The alternative financing option for SMEs

31-Oct-2018

Ten years ago a small to medium-sized enterprise (SME) looking to expand its business would have visited its local bank branch to procure the necessary financing in what was usually a fairly routine and straightforward exercise. Fast forward to 2018 and that once dependable funding source isn’t what it used to be, as regulatory capital requirements under Basel III make it all but impossible for banks to lend money to SMEs irrespective of their growth potential or promise.

“The cost to a bank of underwriting a loan for £100m is roughly the same as lending out £1m. Banks ultimately want to keep their shareholders happy and they are looking to deliver and maximise their return on equity (ROE) by focusing their lending to the larger corporate customers,” explains Ayan Mitra, CEO and founder at CODE Investing, one of the UK’s leading institutional debt finance platforms, speaking at a BNP Paribas Asset Management seminar on SME lending in September 2018.

New entrants take ownership

These lethargic lending conditions are forcing SMEs to identify credible solutions to solve their existing funding shortages, conscious that a failure to do so will impede future growth and development. Non-banks have heard SMEs’ calls and are rallying around to fill the lending vacuum. Fund managers have been especially active in launching private credit vehicles with lending facilities to diversify revenues away from flagship strategies.

The Alternative Credit Council (ACC), an industry group, says the private credit market has grown 14-fold since 2000 and presently looks after $600bn in assets, although it is bullish that the sector could break through the $1 tr barrier by 2020. Digital solutions are also becoming more prominent with peer-to-peer (P2P) lenders and crowdfunding platforms increasingly dominating early stage equity fundraising.

Between 2012 and 2014, the amount of capital amassed through crowdfunding grew by 410% while reports suggest that these platforms accounted for as many seed equity deals as the private equity industry. Estimates suggest around £272m was raised in 2016 through equity crowdfunding, while P2P loans totalled £1.23bn. Data from CODE Investing suggests digital, alternative financial platforms could encompass 9.1%, or £52.6bn, of the total SME lending market in Europe by 2021, more than four times the 2% in 2018.

Identifying the forgotten borrowers

While the emergence of alternative lending providers is a welcome development, experts acknowledge that some borrowers are not yet reaping the benefits. “The average ticket size of a private credit manager is in the region of £60-80m, so the beneficiaries of these loans are still fairly large companies,” says Stéphane Blanchoz, head of SME Alternative Financing at BNP Paribas Asset Management. Even the ACC concedes that large cap companies receive roughly a fifth of all committed capital from private credit managers.

In contrast, crowdfunding and P2P platforms typically support micro or small businesses, with the average P2P loan size in the UK standing at only £95,000.  “A lot of SMEs are simply too small to access the debt funds, and too large for the platforms, and underserved by the banks. With an average loan size of £2m, these SMEs nonetheless represent a substantial and attractive investment opportunity. This is our target SME market,” comments Michiel Slinkert, managing partner at Caple. He adds that the bulk of companies Caple supports are either those in need of growth capital to facilitate operational changes or enterprises undergoing an ownership transition.

Blanchoz concurs a significant proportion of the corporate borrower market – estimated to be about 34,000 companies in the UK – are not having their financing needs properly addressed by the current incumbents, adding that BNP Paribas Asset Management’s SME Alternative Financing platform issues loans in the region of £500,000 to £5m to companies with turnover of between £2m and £50m.

New lenders inject fresh thinking

Equity volatility, low interest rates and erratic geopolitics have all hurt returns for investors. A lot of pension funds are wrestling with large deficits and are increasingly operating with negative cash flows, twin challenges which could be cured with a dose of robust returns. SME lending funds provide allocators with consistent, risk-adjusted returns, which are isolated from market volatility and well-insulated against interest rate rises. The returns from direct lending funds in aggregate may have declined to 7.9% but their performance is strikingly stronger than other asset classes and fund subsets.

Despite the respectable returns, some investors are adamant that SME lending is at the peak of its cycle and due a significant correction. “Investors said five years ago that SME lending was at the peak of its cycle but the yields are still far superior to those of 10-year gilts and Sterling investment grade corporate bonds. Compared to capital markets, the credit risk of SMEs equates to a BB or BB- risk profile with a default rate volatility through the cycle far lower than European high-yield,” says Blanchoz. While European high-yield default rates peaked in 2009 at 6.6%, the worst year for UK SMEs was 2008 when default rates hit 2.6%.

An underrepresented corner of the market

There is certainly an abundance of non-bank sources of financing, and there is a niche opportunity for those providers supplying funding to mid-sized SMEs who are simply too small in balance sheet terms to attract flows from private credit managers, but are simultaneously precluded from P2P and crowdfunding platforms as they are too big. It is this category of SME which BNP Paribas Asset Management is focusing on. Not only can SME lending strategies deliver consistent returns to clients, but it supports corporates’ growth ambitions providing a much-needed boost to the real economy.