Ahead of SuperInvestor, the worlds largest private equity conference focused on LP/GP relationships... James Newsome, Managing Partner at Arbour Partners shares his thoughts on direct lending.
Tech and data based lending platforms are now increasingly tapping global pension funds and insurers for capital and serving tens of thousands of SMEs with loans. One marketplace lender is deploying its data systems and over 800 people worldwide to crunch millions of data points to allocate $100m per month directly to SMEs on behalf of its capital subscribers.
Welcome to direct lending 2.0. The diversity and steady income that technology is bringing to credit investors is highly encouraging. If we only ensure that it is a natural evolution building on the proven principles of credit investing, this potentially vast capital market is a sustainable alternative to the banking system.
"Since the financial crisis over half a trillion dollars globally has been deployed by non-tech direct lending funds into hand crafted corporate middle market situations."
Direct Lending 1.0: A Successful Climb to Here
Since the financial crisis over half a trillion dollars globally has been deployed by non-tech direct lending funds into hand crafted corporate middle market situations. Some have financed private equity buyouts and some have funded companies looking to grow. Offices have been opened in locations all over Europe and the USA to source and structure face to face high-yielding loans without banks’ involvement. Investors have responded and scores of new asset managers have launched to provide the expertise for pension funds to invest in credit.
However, there are signs of plateauing in what is currently the largest sector of private debt 1.0, the financing of private equity buyouts. According to industry watchers PDI traditional direct lending funds raised US$111 billion last year, down from $120bn in 2015. This year's fundraising has kept pace but the exponential growth of four to five years ago is not there. This is in part because investors are concerned about how quickly and how effectively the existing cohort of ‘analogue’ direct lending funds can source the hand crafted loans of €10m to €200m in size that is their staple diet. Will private equity M&A activity, still the source of most private debt offerings, remain robust enough and of sufficiently high quality to absorb all the new investor capital?
Moreover, most of the private debt funds in direct lending 1.0 have been providing credit to only 10 to 20 firms each per year. In fact, the $700 billion of non bank lending deployed in the years since the financial crisis has gone to just a few thousand companies worldwide. This is a tiny fraction of the number of SMEs looking for better credit solutions.
Marketplace Lenders – Helping Investors Reach Far Further, Faster
Meanwhile, as in so many other spheres of life, technology is shaking up the processes by which we make decisions and allocate resources in the capital markets. Alongside the growth of private debt funds there has been demonstrable progress for technology platform lending, typically known as marketplace lending. Only around $20bn has been deployed so far, a fraction of the total in the private equity-based 'direct lending 1.0', but this has gone in smaller loans to up to a quarter of a million global SMEs since 2010. Through these data rich platforms pension funds and insurance companies are allocating directly, without investment banks and private equity firms in between, to much more diverse and granular pools of credit.
A fund served by a marketplace lender (MPL) may allocate credit to tens of thousands of SMEs in loan sizes of less than 1 million euros or dollars, achieving a yield from the loans at similar or better levels to those in the traditional private equity based direct lending. Moreover, marketplace lenders are showing default and recovery experience in many sectors better than that of the banks.
While the platform lenders’ machines have themselves have been learning and improving their own credit selection algorithms, the business models of the lenders have undergone some crises and some rethinking, which is healthy. Some of the well publicised difficulties of Lending Club and other US platforms who have mixed consumer and SME loans for example, have given some equity investors in the sector’s firms reason to pause.
Such is to be expected. While the models that work will scale up, lead the sector and attract professional capital, others will consolidate and some will fall by the wayside. One would worry if this were not yet the case.
The platforms which attracted equity capital have been able to build their tech capabilities and their human resources very rapidly. One lender, Funding Circle, has over 800 people worldwide working on credit monitoring, origination, tech, compliance and capital markets functions. This means that they haven’t actually needed to ‘achieve more with less’, the usual tech company mantra. It is the next phase of the MPLs’ development – providing a channel for institutional investors in large scale – where they will achieve that operating leverage. The key to that is raising large amounts of pension fund and insurance capital to put to work in their now seasoned lending operations. The best platforms are about to do that, big time.
