Europe: PSC Eaglewood on small balance lending

Specialising in the financial and business services sector since 2008, Pollen Street Capital combines private equity and private debt with over $2 billion in assets under management. Pollen Street Capital is now poised to launch its first private debt fund in Europe, which will target small-balance lending in the UK and Irish real estate markets.

Q How would you define small-balance lending?

Simon Champ: We don’t only define the area in terms of size of the loans, but rather in terms of the nature of what we are doing. On every loan that we make, we work with platform originators who are very skilled in their niches. They source the appropriate deals for small-balance lending. The opportunity has arisen in this space because it’s an area where the banks have withdrawn almost completely, and that’s because the origination costs of small-balance lending and the cost bases of the banks no longer match. It’s an area of acute dislocation. So, the large banks are no longer willing to commit people, resources, time or money to making these perfectly sound loans, and we are effectively disintermediating the banks in these niche areas.

Simon Champ

“The opportunity set for small-balance secured real estate lending is strong in part because there has been a sweeping tectonic shift in bank regulations, leaving niche areas of opportunity in its wake”

SC: The opportunity set for small-balance secured real estate lending is strong. In part because there has been a sweeping tectonic shift in bank regulations, leaving niche areas of opportunity in its wake. Also, because it’s challenging to accumulate and originate the loans and build scale, this can act as a barrier for many. We have invested very heavily in building origination. The cost of originating a large loan and a small loan might be similar, and thus it has until now been less economic to pursue the small-balance lending for fund managers. What differentiates Pollen Street Capital is that we have invested a huge amount in building proprietary origination networks that don’t sit on our balance sheet, which means we have mitigated some of that in-house origination cost by working with external platforms. At the same time the origination network allows the manager to remain opportunistic and flexible. Because it is difficult to originate these loans reliably and in scale, the barriers to entry remain high. Additionally, in the property market especially, small-balance loans are a little less susceptible to headline economics. The loans often have very local requirements and considerations, so it is the street or the building in question that matters, rather than global trends. It is much more niche, project-by-project financing, where the individual idiosyncrasies determine how the loan is structured. That means you need a lot of local skill to understand the project and make the loan, but unlike those making larger ticket, long duration loans, you are less susceptible to macroeconomic trends. Typically, our projects are smaller and staged too which should reduce the duration risk of the loan. Finally, of course, it is about diversification and spreading risk across more borrowers and loans rather than having too many eggs in one basket.Our listed funds, Honeycomb Investment Trust and P2P Global Investments have made loans to consumers, small businesses, and in the trade finance and real estate spaces with a focus on granular, small balance loans. We believe that small balance lending creates a degree of diversification rarely seen in other private debt funds. Our average real estate loan is 100 percent secured against UK and Irish real estate and considerably smaller than the traditional big-ticket private debt funds, at around £3 million. If you consider those numbers in the context of a real estate fund, that means that if you build a £300 million fund, you have about 100 projects in there, so you have really diversified your risk. We don’t only define small-balance lending by size, but rather we seek those traits of huge diversification, working with skilled independent originators, and disintermediation of the banks.

Q How can you make the origination process economically viable, given what you have said about the challenges of accumulating and pricing so many loans?

SC: We have met a lot of originators over the years, and we only work with a small handful that we like after extensive due diligence. Those originators then manage the initial loan application process, assessing whether they think a loan will meet our strict criteria. They perform the borrower profile checks, creditworthiness, anti-money laundering, assess the track record and so on, and they also instruct a valuation of the asset. They will typically create an assessment of rental streams or building value, confirm specific building costs and timeframes, and the suitability of the borrower for those conditions. Once they have that data, they present an opportunity to us in a standardised format that we’ve created with them. All of this is designed to be stringent but give the borrower a superior customer journey relative to the banks. We see multiple opportunities from originators on any given day and we then work with them to allocate our capital on a project-by-project basis. We don’t give any money to the originators; each opportunity is originated, presented to us, and then we can say yes or no. All our real estate loans are fully secured. In real estate development, we insist that our platform partners put up their own capital as a first-loss piece, so we are pushing them to have skin in the game. We believe this ‘first loss’ piece makes a huge difference to the risk profile of the business, not just in a lower LTV to us, but also in terms of incentive for our partners. If the loan is approved, they then also help manage the drawdown process. This means the loan book is periodically appraised and stress-tested, and then they ultimately take responsibility for collecting the payments to pay down the loan. The Pollen Street Capital group has to date deployed around £650 million into real estate debt with no losses.

