Small and medium-sized enterprises have been among the worst affected by the prolonged economic shutdowns implemented at the height of the pandemic. With smaller balance sheets and fewer lines of credit compared with larger businesses, SMEs were less likely to be able to survive through extended periods with low or zero revenue and other business disruption caused by lockdowns.
With the worst of the pandemic hopefully behind us, recovery in the SME sector is a key issue on the minds of policy makers around the world.
Figures from the UK’s Federation of Small Businesses show that at the beginning of 2021 there were around 5.5 million SMEs in the country, accounting for 99.9 percent of the entire business population. SMEs account for three-fifths of employment and around half the turnover of the UK private sector, worth £2.3 trillion ($3.1 trillion; €2.7 trillion), which outlines the huge contribution they make to the economy. Failing to ensure SMEs can survive and recover in the challenging months and years ahead could pose a huge threat to overall economic recovery.
In recognition of the role SMEs play, governments have been keen to ensure they are able to access capital through the pandemic with a variety of government-guaranteed loan schemes, such as the Coronavirus Business Interruption Loan Scheme in the UK, as well as by providing backing to alternative lenders via sovereign wealth funds.
One example of the latter is Dublin-based DunPort and its recently launched Oak Corporate Credit Fund, which held a first close in September 2021 with €255 million after receiving backing from Ireland’s Strategic Investment Fund.
DunPort co-founder Ross Morrow tells Private Debt Investor the firm is focused on the underserved “S” end of the SME market, looking at companies with a typical EBITDA of less than
€7 million. He says that while banks have played a big role in supporting SMEs through the pandemic, their approach to risk and regulatory constraints is likely to curb their ability to lend to this segment in the future.
“Banks that have been lending via schemes like CBILS are now going to have to take stock of where they are and work through their loan books to understand where the credit risk is, and as such, we are seeing less risk appetite from the banks,” he explains.
“SMEs also have a lot of demand for capital to fund acquisitions and growth, but banks may not be able to meet this as they often cannot offer the same flexibility as we can.”
DunPort believes it has a role to play in helping banks to unclog their balance sheets as government support schemes begin to wind down.
Ravi Anand, managing director at London-based SME lender ThinCats, says banks are only able to lend to companies that are already in a relatively strong financial position.
“We see the SME market as being divided into three parts; the first is the mid-sized SMEs that have restructured and have cash-positive balance sheets that have bounced back well since the pandemic, and these are the ones the banks are keen to support. The second is the smaller firms that have been replacing their revenue with debt during the pandemic but are in a weak position and likely to fall over next year,” he explains.
Supporting the strong
His firm, however, is interested in a third segment – firms that fall between the two extremes above, which need to rebuild their capital, have some debt and need more debt or equity to help their recovery. Anand says that banks find it difficult to lend to this part of the market. This spells opportunity for non-bank lenders to help finance the recovery of the SME segment in areas where banks cannot.
“We’re very busy and have seen more transactions in the post-covid period than we did pre-covid, for both recovery and growth,” says Morrow.
Market participants report that corporate finance houses are extremely busy, with many currently unable to take on new work due to the sheer volume of transactions.
“Strong businesses are growing very aggressively, private equity is very active and there are a lot of growth opportunities out there,” comments Anand. “We see a lot of entrepreneurs are quite tired after the difficulties of surviving the covid period and will see now as a good time to exit, so we expect this glut of M&A activity to continue well into next year.”
On top of opportunities for growth, as government support schemes come to an end, many businesses that have used them will need to refinance their debt on a longer-term basis, which could also provide a good avenue for alternative lenders to build new relationships with firms currently using bank debt.
While the demand for capital may be there, it is less clear whether the market has the capacity required to finance it all. “Certainly in the ‘S’ part of the market where we operate, there is nowhere near enough capital,” says Morrow. “It’s a really short list of lenders that serve the smaller end.
“What we’ve seen happen, particularly in the last 18 to 24 months, is allocations are being made to larger managers with a track record and as those managers receive larger allocations, they need to move away from the smaller deals because the ticket sizes are too small, and it becomes inefficient to lend to these companies.”
PDI fundraising data confirms this, with average fund sizes jumping drastically in the past year to almost $1 billion. With so many larger funds now in the market, the number of lenders willing to write tickets of a few million pounds, euros or dollars are dwindling.
Big funds dominate
“The institutional investor base has also consolidated,” adds Morrow. “For example, UK local government pension funds are now pooling their assets and that means they are looking for much larger commitments than the smaller end of the private credit market can handle.”
Anand agrees, saying: “It’s a challenge to operate in our space and there are very few managers who can provide the kind of scale that can service LPs that want to make commitments of several hundred million.” He says institutional investors are interested in the SME segment as it can be a good diversifier from their more conventional direct lending commitments, but they struggle to find managers who can put enough money to work to meet their investment needs.
All this leaves policy makers with a conundrum. Demand for SME finance has never been higher and institutions are theoretically interested in the segment, but there simply are not enough firms that can service larger investors.
It is not clear how this can be resolved, but technology that can assist in underwriting large quantities of small-ticket loans is likely to play a role. Many SME lenders already utilise some degree of technology to filter out unsuitable businesses and enable human underwriters to due diligence deals in more detail.
However, with potentially millions of small businesses looking for finance, machines will need to pick up more of the slack to enable all the finance required to be allocated to areas most in need. Supporting alternative lenders not just with capital to lend, but also to invest in their own systems, may be crucial to global economic recovery in the years ahead.