How SME needs can be met

The need to support smaller businesses has increased hugely in the wake of the pandemic. Claire Madden of Connection Capital examines the options, including for mezzanine finance.

There’s a huge amount of uncertainty about the economy right now, but one thing we do know for sure is that small and medium-sized businesses need cash. Not just today, to survive the immediate pressures of lockdown but in the months ahead too, to give them enough headroom as they trade out into recovery.

However effective government covid-19 support measures might be, they are only sticking plasters. Once they come off, high-quality businesses will need long-term, sustainable financial solutions. Herein lies an opportunity for private debt providers at the lower end of the market to give them the liquidity they will desperately need.

Cash crunch

SMEs are facing challenges on multiple fronts. Despite the Chancellor’s moves to wind down initiatives like the furlough scheme gradually, they are still likely to feel a major squeeze on working capital as business activity picks up and staff are brought back on board. Interest and capital will need to start being repaid on debt taken on under the Coronavirus Business Interruption Loan Scheme or the Bounce Back Loan Scheme after just 12 months. Deferred tax bills will eventually become due.

Looking ahead, banks are likely to be even more cautious about small business lending than they were before the crisis. They may be stepping into the breach by participating in government loan schemes now, but beyond that their appetite to lend more or restructure debt on favourable terms, or at all, remains to be seen.

Banks’ business models don’t allow for pricing in equity upside, nor are they geared up to offer the kind of flexibility SMEs need – and they need it now more than ever. Tying themselves into banks’ rigid standard terms and conditions could limit a company’s ability to be agile: something that’s likely to prove vital as they navigate the “new normal”, whatever that looks like.

In short, once (or before) government aid ends, underfunded businesses will need to raise capital in order to be able to capitalise on recovery, and balance sheets will need more permanent and flexible structural debt solutions.

Securing private equity funding to deal with these issues is one option, but it brings its own challenges, since pricing equity accurately in the current, uncertain environment is incredibly difficult. And while it may be suitable for some, it won’t be appropriate for all needs.

Sitting as a hybrid between bank debt and private equity, mezzanine finance offers huge appeal for SMEs and investors, given its ability to drive higher returns off the debt instrument, while imposing a lower cash burden on the business, with interest either rolled up or amortising with a final bill of repayment. In our experience, many business owners see paying a slightly higher interest rate or including an equity kicker as a price worth paying for being able to access finance in a way that fits around their specific needs. Demand is there.

An eye for an opportunity

Which brings us to the question of supply. As previous market dislocations in recent history have shown, investors who are liquid and are happy to invest at this point in the cycle if they spot an attractive opportunity can expect to reap strong returns. Private debt funds sitting on substantial dry powder are poised to take advantage at the mid-to-top end of the market. However, there are likely to be plenty of attractive opportunities to support SMEs at the smaller – sub £10 million ($13 million; €11 million) – end too, for those who are prepared to consider them.

Private capital is showing itself ready and willing in this respect. A recent survey we conducted among high-net-worth private investor clients found that more than half (53 percent) have increased their cash reserves since the start of the coronavirus crisis, with the main aim being to provide liquidity for investing in opportunities emerging from it. Nearly seven in 10 of those surveyed expect to start investing in private debt opportunities as social distancing restrictions begin to be eased. Distressed debt and special situations investing also emerged as a particularly attractive area.

These are astute investors with an entrepreneurial mindset and an appetite to seize opportunities despite, or because of, the wider market turmoil. They may be looking to further diversify their portfolios to reduce risk and drive returns and they’ve got a nose for a good deal but they are also often seasoned business people who understand and want to help SMEs.

And though it’s understandable that special situations and distressed debt are often the most obvious options in tough times, rescuing troubled companies from the brink is by no means the only area of interest. Supporting sound businesses that have been successful before and have the potential to be successful again by providing sustainable solutions to structural issues can also be highly rewarding – in many senses of the word.

To what extent, if any, the bigger private debt funds will be drawn towards the smaller end of the market remains to be seen, but there are good opportunities to be found and investors are prepared to seek them out. Strong, well-matched supply and demand make for a highly functioning, efficient marketplace and the signs are that this is ready to fall into place, giving businesses the runway they need to succeed when recovery comes. Despite all the uncertainties and concerns about a post-covid world, that’s a positive prospect for the private debt space, and UK PLC as a whole.

Claire Madden is a managing partner at Connection Capital, the UK-based alternative investments firm.