Q When it comes to institutionalising this strategy, what kind of investors does it appeal to, and why?

SC: Typically, real estate debt funds have focused on large ticket lending, for obvious reasons. Despite its attractions of strong yield and duration, small balance real estate lending has historically been challenging to scale. We believe that over recent years, we have created origination channels that can now deploy £300 million plus. We are at a relatively early stage in the evolution of this market, but we see substantial growth in the future. We are originating using the experience and infrastructure that we’ve built up as a pioneer in the public market for these loans. Given the scale of the opportunity today, we believe it is best suited to investors seeking income, who we think will be attracted by the fact that it’s a lower risk real estate vehicle focused on debt and not the more volatile equity part of the capital stack.

Investors like it because it is debt, not equity, and hence a high level of predictability of returns. There are hundreds of property equity funds out there, but not many debt funds, precisely because historically the banks held most of this type of secured debt. But in this part of the cycle, where property prices may not rise, some investors are not so sure about the equity story but still want exposure to the income characteristics of secured real estate. The attractions to investors are therefore less exposure to property prices, security, stable income, lower loan-to value relative to other areas of lending, first-loss protection from the originators, and then the fact that the lending seeks to add value. We are filling the gap left by banks and building societies, and the pricing of the loans can be a bit more sustainable because it’s not driven by global economics but local ones.

Q Is small-balance lending becoming a competitive part of the private debt space in Europe?

SC: There’s been substantial dislocation in this market. Historically, if you were a building owner or a developer, you would go to a loan broker, who would help you fill out an application, and then go to a bank or building society who would lend you the money. But large banks are no longer motivated under the new capital requirements to make these small balance loans.

“We see multiple opportunities from originators on any given day and we then work with them to allocate our capital on a project-by-project basis.”

We see a big opportunity in the UK and Ireland because that’s where the banking regulations have hit the hardest. There is huge underlying demand for the asset, as evidenced by the government’s recent substantial housebuilding announcements, and yet it is not being funded, so you have dual forces driving the attractiveness. For investors, there are very few ways to tap this market. There are some open-ended funds, but in those there always is an element of danger that everyone wants to exit at the same time. The barriers to entry remain very high for new funds wanting to compete in this part of the market, precisely because of the origination costs and the time to market. We think the returns on smaller loans are more sustainable, but they are harder to find, and you must build a significant infrastructure and scalability to be able to offer investors the diversification and other attributes that appeal.

Q What was the logic behind the Pollen/ Eaglewood merger, and what are the challenges in scaling this kind of business?

SC: Pollen Street Capital is a private equity fund management business borne out of Royal Bank of Scotland, focussed on investing in financial services businesses, including Shawbrook, the UK challenger bank. It has considerable knowledge and experience of owning and building specialist lending businesses in the UK and Europe across a broad range of asset classes, and in December 2015 created its first credit fund, Honeycomb Investment Trust. Prior to the merger of Pollen Street Capital and PSC Eaglewood in September of this year, PSC Eaglewood had been part of the Marshall Wace group. Pioneering institutional funds in small balance platform originated lending. Thus, the merger made perfect sense. The merger of the two businesses has combined the global reach, world class infrastructure and specialist platform knowledge of PSC Eaglewood with the relationships, track record and industry expertise of Pollen Street Capital in a merged entity that is now probably the largest manager in this small balance lending space in Europe. Growth now is about offering opportunities for investors, and it’s my view that the banks find this space difficult.

Q Given your investments are so small, is there a greater element of risk? How does a lender mitigate that risk?

SC: There are lots of risks that we can mitigate, and many of those are ones you would need to think about for both small and large-ticket loans. However, we think we can mitigate risk more easily with small-balance lending. For example, duration risk is significantly reduced in smaller balance lending as many smaller projects simply take less time to complete. Our construction risk is also less as many of the projects we fund are the refurbishment of existing buildings rather than large, multi-year, ground-up projects. However, diversification is the main mitigation, because if you have hundreds of small loans, any individual idiosyncratic risk can be mitigated. There are then the other risks: regulatory risk, default risk, developer risk, prepayment risk, elongation risk, interest rate risk, capital deployment risk, and so on. Again, working very closely with our origination partners who have ‘skin in the game’ in each loan helps in this regard. Typically, our loans are made in 10 or 12 payments to the borrower, administered by our partners, with a quantity surveyor visiting the site every time. That is something the banks just cannot replicate now, because it would simply cost them too much.