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For some investors, raising the idea of investing in corporate private debt brings almost immediate questions about the risk of default, the security of the loan and even why a company would raise debt and not equity. Yet almost every day we make debt-like investments, a term deposit being the simplest, through which you are effectively lending money to a bank, which will then on-lend that money as it seeks to make a profit.

Debt funding is one of the most important parts of the capital structure for the majority of businesses around the world, but particularly those that are not listed on the ASX or other exchanges. Consider for instance the estimated 35,000 Australian middle market companies, which specialist lender Epsilon Direct Lending highlights as being starved of capital in the current environment.

Stepping back, place yourself in the position of a medium-sized business owner, perhaps running a manufacturing warehouse with a good financial track record, solid market position and opportunity to acquire a major competitor. In order to fund the acquisition, the business owner has three main options to do so. The first is to use existing retained cash in the business, or its own equity.  The second, is to raise money from external parties, or equity, to fund the acquisition. The third is to seek a medium-term loan, secured by the assets of the company and business being acquired.

In the case of raising equity, you immediately lose a portion of control over your business and are now responsible to those new shareholders; who may be passive or seek to be actively involved in your operations. In the case of debt, as long as you meet the terms of the loan you receive, paying interest, reporting any changes in your business and continue to perform, you retain full ownership of both the new and old businesses.

In investing, the saying goes that there are three emotional drivers for investors; fear, greed and hope. Lying at either end of the spectrum, fear tends to work best when you consider how many times you have clicked on the article about ‘financial apocalypse’ or why newspaper headlines read ‘XX billion lost in a single day’. Hope on the other hand has been a key driver between the incredible popularity of highly-valued technology and speculative smaller company stocks in the last year.

What these ‘hopeful’ investors are effectively seeking, though, is ‘growth’. Anyone involved in the small and micro-cap company space will agree that it can be something like the Wild West in the way that deals get done and capital gets raised. The issue, of course, for smaller investors is that they have access to very limited information on the companies in which they seek to invest, particularly if they are private. In most cases, this is limited to publicly available information in financial statements and prospectuses.

On the other hand, however, there are the lenders. As we have seen in a number of high-profile corporate collapses over the years, the ultimate owner of a collapsed company is its lenders. If you no longer have access to debt and are required to repay it, you might be in significant trouble. The position and legal power of lenders is such that they can demand significantly more information and more detailed reporting from the companies to which they lend: this is guaranteed by their loan agreements.

A growing cohort of specialist lenders is now opening up access to this other side of the capital structure for fast-growing and performing businesses. Who said debt can’t be sexy? Epsilon Direct Lending is one name that is building a reputation in the private corporate lending sector, targeting the so-called Australian middle market, which it defines as companies with annual turnover greater than $25 million and generating consistent annual free cash flows.

The group was founded by three ex-CBA bankers, Mick Wright-Smith, Joe Millward and Paul Nagy, who will invest only into performing and growing companies. Just a few short years ago, the Australian banks’ market share of middle market lending exceeded 95%, but the environment has changed, and continues to evolve. Incentivised by lower capital requirements, the major banks have moved to residential and commercial property-backed lending once again, starving an important part of the Australian economy of capital.

This was among the reasons for the founding of Epsilon, with the team spending years building its corporate lending division along with a diverse network of relationships with a multitude of entrepreneurs and businesses all around Australia. For the benefit of scale, Epsilon points out that the ASX is valued at some $2.5 trillion, and has hundreds of fund managers offering exposure to the market in various ways. On the other hand, despite there being an estimated $1 trillion in corporate debt, very few fund managers offer access to anything outside of property, distressed, consumer, small business finance or large corporate lending.

Epsilon’s strategy is based on backing performing and growing companies. Their loans are specifically structured and largely require the borrower to put the capital towards expanding their businesses, whether that is in the form of acquiring new businesses, opening new stores, or expanding overseas.  The group has historically partnered with a number of local and offshore private equity firms, providing the debt finance to support the fast-growing companies in which they invest.

According to Epsilon’s recent white paper, “Australian middle-market companies are distinctive in that they are large enough operationally to make a meaningful impact on the economy, yet are often small enough to be entrepreneurial in nature, hold leadership positions in market niches, and adjust quickly to prevailing market conditions.”

Of course, there is no such thing as a risk-free investment. However, one of the key benefits of being a debt provider to a performing and growing company is the generally shorter term to maturity and the high proportion of contributed equity in middle-market direct lending. With most loans carrying three-to-five-year terms, this is far shorter than the seven-to-ten-year lockups required for an investment with private equity alone. Loans typically only contribute 40% of the value of the business, which is far lower than the 70%+ typically seen in commercial property loans. With Epsilon targeting a net return of the bank bill swap rate (BBSW) plus 6%, this investment isn’t without its risk, but with equity markets increasingly volatile, there is little wonder that direct lending strategies have become so popular around the world.