Guest comment by Claire Madden

Private debt is more popular than ever, with Private Debt Investor recording the highest level of fundraising activity last year since 2017, at almost $249 billion. But despite this hearty investor appetite for the asset class, small- and medium-sized enterprises (SMEs) in the UK struggle to get much of a look-in.

Most of the focus is on the larger, generalist funds that provide debt capital to major corporates – competition in this part of the market is high. Investors who are prepared to be more open-minded and invest at the smaller end of the scale would discover a wealth of opportunities to drive outsized returns by supporting strong and successful SMEs with the funding they need, structured to suit their requirements.

Resilience in tough times

Two years since covid-19 arrived and disrupted everyday life so severely, SMEs urgently need – and are worthy of – greater attention. Thanks to rapid action early on by the UK Treasury and banks to deliver financial support, businesses have, for the most part, stayed more resilient than most people expected. Even so, many significant challenges lie ahead.

The real stress comes now that those financial quick fixes are no longer available: emergency loans need to be repaid, furlough is over and SMEs need working capital to trade out into recovery. Added to which, the outlook for the year for organisations of all sizes is cloudy, with more storms threatening.

Supply-chain delays have already started to bite, putting cashflow and sales under pressure, and making it harder for businesses to grow. Rising inflation thanks to higher energy, materials and transport costs, tax hikes in the form of the planned National Insurance rise, and wage increases due to staff shortages in some sectors will only add to the strain on working capital.

That said, the past two years have shown that SMEs can be extremely agile in the face of uncertainty and change, adapting quickly to new realities, facing down problems and spotting opportunities, no matter how bad things get. There are plenty of high-quality businesses out there, which, with the right financial backing to meet their working capital requirements, can not only survive any ongoing and emerging difficulties, but flourish as the world returns to some sort of normality, helping to ignite sparks of growth in the UK economy. For that to happen, though, lending conditions must be favourable, and that’s where private debt comes in. The hard truth for many UK SMEs is that mainstream lenders may be unable to provide the funding they require now.

Broadening horizons

Having dished out large volumes of Coronavirus Business Interruption Loan Scheme loans and Bounce Back loans, banks may be reluctant or unable to take on new business (especially from SMEs), instead focusing almost entirely on their existing customers, with the larger ones at the front of the queue. Traditional senior debt is, by nature, restrictive, and banks are becoming even more rigid on what types of credit risk they will take on, while loans typically come with strict covenants attached.

SMEs that are unable to negotiate additional funding from their bank, or who find that refinancing will only be granted on what they see as unacceptably onerous terms, could find it hard to ‘shop around’ for another, better deal. Bank lending was elusive for several years after the 2008 financial crisis for smaller businesses, and they are right to be worried that a similar situation could develop again. In the past, it has been the case that whole industry sectors have been affected by a dearth of traditional bank lending, meaning that even the best-performing companies could find themselves locked out.

As a result, many will be compelled to broaden their horizons and consider other options, including private debt. This could turn out to be a blessing in disguise, with borrowers finding a level of flexibility and customisation from private debt lenders hitherto unknown to them. No longer are standard amortising loans the only option available: the fact that private debt providers are often willing to offer other repayment profiles that better suit specific operational models and circumstances is just what SMEs want to hear.

Efficient use of capital

As companies navigate their way out of recovery, it makes sense for them to put the capital to use servicing business needs or to seize growth opportunities, rather than being eroded each month by repayments. Where lending risk is not fully covered by cashflow, private debt providers may seek to negotiate taking a small equity stake as part of the deal (in the region of 10-15 percent); in which case they will likewise share in any value created, making such arrangements mutually beneficial for all concerned. For SMEs, this is still less expensive than a ‘full fat’ private equity deal, where they would have to part with a much larger (probably majority) shareholding, so it is a trade-off they are likely to be open to.

Moreover, loans with lighter covenant requirements play very much to SMEs’ advantage in the current climate. Instead of constantly having to think about whether they still meet covenant tests when trading conditions are so changeable, budgets are under constant review and forecasts must be regularly adjusted.

‘Cov-lite’ arrangements give them room to breathe. Then they can focus on what matters: running a tight ship operationally, steering the right course and staying ahead of rivals. This approach may not be the cheapest option, but it is the most sympathetic, and that’s a key reason it is proving to be so appealing to borrowers.

For private debt investors, all the ingredients are there to generate alpha returns: a sizeable, growing market of well-run companies looking for funding, which offers attractive terms, with very little competition crowding around.

While it is hardly surprising to see most private debt capital being channelled into major deployments for corporate borrowers, the field is wide open at the other end of the market, in particular for deals below the £10 million ($13 million; €12 million) mark that are widely deemed too small and fiddly to bother with. For those niche providers who are prepared to take the trouble, who understand this segment, and who know how to source consistent dealflow, there is plenty to choose from.

It’s not always the case that bigger is better, and by overlooking SMEs, investors risk letting good opportunities pass by. Allocating capital to different types and sizes of investment to increase diversification and boost overall returns, via specialists operating in select subsets of the market, is a smart strategy in anyone’s book. Small can still be mighty.

Claire Madden is managing partner at Connection Capital, a UK-based firm that provides access to alternative investments for private investors