Written By: Bernard Abrahamsen
In the fast-paced, high-tech and glamorous world of Formula 1, racing drivers famously stick to a circuit’s “racing line”, the fastest, most efficient route around a racetrack. As a race weekend progresses, this racing line is the most used and becomes all the cleaner, grippier and, ultimately, faster. Off the racing line, the track is dirtier, dustier and more slippery – far tougher to drive on.
But, as with financial markets, conditions on the racing line can be volatile and unpredictable. Just as investors’ volatility statistics failed to prepare them for the financial storm of 2008, even an F1 team’s expensive systems often fail to predict the local weather. When it rains on the track, mixing water with rubber, parts of the racing line can become more slippery than the surrounding road. Consequently, racers are faced with the challenge of finding the most grippy parts of the circuit, and in doing so, discovering a brand new racing line.
Before I get too carried away with my motorsport analogy, let’s agree that F1 represents the UK economy, racing drivers represent investors, and a torrential downpour during a race weekend represents the financial crisis of 2008. Since that crisis, economic and financial conditions have been volatile and tricky for investors, who, like racing drivers, have had to adapt their behaviour, and consequently their portfolios. If there’s a new, post-crisis, “racing line” for them to discover, what investments may sit on it?
Non-bank lending – part of the new “racing line”?
One opportunity – lending directly to small and medium-sized companies – has been highlighted by the UK Treasury, which announced details of the “Business Finance Partnership” in November 2011, an initiative to encourage investors to lend to medium-sized UK businesses, as an alternative to bank loans. Since then, the Budget in March announced a shortlist of potential asset managers (which included M&G Investments) to invest alongside the Treasury in this sector. But why is there a need for such lending in the first place? Simply because there’s less bank credit available today than before 2008.
Today, it’s far less attractive for banks to offer the abundance of cheap loans that they used to, as their cost of borrowing has increased and new regulation from the Basel Committee makes it less attractive for them to lend long-term. And while the government has introduced several initiatives to get UK banks to do more, they haven’t been able to do much about foreign banks withdrawing from the lending market.
With less new credit available to small- and medium-sized companies, it’s difficult to see where future economic growth in the UK will come from, and so, alternative sources of lending could prove very important to the UK economy.
Can institutional investors really lend directly to companies?
Although I understand that the idea that any organisation other than a bank can offer a loan may sound slightly outlandish, it really shouldn’t. Although it can easily be forgotten, investors already engage in a form of non-bank lending, by investing in the public bond markets – the mainstream, or “racing line” of non-bank finance. Direct lending is actually fairly similar to investing in bonds, but with a few key differences.
In public bond markets, banks and ratings agencies play a huge role. The banks bring companies to the bond markets, find potential investors such as pension funds or asset managers, and perform a great deal of other work, like setting up the legal framework of the deal. Outside the banks, ratings agencies provide their opinions on a borrower’s credit quality, useful information for investors.
But in the realm of direct lending, there are no banks, there are no ratings agencies and every agreement has to be negotiated from scratch. So, investors need to be able to do all of the work that the banks and ratings agencies would normally do themselves. This means, for example, being much more proactive in finding borrowers and in employing their own rigorous credit and legal analysis on each potential lending opportunity.
Not all investors have this type of resource and experience to hand, and so they either need to employ it, or lend via a suitable investment manager. Once the investor has decided to invest, what does it take agree a loan?
Direct lending without banks – a “how to” guide:
The first thing an investor needs to do is find a potential borrower, which is not always easy in itself as historically, banks have dominated companies’ lending relationships.
However, investors can make use of intermediaries such as corporate brokers and debt advisory firms, both of which are well placed to understand a company’s borrowing needs. As it becomes increasingly challenging for companies to finance themselves, it’s likely that more brokers and advisers will spring up to help bring potential borrowers and lenders together. The larger investors may well have existing relationships with companies and be able to promote their lending capabilities themselves.
When the investor does find a potential candidate, let’s call it Company A, they need to carry out the following tasks as a bare minimum:
1) a general analysis of the firm’s business and financial background. If Company A survives this “sense check” it’s on to step two.
2) a meeting with the senior management, either the CEO or finance director, to discuss A’s business, both the challenges it faces and its likely funding needs in the future.
3) a detailed due diligence visit – if all of the previous activity suggests this is worthwhile – to talk to senior operational management and to see Company A in action. These meetings will include in-depth discussion about the company’s strategy, historic financial position as well as future projections, and the key risks the business faces.
By working so closely with Company A, the investor can obtain highly detailed information about the company’s financial situation and creditworthiness – all of which will help to make the final lending decision. And because this relationship is private, the investor often gets access to non-public information about Company A. When investing in public bonds, investors simply don’t get access to information in such a fine level of detail.
All of this information allows the investor to evaluate the risks of lending more effectively. But even better, investors can also negotiate a contract which can help mitigate any risks they have identified.
For example, if the investor is concerned that Company A may increase its borrowing to a level they are uncomfortable with, the investor can put a restriction in the loan agreement which forces Company A to discuss the situation before it becomes an issue. This way, investors can discuss the company’s borrowing levels with Company A and learn of A’s plans to deal with it. If necessary, the investor can agree to be compensated for taking on the increased risks relating to Company A’s borrowing levels. In the bond markets, it is very difficult to negotiate a deal like this.
So, should public sector investors be getting involved in direct lending?
Following our experience in this sector since 2009, we firmly believe the answer is “yes”. There are real advantages in investing in this way. Also, they offer the added benefit of bringing an extra measure of diversification to an investor’s bond holdings, and returns can be attractive for the risks.
The non-bank direct lending market is currently off the “racing line” for most institutional investors, but through it, investors can help to provide an alternative to bank finance, a factor that could prove crucial to the UK economy over the long term. The market needs to develop and this will only happen if more investors get involved. We encourage other investment managers and investors to join us. To end on the analogy I began with, we need other investors to help us burn rubber on this part of the racetrack, and help develop non-bank lending as part of a new “racing line” for public and private sector institutional investors.