Credit vs. private equity: what edge do secured lending funds bring to investment?
January 2016 | EXPERT BRIEFING | FINANCE & INVESTMENT
It has been apparent for some time that many small and rural businesses such as farmers, and companies serving the farming sector in the UK, have been struggling. They have been facing the combined challenges of falling commodity prices, and high electricity prices combined with a general retreat of commercial banks. The continued decline of certain types of business finance was demonstrated recently when it was announced in the mainstream media that UK bank overdraft facilities for small businesses were still being reduced by approximately £5m per day, and that the bank branch network has shrunk by approximately 40 percent since 2008. Financing, much needed to provide for the modernisation of infrastructure and for cheaper sources of energy, along with dealing with increasing amounts of recycled waste requirements, has been hard to come by for many.
Is this something the private equity industry could have helped with? The demand in this market was for commercial loans. Such loans could be secured against British farmland, a real asset that has retained considerable value regardless of the UK’s economic position. But beyond that, the investment opportunity is a different one to private equity (PE).
PE funds generally don’t wish to own individual farms and food production related businesses. While they will invest in energy companies, they are less interested in financing smaller solar, wind or bio gas related projects, for example.
Smaller enterprises tend to have cash flows and balance sheets that would be too small for most private equity firms and too large or complex for most crowd funding or peer to peer groups. Secured finance, by contrast, can generate a consistent income stream that is founded on businesses in the food production and processing sectors, industries that are less vulnerable to economic downturns.
Beyond this, however, is the issue of liquidity. Investors in alternative assets remain sensitive to liquidity risk in their portfolios. PE and venture capital funds will tend to require substantial medium term commitments, typically of 10 years, but sometimes longer. Asset-based lending, on the other hand, has the potential to offer a much shorter term liquidity profile, with scope for funds to be redeemed within a few months’ notice. Not all loan funds are structured this way, and many retain the liquidity characteristics of longer term investment vehicles, but funds with a very diverse range of clients can certainly deliver superior liquidity to private equity, while often maintaining a low correlation to traditional equity and fixed income market based investment opportunities.
Asset-based lending funds are growing in size around the world. In the UK alone, according to the Asset Based Finance Association (ABFA), £4.2bn of alternative business finance is now secured against hard assets. This is a 9 percent year on year increase. The overall amount of funding in the UK provided to businesses via asset-based finance, including invoice finance and secured lending, was £19.3bn at the end of June 2015. Within the European Union as a whole, factoring and commercial finance volumes grew by over 7.5 percent in 2014 to €1.37 trillion, accounting for 10 percent of EU gross domestic product.
Private equity is a more mature industry – but in Europe, according to the European Venture Capital Association, PE funds invested €42bn and divested €39bn in 2014. Data from Preqin indicates that €158bn had been committed to loan funds globally by the end of Q1 2015, with €46bn aimed at Europe. Other research suggests even greater numbers. This demonstrates just how quickly this industry has grown in the last few years.
A funding gap for small and medium enterprises (SMEs) in Europe and elsewhere has emerged, as banks continue to retrench from various countries and sectors where margins or high capital requirements make it less attractive. At the same time, investors have been searching for funds that use strategies which are not correlated to public markets, and make use of an approach which is both transparent and easy to grasp, and can beat benchmark bond yields. Asset-based lending offers both.
Private equity is an established asset class but, as we have seen in the last 15 years or so, it can prove to be cyclical. Managers will seek to divest companies from their portfolios at superior valuations in the right economic climate. Individual funds, once raised, are closed ended, beholden to a limited timeframe, and will often need to begin to look at divesting assets after the fund has passed the five year mark.
Asset- based lending funds tend to be open ended, with a potentially unlimited lifespan, and a more diversified portfolio. A typical structure that could offer a diverse loan portfolio might see a fund owning a number of financing companies that provide the loan capital to the end clients and act as a significant source of ongoing deal flow origination.
The underlying financing companies are a critical part of the strategy as they oversee the risk of the various loans that are extended to SMEs. It is important that they are managed by personnel who have extensive experience in commercial finance or banking and also understand the economics of the sector they are active in. Like private equity, asset-based lenders tend to gravitate to particular sectors or segments of the market where they have expertise, relationships and deal flow.
Private equity funds, and in particular venture finance funds, play an important role in providing capital to businesses, including start-ups. We have also seen a more recent trend toward impact investing within fund management, the financing of firms or projects that can deliver benefits to wider society. Asset-based lending is starting to play a similar role to private equity in this respect, replacing the sources of finance needed to keep critical sectors like farming, food production and the renewal of energy infrastructure investment going, literally helping to keep the lights on.
One of the benefits of impact investing, apart from the obvious social input, is that its role is recognised by government. In the UK, the government is providing guarantees on pricing for new electricity generating capacity. The UK continues to have some of the most expensive electricity in Europe and it is approximately 90 percent higher than 10 years ago while remaining the same price as one year ago. We are seeing this with large projects, like the nuclear power station at Hinkley Point, and with smaller projects too. It is this encouragement at the political level that is helping to contribute to the wider growth of asset-based lending as a mature and respected investment class.
Finally, from the perspective of financial structure, while private equity funds are treated as owners of a business in legal terms, asset-based lenders tend to be creditors of the business, and providers of secured loans. They have recourse to valuable assets in the event of the failure of a business.
Whether asset-based lending comes to be regarded as a subset of infrastructure investment is an open question, but we believe that it is evolving into an asset class in its own right, alongside real estate, PE and hedge funds.
Craig Reeves is the founder of Prestige Capital Management. He can be contacted on +44 (0) 203 178 4055 or by email: firstname.lastname@example.org.
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