A hit from its European Investment Bank transaction as well as higher UK loss rates have prompted a fall in expected returns for the Funding Circle SME Income fund.
The £332m Funding Circle SME Income Fund saw a fall in its net asset value (NAV) of 1.4 per cent in November as the investment trust’s board said it expected returns for the full year would be lower than previously anticipated owing to a higher expected rate of defaults among certain loan pools.
The portfolio, which holds exposure to loans originated by Funding Circle in the UK mainly but also US and European geographies too, has been something of a reliable performer since launching in 2015 and has as a result tended to trade on a small premium to NAV as well as eyeing continued growth in assets via new share issuance programmes.
In 2018 performance has become more challenged in the second half of the year, owing to a number of factors however, and the portfolio is now trading at a 15.1 per cent discount to NAV after a rapid fall in sentiment in recent weeks.
According to Richard Boleat, the chairman of the fund - who said in a statement to the market this morning - it has “been a more challenging period” owing to lower projected returns for UK loans originated in 2016 and 2017 as well as other factors such as increased hedging and other costs and the implementation of new accouting practices in the form of IRS 9.
He also gave guidance that returns in 2018 would likely be lower at around 4 per cent in NAV terms in the 12 months to December 2019. Its quarterly dividend will be maintained at 1.312p (5.25p annualised) until at least June 2019 but that it would be uncovered.
“Evidence has now started to emerge through credit stress that this is largely, though not exclusively, attributable to the underperformance of certain UK loan cohorts from 2016 and 2017 and specifically in respect of younger businesses and/or those with guarantors with a low consumer score - typically borrowers assigned to Funding Circle's higher risk bands,” Boleat said.
Analysts at Liberum, which recently put a “SELL” notice on the fund say the November fall in NAV returns was primarily due to a -2.2 per cent impairment in the month, including a -1.2 per cent fair value adjustment on its investment a European Investment Bank (EIB) transaction. The impairment charge also includes -0.4 per cent impact from lower recovery assumptions on delinquent and defaulted loans.
However they also note that performance has deteriorated significantly, mainly due to a material increase in credit losses on UK loans.
“Other factors such as increased hedging and operating costs have also reduced returns.The weakening outlook for UK consumer credit has impacted the higher risk Funding Circle UK loans that are more susceptible to changes in the consumer credit environment.”
“The EIB transaction is a levered SPV structure investing in UK loans, in which the fund holds a £25m junior Class B note. The investment is held at fair value and is sensitive to changes in default, prepayment and recovery assumptions as the structure is 4x levered,” Liberum said.
The more a tansaction is levered, the more it is subject to changes in the expectation of losses. The analyst team at Liberum also believe there is a seasoning impact from its 2017 C share issuance when the fund raised £142m in April 2017 which was invested over the period to December 2017.
“The average age of these loans would be around the peak level of delinquency across the loan life cycle.There is now a greater share of US loans which have a higher expected loss rate (c.5.4 per cent for US loans vs. c.3 per cent for UK loans).”
Boleat also emphasised that the fund is “acutely aware of the uncertain macroeconomic environment derived from the UK's impending exit from the EU”. However, he says as yet there is no direct evidence for Brexit-related credit stress within its portfolio. Nonetheless, he adds that there is a significant risk to the UK economy and SME borrowers from the UK leaving the EU and as such has deemed it appropriate to take a more cautious view on potential UK loan returns by building in anticipation of a delinquency increase when providing forward guidance.
“The likely outcome of the Brexit process on the UK economy and the UK SME sector is not possible to predict with any accuracy at this time, and may differ materially from our base case,” he added.
"We are pleased with loan performance across all four of our markets, with loans taken out since 2016 projected to deliver returns of between 4 and 7 percent per year. We recently announced two £/$1bn lending transactions in the UK and the US respectively, which is a vote of confidence in the quality and risk-adjusted returns of loans on the Funding Circle platform. We are projecting loans taken out today to deliver returns of between 5 - 8 per cent globally.”