By Pietro Nicholls on Monday 16 December 2019
RM Funds' Pietro Nicholls on how the lending industry is maturing.
Arguably when we look back at the .com bubble almost 20 years ago, the retail sector was the only industry to truly be disrupted by the birth of e-commerce. Since then, the e-commerce sector has matured and its impact on retail has been staggering - the UK’s high streets are forever changed.
Digitisation of everything!
The last decade has seen the emergence of more practical disruptive tech or rather the digitisation of existing industries. In the digital age, we’ve seen the Tesco club card (a game-changer for the marketing dept at the time) be replaced by Facebook et al, ride-hailing apps like Uber rattle transport, Airbnb transform every phase of hospitality and financial services have seen a revolution by mobile-led technology.
Now, most aspects of financial services are being digitised or disrupted by fintech with varying degrees of success and maturity, from bank accounts, currency, payment processing, investments, pensions and possibly the most advanced of them all, lending.
Alternative lending is a term used to describe many forms of lending, from platform lending to direct lending. As a portfolio manager, I have always been a tad wary of platform lending, not because I don’t believe in it, I believe if one can originate high-quality homogenous loans via a platform then it just becomes a question of pricing for the various risks including the most important one; credit.
Direct lending, by contrast, is simply a way of describing lending which the banks do, except by non-banks, real asset/project finance and cash flow (corporate) lending. Naturally, there is less homogeneity within direct lending, as a manufacturing business will have vastly different funding and banking requirements than a satellite communications operator.
The end of the business cycle is coming... Eventually
Why am I waffling on about these related areas of lending? To put it simply, the business cycle is slowing down. Domestic concerns over Brexit have impacted spending, increased costs, and reduced business investment. In addition, further afield trade concerns with the US and China have increased the cost of goods and set a general negative tone, with cyclically exposed businesses starting to feel the pressure. Pressure on margins among other financial performance factors will usually lead to a deterioration in cash flows and balance sheet flexibility.
The elephant in the room
This leads me to the elephant in the room for the alternative lending sector; which is the topic of workouts, impairments and defaults.
Most direct lending funds finance larger businesses often with Earnings Before Interest, Tax, Depreciation and Amortisation (“EBITDA”) in excess of £5mm-£250mm per annum, placing the value of such companies in excess of £45m - £2.5bn (assuming current valuation multiples), therefore any weakness (which will inevitably occur within a funds portfolio) can be met with a multitude of responses from divesting assets such as real estate to paying down debt or some form of equitization by the lending group. In contrast, platform lending hasn’t yet experienced a whole business cycle, and therefore the credit and risk policies have yet to really be tested, likewise the response mechanisms such as workouts and recovery functions have yet to truly kick-in. For example, assuming a platform has financed hundreds of consumer loans, will it make financial sense to take legal action against tens or hundreds of delinquent borrowers?
I often think about this last question, as it ties in so closely to the pricing of credit risk. Companies such as Provident Financial, International Personal Finance and NewDay have been originating loans to sub and near prime borrowers for years, and have (bar the odd bump in the road) performed well, why? Two reasons: 1) strong credit underwriting, and 2) pricing for the risks that lending to such markets entails.
Now that the alternative lending sector is facing the prospect of rising impairments and defaults investors can see how management teams, platforms and funds perform through the cycle – this is where the stripes are earned and the sector matures. The key to retaining investors’ confidence is in the strength of reporting, clear credit and recovery processes, appropriate recognition of the perceived or actual risks, and finally transparency over the performance of the loan book(s).