Private Debt: the flexible formula for SME growth (and other ambitions)
26 April 2019
Innovation in the private lender market is essential if small businesses are to access the funding they need, says Stephen Catling, Head of Private Debt
You’ve probably heard the one about a banker being someone who wants to lend you an umbrella when it’s sunny, but takes it back when it rains. But it might surprise you to learn that even after 25 quarters of positive UK GDP growth, the number of ‘umbrellas’ being handed out by UK banks continues to fall.
Recent figures from the British Business Bank show that the proportion of small and medium-sized businesses using external finance has fallen significantly in recent years: just over a third used it in 2018, compared to 44% in 2012. But at the same time, 50% of SMEs still aspire to grow over the next 12 months and without the right external funding, that can be a challenge.
Ever since the financial crisis a decade ago, constraints on bank lending have left many small businesses, no matter how strong or successful, out in the cold as far as mainstream lenders are concerned. Today, bank lending figures to SMEs don’t look much healthier than they did five years ago.
According to data from UK Finance, which represents around 300 firms in the UK providing credit and banking services, the number of monthly overdraft approvals to UK SMEs regularly exceeded 20,000 back in 2012. In the latest twelve months (to September 2018), the average number of approvals per month was just 11,000.
Added to which we have the ‘known unknown’ of Brexit, with one in three small businesses expecting access to finance to become tougher once the UK has left the EU, according to the British Business Bank’s research. Given what an important contribution SMEs make to our economy, this is a significant concern.
Of course, there are alternatives to debt, such as private equity investment, but that’s not always a suitable option. A private equity investment is ideal when a company is undergoing a change of ownership (e.g. when the next generation of management wants to buy the company), or when there is an opportunity to invest riskier ‘growth capital’ in new products or markets that could just be the next ‘big thing’. But what about good, solid, dependable UK businesses that don’t want to give up a significant equity stake, or who aren’t trying to shoot for the moon?
Accessibility and attractiveness
In those cases, debt finance may be the suitable option and with the banks still in retreat, that means there’s clearly a huge opportunity for alternative lenders to step in. One of the fastest growing areas of the market is private debt, which now has record levels of assets under management – an estimated $769bn globally last year compared to just $281bn a decade ago. But unfortunately (as is also the case with private equity), most SMEs are too small for the big private debt funds to get involved with.
Gaining access to capital is only one side of the coin. What’s also important to a lot of the SMEs we talk to is doing so in a way that suits their specific needs and puts their business on the firmest footing. The traditional banks are becoming ever more rigid in their approach to lending, both in terms of which type of credit risks they are willing to take, and the terms they will lend on. We’ve seen whole sectors lose favour with the High Street banks, so even the star performers struggle to find the credit they need. And when they are offered debt funding, it often comes burdened with unrealistic restrictions (covenants) and repayment profiles (amortisation). Often, it can feel more trouble than it’s worth.
So, what’s needed is a well-functioning SME alternative lending market that is creative and flexible with the solutions it offers. It needs to be attractive, not just plug a gap – we call this “sympathetic funding”. And that’s starting to happen, with providers such as Connection Capital taking the lead.
The benefits of flexibility
As far as we’re concerned, there’s no reason why private debt shouldn’t be available to stable, profitable SMEs. Nor is there any reason why it shouldn’t be used to fund a range of requirements including equity release, a change of ownership, or acquisitions as well as providing growth capital or replacing unsuitable legacy debt. We can be commercial in balancing any risk for investors against more realistic covenant and repayment profiles (often only requiring a ‘bullet’ repayment at the end of the term). Too often businesses end up chasing their tails to make the next quarterly interest payment, or to hit the next covenant test, when really they should be focusing on beating the competition.
Clearly there’s a trade-off to be considered here with the overall ‘cost’ of the money – we can afford a more sympathetic and flexible approach because we know in the long-run it delivers a better return for all stakeholders. Sympathetic funding might not be the cheapest on the page, but we think SMEs are not just accessing capital, they’re ultimately unlocking value.
Appetite is stirring
With no sign of it becoming easier for small businesses to find mainstream debt funding, and with more awareness of alternative finance as an option, demand from SMEs for these kinds of flexible finance solutions is picking up. At the same time, we’ve seen that there is growing interest in private debt from private investors keen to increase portfolio diversification and enhance returns at a time of heightened volatility in public equity markets.
That’s why this year, we increased the size of the debt packages we offer via our specialist private debt solution to up to £10m, to provide more SMEs with innovative flexible finance options, which can be tailored to meet their specific needs, with no constraints on our lending criteria. Our focus is on high quality businesses and since launching our private debt offering two years ago, we’ve supported SMEs across a range of sectors, from property development, oil & gas, hospitality and leisure, and IT.
Solving the productivity puzzle
We believe it’s critical for ‘UK plc’ that suitable solutions to this dearth of traditional lending are made available. Policymakers are clear that improving productivity must be a critical element in delivering a successful economy in the years ahead, so anything that stifles ambition and thwarts potential will be harmful to us all. Small and medium sized businesses clearly have the scope, appetite and confidence to grow, they just need the means, and that requires alternative forms of finance such as private debt to come to the fore.
So, successful, ambitious businesses plus a wider choice of attractive and accessible mainstream and alternative debt options – in which flexible private debt has a major role to play - that’s a formula that works.
How we’ve helped:
The leisure resort - When the family that had owned a unique multi-hotel and leisure complex resort in one of the UK’s top tourist destinations since the 1940s decided to exit via an MBO, we supported it with £3.5m of sponsorless mezzanine finance behind a commercial mortgage. Connection Capital clients provided the capital that exceeded the mortgage provider’s appetite, and delivered an alternative to private equity, which would have demanded too much dilution of the management team’s shareholdings.
The property developer - The developer of a new high-spec residential development in central Belfast required funding to ‘up-spec’ units to a higher standard than originally planned, and to release equity so it could pursue additional developments in its pipeline. The senior lender wasn’t in a position to provide additional funding, so we worked alongside them to provide £2.6m in short-term secured private debt facilities.
The global oil and gas consultancy - The company’s inflexible banking arrangements were not set up in a way which allowed for growth or to deal with the once-in-a-generation oil price slump of 2014-16, so Connection Capital clients invested in a £4.75m mezzanine funding package to enable it to replace its existing senior debt. Structuring it with a final bullet repayment instead of an amortising loan allowed the company to pursue strategic M&A and organic growth opportunities.
SMEs: what we look for:
- High quality (private equity-standard) business or robust property assets
- Corporate profile: UK HQ, minimum £1m EDITDA or deep asset coverage
- Property profile: 800+ sq.ft., limited development risk
- £3-10m investment size
- 3-7 year typical term
- Types of deal: refinancing, growth capital, equity release/cash-out, acquisition funding and change of ownership
Stephen Catling, April 2019
Stephen heads up the Private Debt team. He is responsible for sourcing, executing and managing Connection Capital’s Private Debt transactions and co-investments with other private equity houses.
To find out more about Connection Capital’s specialist private debt solution click here.