Friday letter: Europe – short on equity

Alternative lenders want to provide credit but could European businesses’ over-reliance on debt be holding back the development of the non-bank lending market?

There is a perception that bank unwillingness to lend to small businesses is hindering economic growth. Historically in Europe, small businesses have relied on debt over equity for growth and post-crisis they have been left with fewer financing options.

Despite this much-discussed funding gap, investors and private debt lenders still worry whether capital getting raised now can be invested at the right price. This seems a bit of a contradiction but with a culture of cheap bank borrowing that has enabled small- to medium- sized enterprises (SMEs) to limp along with under-capitalised balance sheets, borrower expectations are very different from investor return demands. How can the gap between lenders and borrowers be bridged?

Education and awareness, say some, while others are starting to blame the European culture of debt.

On the education issue, many businesses are unaware that alternative finance is out there, Adam Tyler, chief executive of the National Association of Commercial Finance Brokers, said at the European Alternative Finance & Marketplace Lending conference in May. Low awareness is so entrenched that the sector might need a jazzier name, Tyler suggested. The group runs a website which sources finance for small businesses, and alternative lenders are keen to join up.

Another initiative in the works, Arbour Capital, will learn from some of the online peer-to-peer processes to accelerate sourcing and automate deal sifting for lenders, which is a big market problem at present, James Newsome, managing partner at Arbour Partners told PDI. It will seek to connect around €2.8 billion in available capital from private debt lenders to SMEs, with due diligence carried out by the capital providers themselves.

“The problem we have in the lending market is that a lot of these lending firms are not set up to reach out and talk to non-sponsored or SME firms. We want to be part of the solution to make that easier,” Newsome said.

Interestingly though, Arbour won’t seek just to match businesses with debt. “The conversation doesn’t close as soon as one type of capital is not appropriate,” he said, adding that it will aim to help SMEs figure out what kind of funding will be appropriate for them.

On culture, even if non-bank lenders and institutional investors with long-term flexible capital are falling over themselves to offer solutions to would-be borrowers, many businesses are simply not candidates for financing themselves with debt.

True, most businesses are used to going to their bank manager for loans. But listening to private lenders, what a lot of these companies need is equity. A recent report on financing for SMEs in Europe by AFME highlighted that these companies’ business sheets are frequently under-capitalised. SMEs in Europe rely heavily on banks for cheap finance, yet for small companies with limited profits or cash flows, bank loans are not really fit for purpose. Equity may be more suitable in many situations.

AFME estimated that Europe’s total identified investable assets stood at around €30 trillion of external funding outstanding, compared to a figure of €49 trillion in the US. That said, for SMEs, the AFME report showed that Europe provides more funding than the US, the problem is with the sources and structure of that funding, with limited minority equity investment available.

In the US, private pension funds, fund managers and other investors such as angel investors, hedge funds, private equity and venture capital provide much more SME finance than is the case in Europe.

Dilution of equity and thus control is not always a favourable option for business owners. But if the goal in Europe and even Asia is to reach a funding model like that in the US where the non-bank market is more dominant than elsewhere, companies will need to take a closer look at the private equity market.

Ridding Europe of the habit of turning to debt as the default source of investment could be – counter-intuitive though it sounds – the key to unlocking super-charged growth for private debt.