Stéphane Blanchoz, Head of the SME Alternative Financing team
Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.
The traditional revenue sources (i.e. stocks and bonds) have helped institutional investors facilitate consistent, steady returns for decades now, but they are facing a number of negative headwinds, a result of continued low interest rates and erratic equity market movements, which could become even more volatile amid the risk of worsening trade tariffs and punitive trade wars between various major powers and regional blocs.
A number of institutions – such as pension schemes – are in the red as the diminutive returns being generated by their current portfolio investments means it is harder for them to meet liabilities, a problem made worse by the growing pool of retirees, whose average life expectancy is also increasing. Government-led reforms in The Netherlands to shoehorn defined benefit (DB) pensions into defined contribution (DC) structures are warranted, but they are not sufficient on their own to remedy the negative cash flows for a number of these schemes.
Instead, a wholesale re-evaluation of the existing investment process needs to be undertaken for institutions, with capital being redeployed out of equities and bonds into asset classes and instruments such as small to medium sized enterprise (SME) lending funds providing an illiquidity premium and environmental, social, and corporate governance (ESG) focus. SME lending funds provide investors with predictable, diversified, stable and long-term cash-flows. These revenues are often uncorrelated to traditional equity and fixed income market movements, making illiquids an ideal investment destination for investors looking to rein in their liability mismatches.
SME funding has been eroded as Basel III capital requirements make it uneconomical and balance sheet intensive for banks to provide financing to riskier borrowers. While new entrants in the form of P2P (peer to peer) lenders and crowdfunding platforms have emerged, their ticket sizes are fairly meagre and most of their loan activity is directed towards seeding micro-businesses or small start-ups.
Asset managers – namely private equity and hedge funds – have also established lending operations for return diversification purposes, although most of their loans are being allotted to mid-tier enterprises and not SMEs. Given the plethora of buy-side activity in the loan space, it is critical for institutional investors to exert diligence and identify SME lending funds offering a differentiated product during the selection process.
At BNP Paribas Asset Management (BNPP AM) we believe there is an underserved segment of the SME marketplace in need of funding, namely, enterprises sandwiched between the micro-businesses/seed deals attracting the P2P/crowdfunded loans, and larger borrowers who have fairly unimpeded access to bank lending facilities and capital markets.
Such SMEs, which usually have turnovers of between €2 million and €50 million and headcount of less than 250, are very diverse offering a number of niche products and services. It is these types of companies which our experts will analyse and research, providing senior, unsecured loans, totalling anywhere between €500,000 and €5 million per transaction.
At BNPP AM we believe lending activities must be intertwined with our ESG criteria. We believe that adherence to ESG principles enhances the quality of the loan for the investor, thus reducing risk. All loan recipients are required to meet this criteria. An example could be the late filing of accounts by an SME, this could prevent us from lending in the first place or initiate action as it sends us an early warning signal that there could be future financial problems.
While we will price rates according to the risk undertaken, we strive to ensure such rates are fair and suitable for the borrower. Lending to companies at excessive rates is detrimental and can undermine investments as it makes it harder for enterprises to turn a profit. As such, we aim to strike a firm balance between being rewarded for incurring risk and ensuring SME borrowers acquire sustainable rates. We acknowledge that we have a responsible duty to the borrowers as well as to our clients.
We believe one of our key differentiators is that, unlike other lenders, it is critical for companies to retain control of their businesses, and that lenders avoid falling into the trap of trying to unduly influence management on strategic matters. This helps build up trust between lenders and the companies in their underlying portfolios, which ultimately augments performance.
Macroeconomic headwinds are denting investor returns, and this will force investors to consider allocating into new illiquid asset classes such as SME lending funds. The upside being that by choosing a firm with responsible lending practices, such as BNPP AM, we will play a positive role alongside you in helping to finance the real economy.
Read more about the SME Debt expertise on Investors’ Corner by BNP Paribas Asset Management
Written 10 August 2018
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