Why SMEs may recover more quickly and sustainably
Six months after the World Health Organization (WHO) classified COVID-19 as a pandemic, it now appears that most institutions have largely ridden out the initial phase.
Investors have re-evaluated and stress-tested their portfolios, both from strategic and near-term cash flow perspectives, and increasing numbers are revisiting their 2020 and longer-term agendas.
The value to be had in liquid and semi-liquid markets early on in the crisis is now thin on the ground, while illiquid programmes are undoubtedly gathering steam.
Within private debt, we advocate an approach that seeks either resilience and/or opportunism. Across lending strategies, resilience precedes opportunism, as upside is generally limited, but opportunities abound, particularly in special situations and distressed. The question now is, following huge central bank and government support, what are the best return-for-risk areas to consider?
We believe there are some key advantages to strategies that access small and medium-sized enterprises (SMEs), which we expect to recover more quickly and perform more sustainably than their larger counterparts:
1. SMEs tend to be simpler businesses to adapt or turnround, with more flexible cost bases.
2. SMEs’ supply chains tend to be more local, more stable and easier to re-start or stop.
3. Customers are localising as work-life balances change, making localised services more sustainable.
4. SMEs are less likely to be exporters and, therefore, less dependent on external transport or delivery challenges. Also, low exposure to future variations in overseas COVID-19 rules will help reduce business volatility and risk.
5. SMEs’ greater direct customer relationships will matter more going forward; fewer intermediaries, more customers directly engaged, and more immediate control will be the order of the day.
6. SMEs tend to have closer alignment with investors, bringing greater vitality, higher commitment levels, more creativity and the flexibility required to navigate an uncertain future.
Of course, there are challenges when considering lending to smaller businesses:
1. Asset-security may be smaller, lighter and thinner, meaning specialist underwriting is key, focused on securing the return of principal at least, even in the most disrupted or distressed scenario. Experience and specialist expertise in niche areas of the market are must-haves for lending into these areas.
2. Higher management and business concentration/risk can occur due to smaller companies having fewer products and greater single customer (and personnel) dependencies. As such, diversification is important, and for institutional investors seeking to deploy at scale, this also points to a distributed approach to deployment.
3. Higher per £-of-loan costs of assessing and monitoring means investors must maximise their use of technology and standardisation to scale.
4. Credit deterioration can be swifter for smaller businesses, meaning lenders need responsive structures to close down risk rapidly through controlled approaches to aspects such as limiting drawdowns or retrieving capital. Amortisation ought to be, and usually is, more prevalent in SME lending.
5. SME’s generally have more difficulty accessing further supporting finance. While this suggests potentially higher yields-per-unit of risk at the smaller end, it is also incumbent on lenders to be more prudent by, for example, sticking with good borrowers via a “prove, recover and re-lend” approach to origination.
6. SMEs may exhibit increased short-term dependency on COVID-19 (limited-duration) interventionist finance.
Private market lenders should focus on the term fundamentals of any borrowing business, and that needs deep experience across restructuring, work-out and operational aspects. Additionally, lending alongside these COVID-19-related forms of government or central bank support requires the ability to deliver a more integrated assessment to the underwriting challenge.
Dramatic changes to the previously well-understood dynamics of many businesses are afoot, and larger, legacy businesses may be more vulnerable to such changes going forward.
In the shorter term, we believe investors are deluded if they believe they can foresee which countries will emerge in better shape after this pandemic; macro risk assessments are over-played.
Over the medium term, we expect some investors will shift their strategic emphasis to more local factors (including those that more directly reflect and hedge local inflation). For maturing, longer-term investors, such as defined benefit pension funds, the rationale for such a shift may be strengthening from both a liability and asset perspective.
Against this background, we believe that smaller companies have a strong role to play in portfolios, and senior lending to those companies on a distributed, diversified basis seems an intelligent way to gain from that opportunity.
Our thinking is reflected in the fund managers we represent, most notably Pollen Street Capital who are hosting a forthcoming webinar, which we expect to be an insightful and informative event, and which we invite you to attend.
Pollen Street deploy via over 50 specialist lenders active across SME, Consumer and Real Estate, and a view on these sectors is crucial for investors in navigating the recovery and analysing the best opportunities going forward.
The webinar presents a great opportunity to review some granular data conclusions in these bellwether lending areas not well-covered elsewhere, where banks are increasingly absent and where sustainable illiquidity premia and creditworthiness appear to be relatively high.
Pollen Street Capital - Market Insights Webinar
The impact of the COVID-19 pandemic on specialist lending markets in the US and UK
Sep 23, 2020 03:00 PM London
PLEASE CLICK HERE to Register in advance for this webinar:
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