The growth of loan funds in recent years has been marked, but many investors remain in the dark about how they work, and what sets them apart from other more traditional options. Institutional and private capital has been flowing into this area of finance rapidly, but how do loan funds work in practice?
Around the world a funding gap has yawned open, as banks withdraw from direct commercial lending to small and medium-sized enterprises (SMEs). Indeed, it is increasingly hard for mainstream lenders to originate ‘non-commoditised’ loans. In the UK alone, the trend towards the closure of bank branches is undermining the vital relationship between SMEs and banks. This is compounded by the lack of available credit for smaller businesses, as banks focus on maintaining higher levels of Tier 1 capital. Royal Bank of Scotland alone has withdrawn funding from more than 40 businesses recently and radically reduced its branch network, a trend reflected in the behaviour of the other major banks in the UK and further afield. Barclays and Lloyds has also announced publicly several waves of significant redundancies over the past few years.
Into this gap has stepped loan funds – asset managers with investor capital available to lend, backed by clients ranging from the largest sovereign wealth funds to private individuals. Asset-based lending funds – funds that lend against real assets such as land and property, for example – are growing quickly, with approximately $450bn (£315bn) by some estimates, under management globally.
The majority of loan funds are active in the US, and will tend to restrict their activities to the US, but the European market is catching up. In the UK alone, the Asset Based Finance Association estimates that £4.2bn of alternative finance is now secured against hard assets. The overall amount provided to business via asset-based finance in the UK, including invoice finance and secured lending, was £19.3bn to the end of June 2015.
Loan funds pursue a range of different strategies, focusing on sub-sectors of finance, specific customers, or geographical regions. This can include project finance, asset finance and invoice finance, for example, or commercial secured loans.
Structure
A typical structure will see a fund own (or contract with) one or several private finance companies that carry out the day-to-day business of lending and risk management. These are staffed by personnel from a commercial finance or banking background. The finance companies will manage a substantial loan book, thus also diversifying the risk of the fund across hundreds of clients. Loans will vary in size, from £10,000 to up to several millions.
The return profile for a loan fund often tends to be fairly predictable: after all, no investments are being made into public markets, and there is no direct exposure to commodities or to the fixed income market. During times of market turbulence, as we have seen early this year, such uncorrelated returns are prized. In addition, there is little use for leverage – most funds in this sector will not use leverage, and when they do, it will tend to be in the region of multiples of 1.0 to 1.5.
There is already a wide variety of lending strategies on the market, ranging from crowdfunding options all the way to serious project finance initiatives. The lack of an active role by the banks has also led to the emergence of a number of specialist lending strategies, several of them now quite sizeable.
The relatively transparent and liquid nature of these investment approaches has helped loan funds to gain traction with investors, who feel more comfortable with the risks and the predictability of cash flow within a typical loan fund’s portfolio (for example, a fund might administer 1,000 loans to 500 loan customers). The fact that lending is often secured against real assets is an added attraction.
Loans can take a variety of forms, including hire purchase agreements, lease purchase, operating leases, finance leases and contract hire. Much will depend on the financing requirements of the client business.
Ultimately, one of the keys to the success of a loan strategy will be the quality of the personnel staffing both the investment fund and the underlying finance company or companies. It is critical that they have sufficient experience and professionalism to both manage credit risks while possessing the sector knowledge and personal contacts that will facilitate the growth of a loan portfolio, and the efficient deployment of investor capital.
Case study: lending to SMEs in farming and alternative energy
The UK agricultural sector is a good example of one example of where traditional funding from banks has been in decline. Here there are many smaller farming and food-processing businesses, which still playing an important role in the UK economy, and which are in need of commercial finance support. In addition, many SMEs in the sector are seeking to upgrade their infrastructure – for example in the form of new machinery or on-site green energy generating capacity (for example, biomass plants/waste to energy).
The sector is also facing the prospect of rising energy costs, coupled with the increased taxes levied on waste disposal. Activity in the UK agricultural sector is often supported by subsidies from the Government, particularly when it comes to helping to increase the UK’s alternative energy generation capabilities and waste-to-energy related projects.
Secured lending in this area is frequently made against arable farmland, a real asset that has increased in price since 2002, outstripping London residential property in the past 15 years. There are also opportunities for invoice finance specialists, particular as many small businesses, including farmers and food producers, are forced to deal with larger supermarkets and other commoditised distribution chains.
Craig Reeves is founder of Prestige Capital Management/Prestige Asset Management
| Key Points |
A funding gap exists, as banks withdraw from direct commercial lending to small and medium-sized enterprises. Loan funds have been set up by asset managers with investor capital available to lend, backed by clients ranging from the largest sovereign wealth funds to private individuals. Loans can take a variety of forms, including hire purchase agreements, lease purchase and operating leases. |
