One (small) part of the puzzle of low productivity growth here in the UK is the plight of what have been called “Gazelle” businesses. These fast-growing businesses with turnover usually between £5 and £100m (and profits between say £1m and £20m) are the lifeblood of the UK economy. Much bigger corporates are frequently listed on the stock market and in recent years have tended to play safe – increase dividends, ratchet up cash flows, control debt and (arguably) self-limit top line growth. Much smaller businesses – the real heartland of SMEs – have lofty ambitions but are frequently hobbled by difficult family structures, low productivity (according to economists), poor access to finance and frequently (though not always) limited global growth ambitions.
We should all care because high growth gazelle businesses will be tomorrow's FTSE 350 corporates but first they need to scale up to a sufficient size so that they greatly improve profitability. Private equity has a role to play in helping these businesses with access of equity capital but many entrepreneurs and boards are careful about diluting the shareholder base – and accepting too much outside control. Debt funding is what many of these businesses want, and need. Build a new factory for instance with state of the art equipment and you wouldn’t expect the payback to start much before the 2nd or even 3rd year, with true payback frequently taking five years or more.
Typical loan sizes might be between £2.5m and £50m though one suspects most of the demand is in a sweet spot between £5 and £25m. Crucially these businesses will also require longer terms, maybe beyond five years. Revolving bank overdrafts are useful but it’s not really what they need – they want long term capital which isn’t heavily dilutive. The high street banks are more than willing to work with the more profitable businesses in this cohort but even at their best, they can be slow, unresponsive, rule bound and expensive in terms of extra fees. Crucially they also don’t like long duration lending, especially above 3 to 5 years which requires them to hold extra risk capital.
What emerges is in effect a funding gap involving lending between £2.5m and £50m. Above that level and we’re into mid market secured lending, dominated by big asset managers – although my suspicion is that in truth even these players don’t really like tickets much below £100m. Below this level of £2.5m we see intense competition from the alternative lenders and challenger banks, who are more than willing to engage in secured lending, usually involving either a personal guarantee or charge against assets. But these alternative lenders struggle at ticket sizes above £2.5m for direct lending, just as the bigger mid market PE lenders struggle with anything below £100m.
Obviously, this gap matters – as I’ve already observed this segment of businesses matters for the economic lifeblood of the UK. They create lots of jobs, have international ambitions, spend more money on capital expenditure and tend to have higher productivity levels. There are a small number of players in this market, mostly connected in one way or another to the British Business Bank. This excellent, relatively new institution in fact has an explicit statutory requirement to help fund these mid sized private businesses. But the brutal truth is that one state owned bank does not a market make. We need much more scale and crucially much more capital.
All of which brings me nicely to the subject of business development companies or BDCs as they are known in the US. These are a little like real estate investment trusts in that they are tax efficient listed funds which can pass on their income direct to investors. Crucially many of these BDCs in effect operate as long term capital lending vehicles for mid sized private and public businesses – it’s also worth noting that there is a much smaller universe of equity based BDCs as well. These loan based BDCs are usually managed by experienced asset managers or even large investment banks such as Goldman Sachs. In truth they also tend to be focused on mid-market loans with bigger ticket sizes but there are plenty of funds that will happily lend $10 or $20m at a go.
Crucially for the investor the income yields are highly attractive. By my calculations the 49 listed BDCs (and there are private unlisted variants trading as well) have a combined market cap of $32 billion (which makes it a more liquid, broad market) and an average yield around 9% per annum. Average total fees are around the same level (extraordinarily high!) which implies that most lending is probably going out the factory gates at rates of between 10 and 20% (once leverage is included). Volatility in the BDC share price space is high and the funds can move deep into discount territory (average is around 6% at the moment) but it’s hard to escape the fact that they are very investor friendly.
Crucially that $30 billion plus in lending capital makes its way into the US mid sized private and public business segment, helping to fuel higher levels of productivity and jobs growth.
Over here in the UK there are a small number of small funds that in effect behave like a BDC including the Funding Circle SME fund, RM Secured Direct Lending (which just raised another £30m this week) and Hadrian’s Wall. But by my calculations the universe of UK focused SME direct lenders probably doesn’t amount to a great deal more than £500m. That’s valuable money for sure but it’s not a game changer for the UK. It needs to be!
What’s really needed here is more government ‘assistance’ or more precisely cajoling of the private sector to step up to the mark. British Business Bank for instance has quietly built a strong portfolio of commercial small to mid-market loans which could be bundled up into a BDC structure and listed on the stockmarket. Crucially such a vehicle could even act as lightning rod around which other activity would emerge.
The BBB could originate a much bigger portfolio of loans working with existing players and then progressively parcel those loans out to varying asset managers running BDC like funds. Crucially UK investors would get access to a much broader (and bigger) SME lending market with better liquidity and useful yields (which one presumes would have to be around the 7 to 9% mark).
More importantly our home grown gazelles would suddenly get access to a pool of capital which, with leverage and cooperation between players, could easily amount to £5 billion within the space of just a few years. All it needs is for the government and the BDC to pick up the baton. Curiously though, despite rumours of government interest, nothing seems to have happened.
This funding gap needs to be unlocked and if the Conservative government doesn’t do it, I reckon an incoming Corbyn government (!!!) will be much quicker to act. I can just see the new Chancellor of Exchequer John McDonnell standing in the HoC announcing that Labour will be aggressively helping to fund the next generation of world beaters using the state-owned BBB and a small flotilla of new BDCs. The City friendly Chancellor working overtime to help investors and SMEs!!! Stranger things have been known to happen.