Big opportunities at the small end

When the Australian government issued its Royal Commission on Misconduct in the Banking, Superannuation and Financial Services Industry in February it called for the industry to improve in four different areas, one of which was the provision of credit to small- to medium-sized businesses.

And the lending gap is clear. According to research commissioned by Causeway AM, an Australian private debt house, non-bank lenders accounted for just 9.3 percent of lending to firms with revenues of A$200 million ($143 million; €127 million) to A$300 million, and just 14.5 percent of those with earnings under A$20 million in 2018. Headroom for increased lending from private funds is one thing, but Martin Donnelly, a Sydney-based partner with placement agent First Avenue Partners, says there are even more reasons to be confident about growth in the Australian private debt sector.

“The backdrop of the Royal Commission means there certainly is an opportunity in the Australian private debt sector, as well as the banks themselves withdrawing from the market,” he says. “Plus, we are also seeing among companies, and their advisors, a willingness to embrace non-bank lenders.”

Acceptance of private debt has occurred at different speeds in varying markets. But according to Donnelly, in the current Australian banking system set-up, the Big Four banks – Commonwealth Bank, Westpac, Australia and New Zealand Banking Group and National Australia Bank – dominate to such an extent that it has resulted in mid-market corporate borrowers paying a high price for capital to compared to other markets.

“The oligopolistic nature of Australian banking, as it is enjoyed by the four major banks, is unprecedented. There is nowhere else on the planet where banks have so much power. This has created an environment where the return on equity for the Big Four banks on SME lending, is one of the highest in the world at between 18 to 22 percent ROE. That is frankly extraordinary.”

The levels of ROE may be extraordinary but, according to Mike Davis, a partner at Causeway AM, in addition to the extra cost to SMEs, bank lending options are limited and heavily property-collateral dependent.

“We have two barriers to entry in Australia that keep supply of alternative capital providers out – the tyranny of distance and market size”

Nicolas Politopoulous

“Because of the contradictions in the Australian economy, a lot of small businesses – which are not heavily asset rich in terms of real estate – find it pretty difficult to get more funds from the bank. This is unless they do a lot of other added value asset services, such as having a big FX book or derivatives trading, in which case the lender may find a way to work around it.”

Davis says that while Causeway will lend against property, typically the private debt shop takes on deals where the borrower has a book of debtors, and inventory, or potentially some plant equipment that the firm can give them some value for.

Not only are market conditions ripe for expansion of the Australian private debt sector, according to Nicolas Politopoulous, chief operating officer and co-founder of Australian private credit provider Dinimus Capital, the scarcity of capital to SMEs means loans are made with much tighter covenants than in the US or Europe.

“The biggest difference between how we invest and how a bank would approach it, is that we offer flexible capital, in that we customise facilities in line with the borrower’s requirement. Here in Australia it is a sellers’ market, therefore we don’t have the same scenario as the US where covenants are virtually non-existent.”

The result, according to Politopoulous, is not only a high demand for private debt in Australia, meaning high pricing, but when this is combined with strong covenant standards, the local market is very attractive on a risk-return basis compared with its international peers.

“I wouldn’t say the Australian private debt sector is price-insensitive, but if we compare our pricing versus what our peers with a similar strategy in Europe would get, we are looking at double the returns. Superior risk-adjusted returns are predominantly in directing lending to non-sponsor SME and mid-market transactions where the numbers are somewhere in the vicinity of 8-14 percent returns in Australia, versus 5-8 percent in Europe.”

According to Politopoulous, one group that has taken an interest in the potential of the Australian private debt sector is multi-strategy credit hedge funds. Dinimus Capital has done several co-investing deals with this investor group, but he says that while opportunities may exist onshore in Australia, actually accessing them is more complicated.

“We have two barriers to entry in Australia that keep supply of alternative capital providers out – the tyranny of distance and market size. Investors are increasingly becoming aware of the opportunity here, and are asking the question, ‘Do we invest in setting up a shop and building a team in Australia, or do it via a partnership with a manager, or perhaps on a remote deal-by-deal basis?’ We see funds trying to issue through all three of those approaches.”

Hedge funds

Others are less convinced of the importance that overseas hedge funds have in the Australian market. Tim Alexander, Melbourne-based chief executive of Judo Capital – a challenger bank in Australia explicitly targeting the SME sector – says that while a number of offshore players are talking about the local market, scant activity is coming from either the offshore banking or hedge fund sector.

“What we have seen is the small number of investment banking businesses that left Australia during the GFC looking to re-enter the market. I am yet to see any live examples of actual transactions from this group, but there certainly has been some posturing.

“We haven’t seen strong evidence of hedge funds wanting to come into our space – while we have spoken to a few, I wouldn’t call it strong evidence of them seriously coming in and making something happen.”

There may be a big opportunity in the Australian private debt sector, but it is at the smaller end of the scale compared with the global market. First Avenue’s Donnelly says that shops in Melbourne and Sydney are currently lending to smaller firms, than the standard definition of A$20 million to A$50 million EBITDA for mid-market corporates.

“Even A$20 million to $A50 million EBITDA is a pretty big company for Australian lending purposes. For most of the private debt funds here in Australia, the sweet spot for lending tends to be around A$15 million to A$40 million loan size, because that’s where there is a real lack of providers.”

Donnelly’s observations were borne out by Judo’s Alexander who says the one of the outcomes of the recent Royal Commission is that small business borrowings are now defined and that it is this part of the market that his firm will target – for now.

“We expect that over time, as our business matures, we will increase our upper lending limits. One of the outcomes of the recent Royal Commission is that small business borrowing is now defined as up to A$5million and we have set-up our business to target that sector, and we expect in a short period of time to Judo will be lending up to A$10 million.”