There’s a problem with shadow banking and alternative finance. It's called what to do when bad stuff happens. I use the term shadow banking deliberately in this first sentence because most forms of alternative and direct lending (a large part of alternative finance) are a kind of shadow banking, i.e. they do a job that was once the exclusive preserve of folk called bankers. As the traditional bankers have refocused, a huge range of new funding sources have emerged including direct lending platforms (intermediated by the internet) and asset managers.
When this lending goes to plan, investors-lenders get an assured stream of income that is usually well in excess of what they’d get from an FSCS protected deposit account. But investors are always hungry for more yield which means that they’ll be constantly tempted to take a little bit more risk as they chase the yield curve. That has tended to mean that we’ve seen a steady increase in demand for small business lending over lending to consumers – largely though not exclusively driven by yield. Whereas most consumer lenders will struggle to provide 5%, platforms such as Funding Circle, Assetz and ThinCats can easily provide a net yield in excess of 5%, even after allowing for losses.
But inevitably attention increasingly gets focused on the last word in the last sentence – losses. Hopefully enough sophisticated investors, who also read AltFi, have started asking all those awkward questions about defaults – and their changing dynamic over time. That necessitates a more nuanced distinction between losses, defaults and arrears. In sum not every default means a total loss – in fact quite the opposite may be true.
This deeper understanding of the lending process and defaults is all for the good but I think it raises a much more critical issue, especially relevant for SME lending – how do lenders cope with problem borrowers?
Arguably this is an especially problematic issue issue for funds and asset managers as they come from a traditional world of investing, where analysts crunch numbers. Big data driven platforms such as Funding Circle by contrast have some safety in the vast flow of customers they get. They take in huge volumes of data, crunch through it, spot patterns, fine tune lending and then overlay human intervention. But Funding Circle also has a sweet spot in lending tens and hundreds of thousands of pounds which means they tend to avoid lending large sums in the £500k to £50m bracket (in fact nothing towards to the top end).
Asset managers by contrast, moving into the direct lending and balance sheet market, are very much beginning to focus their attention on this crucial £500k to £50m lending space: that’s simply because the economics work and the returns can be higher.
But, as I have said already, what happens when those loans go wrong? Talk to wizened (non shadow) traditional business bankers and they’ll say that responsible lending – and the consequent management of defaults – requires a time intensive approach involving some or all of the following:
1. Regular monitoring of loans with monthly reporting from management accounts and faithful analysis of whether covenants are being broken.
2. When a problem occurs the lender needs to be able to decide very quickly whether to hand over the problem to an insolvency practitioner (expensive and frequently socially toxic) or work through a problem.
3. Once the problem has been clarified, frequently via an internal business review, a sensible recovery plan needs to be invoked with experienced seniors working through plans. That might involve everything from dropping in non execs for a day a month through to a full take over of the asset and subsequent resale. These skills require a combination of private equity and relationship banking skills.
The bottom line here is that not all defaults turn into losses or even impairments – they obviously don’t. It’s rather that sensible management of these ‘special situations’ requires a huge investment in terms of people and time – and that inevitably carries a cost, one that many asset managers and even some tech driven outfits are reluctant to commit to. It means running a whole, fully staffed department of recovery experts who go out of their way to avoid pushing businesses into insolvency. And it requires a change in culture. Managing SME challenges is a painstaking approach which doesn’t always fit into the neat world of technology or investment management.
My concern here is that as shadow banking and alternative finance inexorably expands its reach, driven by the scramble for yield, more and more money will be focused on the SME lending market and in turn on forms of direct lending, once done perhaps by banks. When arrears and defaults start to rise, thinly staffed fund managers and platforms will be stretched for time and money and simply hit the administration button, arguably increasing the possibility of full defaults.
Also as the number of direct lending funds increases, we’ll see a sorting of the ‘pack’. Experienced lenders with first rate intensive care units for lenders will minimise final losses and thrive – and perhaps even take over the ailing lending books of rival funds. Understaffed lenders will by contrast will experience a catastrophic loss of their investors' moneys. Winter is coming!