ONE CONSEQUENCE OF THE GLOBAL CREDIT AND BANKING crisis is an ongoing lack of available capital for so-called middle-market companies. Big banks don’t lend to smaller businesses as freely as they once did, and firms like CIT Group have followed suit. Meanwhile, several hedge funds have pulled back or moved into other markets. “The hedge fund community generally was once a serious provider of private credit to these companies,” says Robert Ladd, CIO of Stellus Capital Management.

This retreat creates a huge opportunity for firms like Ladd’s. Houston-based Stellus focuses on lending to companies with annual earnings before interest, taxes, depreciation and amortization of $5 million to $50 million. The firm has two main investment strategies: a middle-market direct lending business and private equity financing for the energy sector. Stellus invests across the corporate capital structure, through first- and second-lien loans and mezzanine and convertible debt as well as preferred and common equity.

Until January the 21-person Stellus team was part of D. E. Shaw & Co. Three of the current five partners, including Ladd, joined the New York–based investment firm in 2004 from Duke Energy Corp. to launch its direct lending division; the other two arrived the next year. Ladd, who holds an MBA from the University of Texas at Austin, was worldwide managing partner for Arthur Andersen’s corporate restructuring practice in the U.S. before joining Duke, where he served as president and CEO of private capital subsidiary Duke Capital Partners.

Stellus has $1.4 billion in assets under management, part of a subadvisory agreement with its former parent. Although it’s always had a diverse business, $26 billion-in-assets D. E. Shaw is best known for its quantitative and technology-driven investing and trading strategies. An illiquid provider of bespoke loans to small companies seemed to many like an unusual fit, even if it was an uncorrelated source of returns for the firm’s hedge funds.

In 2008, D. E. Shaw raised a separate fund for its direct capital business. But like almost every other manager, the firm as a whole struggled in that year’s economic collapse. Since then D. E. Shaw has undergone a retrenchment that included laying off 10 percent of its staff and getting out of certain noncore businesses. The spin-off of Stellus was part of that shakeout.

Ladd and his team were also keen to strike out on their own. Given the nature of their business, they were already largely independent. “We had been interested in starting our own firm,” Ladd says. “We were able to do this with the continued support of D. E. Shaw.”

Louis Salkind, a member of the Executive Committee of the D. E. Shaw group , points out that over its 24-year history his firm has built several units that were spun off as stand-alone businesses. For example, in 1996, D. E. Shaw launched Juno, an Internet service and e-mail provider. A few years later the firm decided to spin off Juno, which later merged with Internet service provider NetZero. More recently, D. E. Shaw has maintained a relationship with Meng (Leon) Liang, who ran its Chinese private equity business from Hong Kong before leaving last year to start his own firm, Ascendant Capital Partners. “The Stellus business occupies a great niche in the middle-market direct capital sector,” Salkind says.

Stellus likes what it sees in the energy industry. Ladd says there are strong opportunities to invest in the equity of North American junior energy companies using new forms of technologies, such as fracking, to retrieve oil and gas from existing deposits that were previously uneconomical to develop. “The risk-reward is more interesting on the equity side than on the pure credit side,” Ladd says of this space. Knowing that the deposits are there makes investing less speculative than, say, wildcatting for oil, and the companies will sell equity at appealing prices to meet their capital needs.

On the lending side, private equity sponsors looking to finance middle-market buyouts have been an attractive source of deals for Stellus. Ladd won’t cite any recent transactions where his firm has acted as lender. But he notes that almost the entire private equity industry is looking for middle-market deals — which happen to be Stellus’ sweet spot.  •  •