BNP Paribas Asset Management launched an investment vehicle covering the UK SME lending market in May, with plans to expand elsewhere. Stéphane Blanchoz, the firm’s head of SME Lending, talks about the gap in the market between minnows and whales, the resilience of smaller businesses and aspirations to serve as the missing link between SMEs and institutional investors.
Where is the biggest opportunity in the market?
There is a space in the market that is pretty much unaddressed: long-term lending between four and eight years of between about 500,000 and five million pounds or euros to SMEs, at between 8 and 10 percent. Above that level are a lot of corporate debt funds; and below that level are alternative lending platforms such as Funding Circle, whose investors see diversification in lending to large pools of small borrowers: Funding Circle’s average loan is only £80,000 ($104,000; €91,800).
The banks, meanwhile, are being pushed to make shorter-term loans than this. All the regulations are trying to make institutional investors contribute longer-term capital rather than the banks, and funds are often the missing link between SMEs and institutional investors. You might not be successful if you want to replace banks, but you will be successful if you can be complementary to bank finance.
To give our fund as an example, we are starting in the UK, with the promotion of BNP Paribas UK SME Debt Fund 1, because it has the biggest alternative finance market. But we are a pan-European asset manager, and our ambition for SME lending is pan-European, so we are expanding into two other markets where we believe there is a business case for our value proposition: the Netherlands and Germany. We are currently finalising our first deal in the Netherlands and are looking at some others there.
Altogether, lending in these three countries makes a lot of sense because they have a lot of SMEs, and the dynamic is positive for SMEs. We do have views on other European countries, but we are looking at them case by case, and are aware that their attractiveness can change: if I tell you a particular market looks good now, it may not be the case tomorrow. We are entering different markets step by-step because the environment is different in each country, including the legal framework.
If this market is unaddressed, presumably there is a decent illiquidity premium?
We see a minimum illiquidity premium of 2 or 3 percent, plus another premium linked to the specifics of each deal. This good premium exists because you can be a bit of a price setter here: what are the alternatives for a company that wants to borrow without collateral? This illiquidity premium also compensates for the amount of time that has to be spent on transactions.
Since it is time-consuming to look at all the potential loans, how is the process made efficient enough to make lending viable, and rigorous enough to make it profitable?
You start with the principle that it takes the same amount of time to look at a €2 million deal as a €20 million deal. In other words, you do not want to compromise on the credit risk but you need to consider a scalable process to deal with smaller loans. For instance, we work with partners to help us on the origination side, such as Caple, an alternative SME credit specialist, in which we have bought a 10 percent stake.
The SME and their advisors can use Caple’s digital platform to prepare and submit credit applications (including uploads of balance sheets and financial statements) on a standardised template, while Caple’s professionals will perform a primary credit assessment based on standards discussed. We have strict eligibility criteria, including maximum leverage of 4.5 and also use a proprietary credit scoring methodology in the decision-making process. We have also developed standardised sets of documentations for the loans, and although our loans are unsecured, we insist on different covenants covering in particular cashflow, leverage and debt service.
Does all this become easier in the era of big data techniques?
It would have been harder and more expensive to do a few years ago. We do not just look at a static audited balance sheet when making loan decisions, but also on the projected balance sheet based on the business case that is submitted. Advancing technology enables us to digitalise and access the flow of information needed to make a proper credit decision.
How seriously should ESG be taken?
Firstly, ESG can be an early warning signal. For example, a company that does not file its accounts on time – a governance issue – might also be a bad credit risk. Secondly, you want to send a message to investors that you care. We have a standardised ESG questionnaire for potential borrowers and promote a proactive approach to the SMEs on these topics.
This is not merely lip service. For example, we have already turned down a company working with plastics where we questioned the substitution strategy. It was not necessarily a bad deal, we discussed it with the ESG team at BNP Paribas Asset Management and ultimately decided not to do it. It was not exclusively for ESG reasons, but ESG considerations did have an impact on the decision.
Isn’t SME lending a risky market – something that investors need to consider as they anticipate the next downturn?
Our quantitative analysis suggests an annual default rate for SMEs below 2 percent, equivalent to BB/BB- levels. Compared to high-yield bonds, the returns targeted are, however, materially higher. As to the next downturn, I initially asked myself whether SMEs might fare badly when one comes, but analysis disproves the idea that SMEs are particularly hard hit by economic slowdowns. Yes, SMEs are sensitive to credit downturns, but statistically less than large companies financing themselves through high-yield bonds and leveraged loans.
For instance, in 2008-09, defaults in high-yield and leveraged loans were much higher. And through the cycle, the annual default rate was less volatile for SMEs than it was for high-yield companies in the UK. Bear in mind also that SME borrowers must pass strict eligibility criteria, and are then subject to credit analysis based on forward-looking cashflow projections.
You also get a positive diversification effect when investing in SME debts, as the total number of loans will likely be higher in the portfolio you are exposed to than in traditional private debt funds, potentially concentrating investments in a limited number of big companies.
If this market is so attractive, why have other alternative lenders not entered it already?
Since we are not smarter than anybody else, that is a fair question. The answer is that it requires resources, effort and commitment. You can industrialise this process to reach scalability, through infrastructure, technology and standardised documentation, but it is not scalable overnight. We are putting substantial capital behind this, demonstrating BNP Paribas Group’s commitment to the initiative, with a view to attracting outside investors later.
Stéphane Blanchoz is head of SME Alternative Lending at BNP Paribas Asset Management.
This article is sponsored by BNP Paribas Asset Management.