A better way for investors to capitalise on private debt
Simone Westerhuis, LGB Investments
As fixed income yields disappoint, secured loan notes issued by growth businesses could be an attractive avenue for investors, whether they be wealthy individuals or family offices, writes Simone Westerhuis, Managing Director, LGB Investments.
Despite the recent rising rate environment, interest rates are still very low by historical standards and as a result private debt has emerged as one of the chief opportunities for investors searching for yield. This is especially true of high net worth individuals (HNWI) and family offices, as, faced with long-term low interest rates, meagre bond returns, poor hedge fund performance and fluctuating equity markets, they have increasingly turned to alternatives: real estate, private equity and – perhaps most strikingly – to the private credit markets to secure the returns they need for their portfolios.
HNWI and family office investors are particularly well positioned to benefit from the growing appetite from businesses for non-bank funding. According to Preqin’s 2017 Global Private Debt report, the average current allocation of a private debt investor stands at 4.7 per cent of assets under management (AUM). Family offices allocate more than double this figure – 10.7 per cent of AUM – to private debt, more than any other type of investor. This, as Preqin notes, can be attributed to “fewer restrictions, increased flexibility and an appetite for higher returns compared to other asset classes”. In contrast to conventional fund managers, HNWIs and family offices are less tightly regulated and view secondary market liquidity as less important.
But as the private debt market has become more popular, its composition has shifted over the past decade. Up until about the mid-2000s, activity was mainly dominated by distressed debt and mezzanine financing. More recently the trend has been towards direct lending.
Marrying small and medium-sized growth businesses with financing from wealthy individuals, family offices and the mass affluent has considerable appeal on both sides. From the growth businesses’ perspective, it bypasses some of the difficulties that come with borrowing from banks that have retrenched in the post-financial crisis climate, making them inflexible and sluggish counterparties. Without the ability to turn to the corporate bond market to raise funds, SMEs are often willing to pay a premium for increased flexibility and speed of execution.
From an investor’s perspective, meanwhile, direct lending can seem a compelling proposition. One of the main advantages is diversification and the prospect of earning uncorrelated returns to the equity markets. At a time when stock markets have produced strong returns for over a decade one may wonder how long this trend could last. The other is the potential for higher yields relative to the public bond markets. Direct lending offers an attractive, steady cash flow in a climate where quantitative easing has driven bond yields down.
But there are also risks that need to be carefully considered. There is, of course, the heightened credit risk that comes from lending to growth businesses, coupled with the fact that that private debt has yet to be tested in an economic downturn. An important consideration is the intermediary or platform that investors use to manage their loan portfolios. While P2P platforms have simplified the distribution process, they could potentially pose a higher default risk to investors who have little insight into the quality of companies they are directly lending to. When a borrower defaults, the investor often finds himself helpless to take any action directly.
Going through investment funds or trusts, meanwhile, may provide more protection against defaults through established debt recovery procedures. But the risks can vary markedly depending, for example, on whether the manager chooses to use leverage to boost returns and cover fees. The key to success will often depend not only on the manager’s ability to analyse risk, but also on its access to deal flow and ability to fix problems when they occur.
LGB Investments has helped develop another variant of the direct lending instrument: secured loan notes. These are secured, fixed-rate instruments with maturities ranging from six months to five years. Issued by SMEs and growth businesses under the terms of a programme, which enables repeated issuance, they often have seniority in a borrower’s capital structure. Most importantly, loan note programmes will have a designated Security Trustee who holds the collateral for all noteholders on trust and will take action on behalf of noteholders when difficulties arise.
To date, the main investors in these secured loan notes have been individual wealthy investors and family offices, although they are also increasingly catching the attention of institutions. There are a number of reasons investors have found these instruments to be attractive. An obvious one is their relatively high yields and short maturities. The notes offer investment returns of around 6-10 per cent per annum, with the interest rate determined by the credit standing of the issuer and investor demand. By contrast, publicly traded corporate bonds typically generate yields of 2-5 per cent in the current climate. Secured loan notes Issues are commonly listed on a recognised stock exchange to take advantage of the Quoted Eurobond Exemption from withholding tax on interest.
We find that another real advantage is that the programmes offer frequent re-investment opportunities and can often accommodate reverse inquiries from investors sitting on cash. Investors have an opportunity to really familiarise themselves with an issuer and can increase their allocation to a name over time. Robust security arrangements help assuage some of the concerns investors to growth businesses might have about taking on excessive credit risk.
Through our Corporate Finance department, LGB & Co. has established secured loan note programmes for 20 mid-market companies raising close to £100 million to date from HNWIs, family offices and institutions. A recent example was the £40m loan note programme for Reward Finance Group Limited, one of the UK’s fastest growing alternative finance providers. Our research suggests there is substantial room for expansion and that the UK’s immediate addressable secured loan note market is worth around £500m.
Investors do need to carefully evaluate the risks of lending to SMEs – whether through secured loan notes or through other instruments – against their investment goals. But as part of a balanced and diversified portfolio, we believe that in an environment where low yields are the norm and alternatives such as hedge funds are underperforming, secured loan notes offer an attractive way to tap into private debt markets.