Market cycles are inevitable and can be self-inflicted, as was the case during the global financial crisis of 2008, or the result of an exogenous event.
The economic crisis brought on by covid-19 certainly falls into the latter category and, by its nature, is very different from previous market dislocations. There was little warning and the US economy and broader financial markets were strong immediately prior to the pandemic taking hold. Rather, the damage was caused by the intentional shutdown of economies around the world and, because there is no comparable precedent in recent history for this, the time to recovery is unclear. It will likely take several quarters or years for the economy to fully recover.
For non-bank lenders – and many market participants, for that matter – this extended period of uncertainty creates business challenges and risks that need to be carefully managed. Diversification is one tool that has proven over time to be an effective way by which companies can navigate these various cycles.
Diversification encompasses both sides of the balance sheet. On the asset side, it means investing in multiple industry sectors that not only perform differently in a given cycle but that can be more resilient during both good and bad times, while minimising single-asset concentrations. Within technology and life sciences alone, there are a variety of specialised sub-sectors that include software (or software as a service), drug discovery, drug delivery, business services, and communications and networking. Each of these have traits that will be affected differently depending the economic conditions at any given time.
The importance of the liability side, which has sometimes been overlooked, has been highlighted by the current market turbulence. A vital component of a durable non-bank lending franchise is a capital structure that features multiple sources of funding (both secured and unsecured) that are well matched to the company’s assets, and that features elements such as long-term staggered maturities on credit facilities and non-recourse structures. For certain business development companies that apply and qualify, the US Small Business Administration offers flexible and cost-effective lending to entities that are approved as Small Business Investment Company (SBIC) subsidiaries.
The combination of these elements creates a lower blended cost of capital. This in turn enables well-positioned non-bank direct lenders to generate strong returns on equity for stakeholders and to then be able to reinvest capital in the origination platform.
Although no lender will escape this market unscathed, winners will emerge and they are likely to be those players that bring a thoughtful approach to both balance sheet and asset diversification. This, ultimately, will enable them to outperform their peers on a relative basis.
Scott Bluestein is chief executive and chief investment officer at Hercules Capital (NYSE: HTGC), a non-bank provider of venture debt growth capital solutions to expansion-staged and established companies