Where is the value in private debt markets? Where do we stand 10 years after the crisis?
The Lending Gap has been one of the most quoted negative consequences of the financial crisis. Many political efforts have been conducted to stimulate the economy. New business models (e.g., private debt, direct lending, alternative finance, peer to peer) were born with the explicit aim and mission to “fill the gap”.
Where are we today, 10 years after the crisis? Are borrowers still suffering? What investment opportunities are out there, if any?
My article reveals the key trends on the lending gap in Europe.
FACT #1. The lending gap has been reduced, and the drivers have changed.
Right after the crisis, the lending gap was distinct and homogeneous. Today, the picture is quite different. In some areas, the lending gap has been reduced; in fact, in several geographies, banks already have excess liquidity. In some sectors, traditional incumbent banks and institutional investors are fiercely competing for high-quality assets.
FACT #2. New alternative lending opportunities have opened up.
There is an emergence of alternative sources of funding with very different business models, return expectations and levels of scalability. These solutions (direct lending, Fintech) provide valuable means of reducing the information asymmetry especially in smaller borrower segments by allowing direct access and risk comparison (provided the risk measures are standardised and comparable).
FACT #3. Banks are in better shape today, but exposed to the digital revolution and various structural challenges.
Banks remain the largest source of funding in Europe and what happens to them is immensely relevant. After the crisis, both banks and institutional investors massively scaled back the risks they were taking. Their conservative risk frameworks favoured high-quality liquid assets. Consequently, smaller companies were hit by the lack of funding supply and financial infrastructure.
In the last few years, we saw strong central bank interventions on public markets. Yields have dropped and funding conditions have improved.
Banks are moving from Balance Sheet recovery to restoring profitability.
Banks improved the quality of their balance sheet and reduced their leverage. The Common Equity Tier 1 ratio increased from 7% in 2008 to 14.4% by 2017 (ECB, 2017). Today, most larger banks are focused on revenue growth and the expansion of their client franchise. They have also started to invest heavily in innovative Fintech solutions, although the change in culture and business model remain challenging.
FACT #4. Credit expansion has resumed since YE 2014.
The market dynamics are certainly different from 2-3 years ago. The European economy is enjoying the best growth momentum since the financial crisis. The lower cost of debt has been offering refinancing opportunities. Further, there are various companies/issuers directly taking control of their financing.
4.a. Lending volume has increased.
ECB’s BLS and SAFE surveys bring to light the fact that the financing situation of corporates and SMEs have improved, although large country heterogeneity exists. Credit standards have eased in the entire corporate lending universe; however, it is more noticeable with loans to large firms and, to a lesser extent, to SMEs. The key factor contributing to the relaxing of credit standards is “pressure from competition” (ECB, 2017).
The rejection rate for loan applications has decreased. Successful loan applications have increased and the rate currently stands at 74% of applications.
4b. Overall cost of debt funding for borrowers has decreased.
The ECB’s QE efforts have continued to trickle down, resulting in declining interest rates for loans of all classes (EIF, 2017). The lending rates to corporations and households are now at historical lows, and there has been a significant reduction in the fragmentation of lending rates among Euro area countries and among large and small loans.
INSIGHT #1. While the lending gap is no longer homogeneous, several value opportunities exist.
Overall, access to financing has improved and the lending gap has been reduced in Europe. The excess liquidity created by central banks impacted the pricing in public markets as well as in asset classes that are the most accessible to investors (eg. leveraged loans).
In some segments, the excess liquidity is created by an imbalance between supply and demand. This is evident in reduced pricing, credit-friendly borrowing terms and compressed pricing.
This reveals significant differences and opportunities:
· SMEs: Smaller SMEs still suffer from lack of funding due to low rating and high acceptance cost. Information asymmetry remains high and liquidity is low. This is the sector where innovative direct lending, market place lending solutions can make a major difference via a technology-savvy setup.
· Venture Debt: In Europe, the venture debt market is small, only 5-7% compared to 15-20% in the US. Venture debt financing could help companies, particularly those with new or changing business models, gain access to funds (AFME, 2017; Duruflé et al., 2016).
· Complex propositions: Complex and illiquid investments such as trade finance, CRE, ECA loans and shipping still offer high premiums over liquid markets. There are still opportunities for investors, especially in sub-investment grade lending.
· Long Term lending: Many value opportunities exist because investors might have more flexibility in lending with longer-term tenors. For banks, long-term lending remain a challenge due to maturity transformation as their deposits remain shorter term in nature.
· Geographies: CEE and Southern Europe seems to offer the best opportunities (KPMG, 2017. See more in the attached link).
INSIGHT #2. A heterogenous market merits heterogeneous return expectations.
We need to see a more diversified and differentiated private debt market.
The cost of borrowing has decreased across most asset classes. It is impossible to deliver the same return expectations that we had back in 2010-2012 without increasing the risk profile. Return expectations should be more reflective of CAPM and risk-free rates. In this respect, I call for and strongly support any initiatives for enabling better comparison of risks, losses and return.
INSIGHT #3. A heterogenous market requires being on high alert
Investors should be alert in risk assessment, not only in terms of credit risk but also counter party. Some key questions to ask: Are historical assumptions relevant? How long am I lending and do I lock in unfavourable terms from investors' perspective? How liquidity might change? What is the impact of current liquidity on the Enterprise Value increase? Who benefits from the current cost of debt? What is in it for all stakeholders? Do we still have appropriate risk sharing mechanism and alignment of interest?
For sure, the 2008 financial crisis was an earthquake. It shook that markets to their core and created a huge lending gap. Ten years later, the landscape is different, but definitely not barren. New and exciting investment opportunities have sprouted and are ready for exploration. Also via new channels (like market place lending), that were not existing ten years ago.
Clearly, this is true in the financing world: if you mind the gap, there is no such thing as crap.
Gabriella Kinder is head of alternative credit at NN Investment Partners.
25 May 2023
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