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Pandemic to accelerate SME’s embrace of alternative lenders

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The maturity of the UK’s private debt market over the last decade represents a significant silver lining for growth-focused SMEs navigating the intensifying second wave of the pandemic. Back in 2008, UK high street banks controlled over 90% of the SME market for refinancing and new lending, but they were also at the epicentre of the crisis, which limited liquidity. The advent of the private debt market has changed this dynamic. As the global health crisis has morphed into an economic crisis, it has engulfed banks’ bandwidth, limiting their ability to service all but the most valued and lucrative clients. But, this time around, SMEs have options to secure new debt financing from the alternative lending market, which is estimated in the UK to be worth around £15 billion per annum. Total UK SME loan exposure is around £180-200 billion, according to the Bank of England, of which, approximately one-third needs to be refinanced annually.

The pandemic is bifurcating the financing of for corporates, at least in the near- to medium-term. As discussed in an earlier article, companies with sustainable business models that also can offer banks fee-based mandates such as M&A, IPO, private placements, foreign exchange, treasury management and liability, will understandably be preferred in the current environment. But the majority of SMEs wanting basic loan products may find themselves beyond banks’ bandwidths over the next six to twelve months. As such, many SMEs could conclude that they need to pivot to the private debt market in the current environment. This can provide a reset for SMEs to first secure their corporate survival and, second, strategically plan an investment roadmap to accelerate future growth. Before exploring the operational flexibility that alternative lenders can provide, a brief review of this sector’s origins is worthwhile.  

The private debt market was born out of the financial crisis. Central banks around the world responded with massive monetary easing – through low, zero and negative interest rates as well as Quantitative Easing (QE). Ever since then, institutional investors – including pension, annuity and endowment funds – have been chasing yield in a low-interest-rate environment, pushing these ‘real money’ investors into real assets and debt in ever-larger allocations.

These yield-starved investors provided capital to debt managers – spanning the risk-return spectrum – which promised a return. The business model of debt funds is crucially different from banks. Fund managers deploying debt capital are motivated to put capital to work and amass assets under management (AUM), to generate a return for investors. This AUM-focused business model allows debt funds to offer: i) more capital (or higher LTVs), ii) longer terms (debt funds usually provide five to seven years, compared to banks’ three to five-year term sheets), and iii) more covenant flexibility.  Overall, funds tend to offer interest-only loan/debt products with bullet repayments compared to banks which prefer amortisation from Year One, which can leave lower cash flow headroom, notwithstanding lower interest margins.

In the current environment, SMEs benefit from swift access to capital to support their medium- to long-term business plans with increased operational flexibility. The flip side is that it will cost more. As a ballpark indicator, borrowers can expect to pay around 3x more on their debt service coupons, relative to their existing interest margins. However, direct comparisons must be treated with caution, as the terms may widely differ to the extent that bank and debt fund facilities – beyond the common thread of senior credit – are often more different than similar. Beyond the structural characteristics outlined above, facilities extended by banks often include principal amortisation within the term, as opposed to interest-only facilities more common from debt funds. Also, the AUM-focused business model is of debt funds are motivated by returns, not arrangement and underwriting fees that are key to banks’ business models.

As SMEs continue to grapple with their liquidity and investment requirements for the next six to twelve months, we anticipate more sustainable businesses will look more closely in the direction of alternative lenders. With the UK now in its second national lockdown, the certainty private capital can offer SMEs will be a powerful driver in accelerating this change.

If the issues discussed in this article are pertinent to your near-term business decisions, and you would like a deeper understanding of the alternative lending market, please do get in touch with our team to do and we will help as we can.

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