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The evolution of private debt markets

In recent years, the term 'private debt' has been used to describe numerous forms of debt financing including loans to micro borrowers, small and medium enterprises (SME), large private or listed corporates, as well as loans to larger infrastructure projects.

The larger corporate and infrastructure sectors have generally been well supported by the local and international banking markets, and more recently by the increasing direct participation of institutional investors. The small and medium corporate loan sector, once the domain of the banks, has since 2008-09 come to rely less on the banking sector due to the impact of Basle Banking accords (I-IV). The Basle accords increased the cost of regulatory capital to banks from such lending.

The Royal Commission and SMEs

The last two weeks of the Financial Services Royal Commission have shone a bright spotlight on loans to SMEs, examining bank practices relating to guarantees, reliance on home equity and questionable enforcement. The general expectation now is that the Commission’s findings will boost opportunities for non-bank lenders (NBFIs).

The re-emergence of NBFI’s has come in a number of forms: specialist loan and credit funds, opportunistic Special Situations funds, direct participation in bilateral and syndicated opportunities by large funds, online peer to peer (P2P) and B2B platforms, and private ‘merchant bank’ style financiers.

After the 2008-09 credit crisis, many NBFIs were forced to liquidate their credit portfolios at deeply-discounted valuations. This created a new form of participant by 2010, mainly in the US and EU markets, seeking opportunistic purchases of such portfolios out of ‘weak hands’. These distressed market participants included traditional private equity firms seeking listed equity-type returns, albeit at a higher level in the capital structure.

The resilience of private debt exposures in terms of capital and income returns post-GFC has now created a new asset class which is both accessible and acceptable to a broader investor set. Demand from the SME and mid-market corporate sector in Australia remains robust.

Private debt lending statistics

Recent research of the lending opportunity to the SME and lower/mid corporate lending sectors, defined as borrowers with annual revenues ranging upwards from $5 million to $300 million, has identified some key characteristics of these markets:

  • Less than 3% of the total 2.2 million actively-traded enterprises in Australia have annual turnover exceeding $5 million.
  • As of February 2018, these selected segments comprise more than 65% of banks’ traditional business lending volumes of $713 billion, according to APRA monthly statistics.
  • Enterprises with turnover of $5 million to $300 million entail more than $464 billion of drawn balances with SME balances averaging $3.3 million and lower/mid corporate averaging $48 million per borrower.
  • NBFIs are writing as much as 15% of SME sector and 10% of lower/mid corporate business, or more than $52 billion by volume. This is expected to increase.
  • We believe that the NBFI share of the non-property backed SME sector lending is far greater than 15% due to bank capital-ratio constraints.
  • Independent research also confirms that since the GFC, over 25% of the SME sector no longer nominates a big four bank as its primary lending relationship.

Uberisation of private lending markets

P2P lending platforms in their many forms are now providing access to one form of ‘private debt’ lending which in years past would have been the domain of traditional finance and factoring companies or other dedicated consumer lending organisations. Some P2P lenders use statistical analysis for pricing and recovery scenarios across diversified peer lending platforms.

In the ultra low interest rate and benign credit environment that the world has experienced since 2012, the allure of these providers as a solution for lower tier borrowers and small businesses (less than $5 million turnover and $2 million loan sizes) has recalibrated and repriced that sector of the Australian private debt markets, both in a risk/reward or pricing and availability context.

This ‘Uberisation’ of lower tier sectors (from a credit and loan size perspective) of the private debt markets, has now enhanced the opportunity for other investors to seek well-structured exposure to senior secured borrowers in the SME and lower/mid corporate sectors which are typically too large for P2P platforms due to concentration risk and the size of loan needed.

It has also been encouraging to see recent discussions initiated by Anthony Pratt of Visy Industries and a range of institutional investors, who are exploring this opportunity in terms of both the structural need and risk/reward profile of lending to small, medium and large corporate sectors in Australia. The growing interest in this sector is a result of the compelling risk adjusted and absolute returns available. History shows that if private debt/direct lending strategies to the SME sector are well structured and managed across credit cycles, attractive low double-digit returns can be achieved by investors through actively managed origination, structuring, monitoring and repayment strategies.

Fintech and private lending

Financial technology (Fintech) and private lending markets have experienced significant development over the past five years, fostered by the impact of bank regulation and the greater market transparency of performance and recovery data.

Fintech lending businesses are using data analytics and new credit models to find incrementally better yield and loan performance. Whether these models are P2P, crowdfunded or associated ‘hedge fund’ models, it is too early to judge the success that their new predictive credit models might have other than in the current benign credit environment in which they have evolved.

It appears that many P2P platforms rely on the benefits of granularity and pricing margin (higher interest rates) to buffer investor returns in the event of default experience. Considerations relating to priority of claims in default scenarios and effective recovery outcomes are yet to be tested across the various market insolvency jurisdictions where these funds have flourished.

There is no doubt that the recent advances in data analytics, social media transparency and growing sophistication of credit scoring agencies has assisted the development of these lending markets with more supportive data points. However, the application of robust credit analysis and loan structuring remains a key determinant of both loan servicing and repayment success. Combining this analysis with a background in quality origination and recovery experience is essential.

Other sectors for private debt

NBFIs including specialist debt funds are now becoming more prevalent in the leveraged buyout and syndicated loan sector as well, targeting loan sizes of $50 million upwards as some of the larger institutional funds seek to participate directly. Secured lending across a diverse portfolio of the small and medium enterprise sector for amounts ranging from $5 million to $25 million is also an attractive complement to the syndicated loan and P2P sectors.

Many yield-oriented investors are becoming more comfortable with including this bespoke area of private debt as part of their alternate debt investment exposures, although professional advice in the analysis of credit and risks is required for investors less familiar with the opportunities.

 

Mike Davis is Co-founder and Director of Causeway Asset Management. This article is for general information only and does not take into account the circumstances of individual investors. Investors should seek financial advice before considering private debt opportunities as many structures are more suitable for sophisticated investors.

 


 

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