coralie De Maesschalck, who was appointed in 2021 in this new function, and has a veto right on the investment committee. Prior to 2021, De Maesschalck was Head of Portfolio and ESG.
Since inception, Kartesia has deployed EUR 3.3 billion into 162 deals, across the primary and secondary spectrum
“We are declining more and more deals each year for ESG reasons, based on discussions with investors,” says Bouvier. The exclusion list grows every year, and with each new launch. Though side letters do cover ESG, Kartesia would rather apply exclusions to an entire vehicle than give individual investors excusal rights to opt out of particular deals.
The usual industries are excluded but there are also more nuanced situations that call for judgement, especially in terms of social impact: “We decided not to expose our reputation to sectors charging high interest rates to consumers, because lending to uneducated people in a difficult and weak situation is not right. We also turned town a deal where part time workers harvesting in the South of France had poor housing conditions,” says Bouvier.
Kartesia has also declined to lend to some businesses where the activity has positive ESG impact but there are concerns about the company’s business model: “When we looked at a company that facilitates carbon offsets through reforestation, we found that EBITDA margins of over 60% meant that only one third of the money invested in reforestation was spent on the end use. This was not a proper balance,” says Bouvier.
Supply chains or customers can sometimes be critical. “Alcohol distribution by itself would be excluded but is acceptable in a supermarket or restaurant with significant additional due diligence as this remains a sensitive sector. On the other hand, paper would not normally be excluded, but might be if a significant part of revenue came from an industry such as tobacco, which is on the exclusion list”, says De Maesschalck.
The Kartesia Impact Fund has a lower return target than KCO because it is a more plain vanilla, senior debt, first lien strategy, implying no overlap whatsoever with KCO. This is not due to its impact aspect. “The objective is to provide financing at lower rates of 4-5% to companies that strive to be in the top decile or quartile on ESG metrics such as carbon emissions and gender diversity,” says Bouvier. This strategy can offer savings of tens of basis points in interest for companies that meet certain KPIs (Key Performance Indicators) on sustainability. Kartesia does not view this as sacrificing returns for impact, argues De Maesschalck: “Stronger ESG performance reduces credit risk, and therefore risk-adjusted returns are better”.
In 2019, Kartesia participated in a UNPRI initiative on ESG and private debt, by contributing a case study regarding their work with Sustainalytics: “The main challenges are getting the data and getting access to management as a lender rather than an owner,” says De Maesschalck. “Some firms are too small to report data, but models can fill some data gaps. We work with Sustainalytics to estimate carbon footprints, aggregate data and convert it to benchmarks. Engagement can sometimes help to access management,” says De Maesschalck.
A sensitive and adaptive approach helps with both data and engagement: “ESG due diligence is integrated into the due diligence investment process. It is tailored rather than standardized, questionnaires are used, adapting the process, modelling and memorandum to each company. This means that portfolio companies welcome the diligence. Questionnaires are different for loans and CLOs, and for sponsored and sponsor-less deals. We collaborate with private equity sponsors and use their own ESG due diligence, ESG and CSR policies. Questionnaires are updated regularly,” says De Maesschalck.
“Companies appreciate this and benefit from sharing of knowledge, such as safeguards to help prevent cyberattacks and Sustainalytics’ modelling on carbon footprints. We encourage them to engage on social media to show their CSR and ESG credentials”. In fact, all stakeholders – investors, regulators, and companies – are uniting towards the shared goals of CSR and ESG. “Companies realise that they need better ESG performance for borrowing, recruitment and insurance,” says De Maesschalck.