In 2008, as the financial crisis shook financial markets and banks were bailed out by taxpayers, SMEs faced an exceptionally challenging environment.
Banks were no longer lending to SMEs as the credit crunch started to bite and their balance sheets became more capital constrained.
The drying up of bank finance had profound effects on business owners. Booming and struggling businesses alike were faced with the uphill task of operating in a world where access to credit became non-existent, almost overnight.
As any SME owner knows, the right funding at the right time is crucial to the success of business.
Access to timely finance serves many purposes, from acquiring and remunerating new talent, to providing cash and working capital using machinery, equipment or real estate as collateral; it is the lifeblood of business.
The level of risk an investor is willing to accept will be crucial when determining if a direct lending investment is right for them.
In such adverse circumstances, the financial crisis spawned new ways of funding SMEs looking for credit facilities. While demand for credit from SMEs continued unabated, banks were unable or unwilling to lend.
Furthermore, tougher regulations reshaped the post-crisis era, and this ultimately opened the door for alternative ways of advancing business funding.
It was Winston Churchill who said: “Never let a good crisis go to waste”.
Enter direct lending. Businesses could once again get loans, but without going through reluctant intermediaries such as banks, by applying directly to the source of the capital – usually asset managers.
Where does direct lending fit in a portfolio?
It is the fixed income nature of direct lending funds that is the most talked about benefit.
The continuing low yield environment, driven by easy monetary policy in the US and Europe, has seen direct lending funds take-off, while the headwinds that have affected savers and investors hunting for income have continued. This era of low interest rates has returned cash savers next to nothing, and while rates have improved slightly they still fail to beat inflation.
The situation is better in equities, but caution must be adopted. The forecast yield on the FTSE 100 is around 4.3 per cent, but in practice dividends are highly concentrated among a small number of companies.
More specifically, the nature of the fixed income stream that direct lending provides makes it particularly attractive for financial planning purposes.
Traditional corporate or government bonds are typically found in portfolios, but are often correlated with equity markets.
Fixed income derived from direct lending can be used for goals-based financial planning to meet a specific future liability, such as planning for school fees.
The yields offered are attractive compared to typical assets used in liability driven investment strategies, such as gilts, which offer only limited returns. Furthermore, direct lending assets tend to be secured, providing additional protection against default.
Direct lending can play a valuable role in offering downside protection during volatile periods for equities and higher yield corporate bonds, and a reliable source of income when conventional fixed income assets offer limited returns.
In addition to goals-based planning, they can provide genuine diversification to portfolios, with low correlations to conventional equity and bond markets, and a predictable rate of return.
Understanding risk and allocations
The level of risk an investor is willing to accept will be crucial when determining if a direct lending investment is right for them.
Direct lending takes many guises, and the level of risk can vary significantly across different products. Not all direct lenders are created equal and what separates them is not only how successfully they make loans, but who they extend credit to and the collateral that they secure loans against.
Some direct lenders provide loans to consumers – others to SMEs.
The way in which they structure products is widely differentiated too.
Getting under the bonnet of a direct lending offer is as important as understanding the investment process, strategy and composition of any equity, bond or multi-asset fund.
Each individual direct lending investment may be exposed to a diverse spread of sectors, differing in size and loan terms, combining to provide investors with diversification within their investment.
Many direct lending funds use secured assets, such as asset backed finance, loans with debentures or project financing.
Direct lending also brings a number of structural protections which shields investors from the risk of loss. Some providers focus on peer-to-peer investments; others offer bonds that are secured against large portfolios of businesses, meaning that the impact of any individual default does not impact on returns.
The UK appears to be showing a greater interest in direct lending strategies.
Products for institutional investors have existed for some time, but appetite is now starting to increase among consumers and consequently the number of consumer-focused products is growing.
A survey by AKG revealed that over half (53 per cent) of the financial advisers questioned had been asked by their clients about products exposed to SME credit/direct lending.
Intermediaries have a big role to play in the future success of the asset class.
As trusted professionals, IFAs prepared to research and understand the direct lending products out there are well positioned to provide their clients with the confidence and insight they need to make informed decisions and achieve reliable and attractive outcomes.
Belinda Thomas is a partner at Triple Point Investment Management