Here’s How Alternative Lenders Can Help Your SME Close the Funding Gap
In spite of the economic uncertainty around Brexit, British SMEs remain hungry for growth and are generally optimistic about the future. What often holds them back is a lack of funding, particularly through conventional avenues. Below Andrew Boyle, CEO of LGB & Co, discusses with CEO Today how alternative lenders are helping SMEs fund their growth strategies as banks have continued their retrenchment in this sector of the market.
SMEs often need to raise money quickly to adapt to changing markets or new opportunities, but obtaining bank financing can be a slow and cumbersome process.
Almost a decade after the financial crisis, bank lending to SMEs has picked up – but a considerable funding gap remains. Estimates by the British Business Bank suggest 100,000 businesses have their applications for debt rejected each year – representing a possible shortfall of £4 billion. This is being exacerbated by the likelihood that UK firms will lose access to EU regional funding once the Brexit process is complete.
Bank funding is generally available to companies that can provide asset backing or personal guarantees. Difficulties arise if companies cannot offer such credit support or it provides limited borrowing capacity. At the other end of the capital structure substantial funds are being deployed by private equity firms, enterprise investment scheme (EIS) fundraising institutions and venture capital trusts (VCT). After a rush of successful fund launches, private equity firms are currently providing substantial funding at attractive valuations for business owners. However, it can be difficult to align the interests of business owners with those of equity investors who wish to see an exit within a relatively short period. In addition, legislative changes are limiting the application of funds provided by EIS and VCT investors.
For companies seeking more flexibility without selling a stake in their business, private debt can offer a compelling opportunity. One option is Peer2Peer (P2P) lending, which has exploded in popularity over the past few years. From a virtually negligible volume in 2011, business lending flows have soared at an annual growth rate of 131 per cent over the subsequent five years, according to Deloitte. Companies can borrow directly or discount invoices on P2P platforms. But while P2P continues to grow impressively at the lower end of the market, it struggles to serve companies that have larger funding requirements – around £3m or more. P2P is also generally inappropriate for borrowers with complex capital structures, particularly if investors are individuals.
Another route to obtaining private debt is through direct lending funds. These tend to offer a faster approval process than banks, and more flexible structures than P2P loans. However, managers of credit funds often favour borrowers that are backed by private equity firms as they rely on support from shareholders and place less emphasis on conventional credit analysis. Smaller funds tend to focus on high growth companies in the tech sector with a high cost of capital. This is because the funds’ relatively high operating costs necessitate lending targets of 10% p.a. or more.
In addition to the amount of funding and cost, borrowers need to consider which structure suits their borrowing requirements over time. At LGB, we believe we’ve identified a gap in the private debt market for SMEs. For firms in both the finance and manufacturing sectors with a need to tap a financing facility on an ongoing basis, we’ve pioneered the introduction of secured loan note programmes. These are based on Medium Term Notes (MTNs), which are a cornerstone of the institutional credit markets. Common programme documentation allows repeated issuance on a scheduled or ad hoc basis with varying maturities of 1-5 years. Issuers build up an investor following through regular presentations and trading updates. Interest rates tend to range between 6% and 9%, which places the cost of funds between the upper end of bank funding and the lower end of lending by credit funds.
Unlike direct lending funds – which typically seek to fund a company’s entire debt capital structure – issuance of loan notes encourages a diverse lender base, including high net worth individuals, family offices, and alternative institutional investors.
From the investors’ perspective, secured loan notes are attractive not only because they offer considerably higher returns than bonds, but also because they have robust security arrangements. Covenants and collateral are monitored by a security trustee. Regular issuance means that investors can build exposure to these instruments gradually.
Our estimates suggest that the UK’s immediate addressable structured loan note market is worth around £450m. All in all, we believe this represents a potentially exciting emerging source of funding for growth businesses to consider. But whether through loan notes or other vehicles, it’s clear that private debt does provide a faster, more flexible alternative to bank loans for SMEs looking to fund their growth strategies – and, ultimately, help to ameliorate the UK’s funding gap.