Direct lending funds have lent to well-known businesses such as Cath Kidston © Cath Kidston/Getty Images
Listen to this article
Give us your feedback Thank you for your feedback.
What do you think?
The great scramble for yield has seen asset managers hunt down ever more alternative sources of income. Many are starting to move into the world of shadow banking, alternative forms of lending in areas where banks are not competing for business as much as they used to.
Over the past few years, peer to peer lending funds grabbed huge attention on the London stock market, with a series of funds, such as Marshall Wace-backed P2P Global Investments, raising billions of pounds.
But evidence from the US suggests that the biggest opportunity probably lies in what is called direct lending, preferably through a structure that might mimic US business development companies. These BDCs are a large and diverse universe of tax efficient, listed, closed-end funds resident in the US. Collectively they are worth at least $100bn, according to Keefe, Bruyette & Woods, the investment bank, nearly all of which has been lent to mid-market private businesses in the US — capital that has arguably helped to improve the nation’s corporate productivity and profitability. Income-hungry investors have also snapped up these funds, with average yields well over 9 per cent per year.
In the UK, the equivalent market in BDC-like vehicles is virtually non-existent. By any objective measure, the UK market for direct lending is minuscule compared with the US. As a result, many fast-growing small and medium-sized enterprises, typically called gazelles, are forced to work in a financial system where banks are reluctant lenders, especially beyond five years, and most peer to peer lenders are unwilling to lend much above a few million pounds. Direct lending companies will service the mid-market secured lending space for loans above £50m but they, in turn, lack an outlet into the public markets typically afforded by BDCs in the US.
UK plc could do with a vibrant BDC sector, if only to provide alternative sources of income for investors as well as alternative sources of funding for business borrowers. The tragedy as I understand it is that, earlier this year, the UK came close to getting the foundation stone for a BDC sector — a listed direct lending fund, backed by the government through the British Business Bank (BBB). I say we came close because my sources indicate that the project was pulled at the last moment for no evident good reason.
A fundraising presentation I have seen states the £500m vehicle was to be called the British Income and Lending Trust (Bilt) and would have consisted of a cornerstone £420m portfolio of UK mid-market loan investments funded originally via the Treasury after the global financial crisis, and channelled through the BBB at a later stage, plus cash raised in the initial public offering. The actual lending was outsourced to sub-managers such as Alcentra and Ares. Bilt was looking to list earlier this year, with a target yield of 6.5 per cent plus Libor on a low fund management charge of 0.45 per cent per year plus charges from the underlying direct lending funds. By my calculations, the total all-in costs would have been around 1.7 per cent per year, much lower than the average total expense ratio for US BDCs of 2 to 3 per cent.
Crucially, Bilt might have acted as a catalyst for future BDC development with other asset managers working with the fund managers over time. The fund itself was already invested in 67 underlying borrowers working with the likes of Alcentra, Ares, Hayfin and ICG. These managers, in turn, run large direct lending funds that have lent to well-known businesses such as Racing Post, the UK publication, David Lloyd health clubs, Cath Kidston, the British retailer, and SimplyBiz, which provides business support to financial advisers. But despite the huge promise of such a fund, — higher returns for the Treasury, support for SMEs, and the ability to kick-start other funds from asset managers — the BBB shut down the project at the last minute in March 2017. I asked the BBB for a comment on the Bilt process. According to Catherine Lewis La Torre, chief executive of the bank’s investment arm: “After rigorously evaluating potential options against many factors, we decided that the British Business Bank Investment’s in-house team should manage the rundown of the portfolio”.
One question centres on whether Bilt itself would have been an existential threat to the BBB. Given that the portfolio of loans likely to be included in the investment trust was highly profitable, especially when compared with its wider portfolio of riskier, more venture-orientated loans, was there a sense that BBB might struggle to hit Treasury-imposed targets for returns? This is particularly acute, as I understand that the book of Bilt loans comprised not far off 50 per cent of the BBB’s total balance sheet. In policy terms, the big question must be this: was it better to establish Bilt and kick-start a BDC revolution in the UK or stick with a government bank designed to help British enterprise?
David Stevenson is editor of www.etfstream.com and the Adventurous Investor columnist for FT Money Weekend