This is the fifth extract from ‘Beyond the shadow of quantitative easing’, BNP Paribas Investment Partners’ investment outlook for 2017, in which Stéphane Blanchoz, CIO for Alternative Debt Management, explores why allocations to private debt investments and other direct lending strategies could be attractive for investors in 2017 as the segment grows.
‘Liquidity’ and ‘market risk’ appear to have become second-rate considerations in a world where cash-rich investors outnumber the investment possibilities, particularly in corporate debt markets. ‘Liquidity’ has been evaporating as many banks retreat from market-making; ‘market risk’ has become less of a concern than ‘credit risk’.
While such developments can be disconcerting, they are also giving rise to new opportunities: private debt investments and other direct lending (alternative debt) strategies are increasingly attracting investors, in particular institutional investors. Initially focused on larger companies, SMEs (small and medium-sized enterprises) are now joining the bandwagon.
The drivers of the growth in the alternative debt segment are bank disintermediation and regulatory support from policymakers in combination with an intensifying search for yield and diversification as investors adapt to the idea that the low interest-rate environment is here to stay for the foreseeable future.
Expanding the offering in the alternative debt segment
The SME segment has so far participated only marginally in the disintermediation trend and is still quasi-exclusively being funded through the banking system. For private investors, financing smaller companies is particularly challenging since this requires time-consuming analysis which might not be economically practicable when investing in smaller loans.
However, there are alternatives, both for investors looking for diversification through an exposure to SME loans and for SMEs looking to diversify their sources of funding. The development of crowdfunding platforms gives SMEs the chance to obtain non-bank financing, while peer-to-peer lending has recently started to attract institutional interest. Marketplace lending securitisation, backed by collateral made up of a pool of loans to SMEs, has started to evolve, benefiting from the clear support of European policymakers.
Another relatively recent development, which we see as definitely positive for SME credit, is the creation of the European Long-Term Investment Fund (ELTIF) label. ELTIFs are well suited to investments in long-term and illiquid assets. Moreover, these funds can grant loans directly to companies, expanding the range of SME direct-lending initiatives. The shift from a concentrated portfolio of sizeable SME loans to a diversified ELTIF of smaller SME loans could well pick up pace in the coming years. However, this will require proximity to origination sources, the development of scoring methodologies and the ability to industrialise credit work through a highly-structured investment process.
SME debt offers diversification benefits and solid credit features
The direct lending market has become both an additional funding solution for SMEs and an asset class bringing diversification to investors. According to a recent Deloitte report, the amount of direct lending fundraising over the 2013-2016 period reached USD 104.3 billion. And just within Europe, the capital raised by direct lending funds reached USD 45.2 billion over the same period.
In addition to diversification benefits, the characteristics of SME debt typically include a low default risk and a high recovery rate in the case of default. In terms of a company’s debt structure, SME debt is usually ranked as senior and the credit protection level is typically ‘secured’. The equivalent credit rating of SME debt, much of which is currently unrated, would be a solid BB.
We believe there is ample scope for the SME credit segment as SMEs tap into different – and often flexible – types of non-bank financing. Investors stand to benefit from the trade-off between liquidity and returns by being able to invest in an additional segment of the European credit markets – alternative debt – with an attractive risk-adjusted return profile.