Insurance companies and pension funds in particular, already familiarised with direct lending through the 1.0 providers, are becoming a larger part of the capital allocation to the marketplace lenders. This is because for certain types of credit underwriting – namely high volume, shorter term SME credit – the powerful new data analytics and communication hubs are bringing about a fundamental shift. Platforms can achieve both tremendous granularity (percentage position size of the fund in each credit) and constant, or even improving, quality of underwriting processes. Aegon of the Netherlands has just announced a partnership with Funding Circle that will channel credit to over 1,000 SMEs in the UK, the USA, Germany and the Netherlands.
The platforms who have kept to the SME focus on the lending side and were early to the institutional investor conversation can now show over 5 years of default and recovery track record. They can also show a good amount of transparency – down to loan by loan monitoring data. Typically the leading platforms are facilitating lending to firms that themselves average 10 years of operating history.
All this is music to the ears of institutional investors – they are seeing broad and fast deployment of funds, reduced risk concentration, regular income disbursement and the ability to deploy large funds above €500 million.
Scaling Up From Here: 4 Big Lessons We Have Learned From History...
But let’s take a step back and carefully revisit our assumptions. So often at this stage in a cycle, when the demand for credit investments exceeds the supply, people start to stretch the core principles of credit investing. The manufacturers of new investment products (typically old products, with new acronyms) ride into town. The rest of that story is our living history. The most dangerous words in markets are of course “this time it’s different”. So, while the promise is great, is the technology being deployed by the MPLs really able to shift out the curve that sets volume against quality?
To help us answer these questions, let’s do what Einstein’s idiots didn’t do and look at history to see what we can learn. What are those core principles in credit markets and how do they get compromised? Then we can assess whether the technology now available is able to give us greater width and scale without compromises. We don’t want it to be different, we want it to be fundamentally right, but also bigger and better than the financial system which melted down in 2008.
The four horsemen of the credit apocalypse I see as: inverted telescopes; buying the packaging; maturity transformation and leverage on leverage. So let’s take these one by one and look at what is going on.
Don’t Invert that Telescope
When we invert the investing telescope we zoom out rather than in, thinking we will see useful overall patterns. The problem is, once you fail to see what’s actually going on in each data point in large samples you don’t actually see any patterns – and start to make assumptions, usually over-positive. ‘US housing prices don’t fall on a nationwide basis’ was the most widely cited fake pattern in the pre-2008 period.
"The leading platforms are accessing, analysing and constantly monitoring thousands of data points on each SME borrower."
The data-led lenders are, however, able to burrow pretty deep into the SMEs they are lending to and to stay down there. The leading platforms are accessing, analysing and constantly monitoring thousands of data points on each SME borrower. With loan sizes of €50,000 to €1m the leading platforms are typically taking full sight of borrowers’ bank accounts (as would a bank of course), and receiving early signs of deterioration which may impact loan payments. Some platforms are crunching data reported to the authorities by SMEs that they are not even lending to, to enrich the data learning process. This helps to recalibrate more accurate default prediction models.
This modelling is not the inverted telescope of the subprime market pre 2008. They ran wonderfully complex Gaussian macros on hundreds of thousands of mortgages to help create AAA bond ratings, but down at the coal face where the credit was actually created they relied on self-certifying salary data and sketchy financial status information. Every London cab driver can now sum up credit modelling in the City of London by saying ‘if you put garbage in you get garbage out’.
The SME-focused platforms of direct lending 2.0 on the other hand are using data from the official filings of companies which average around 10 years of operating history to drive their machines’ learning.
Remember: Packaging is Just Packaging
The financial packaging created for investors when mass scale-up of credit investment takes place often exaggerates these fake assumptions. In the subprime bubble of 2005-2007 the packaging of new securitisations and CDOs retained the same AAA attachment points, and, if anything, tighter and tighter spreads on their liabilities – supposedly an indication of less risk – while the poison flooded into the system. In the hunt for yield, buyers loaded up on the shiny financial packets, as has been chronicled in countless SEC investigations, senate hearings and Hollywood movies.
So how are the data-led marketplace lenders of today bringing in their investors? In many cases large institutions have been committing to the platforms in remarkably simple investor agreements whereby they commit to capital amounts that are drawn over time and the platform commits to pass through all interest and principal after service fees. The complexity is not in the packaging, it’s in the data – and that is being systematically mined and learned from. Yes, some of the lending platforms are doing securitisations. On first principle this is not a bad thing at all. However, the mass adoption of securitisation has in the past driven down yields and, in my view, has led to deterioration in underwriting standards just so that the SPV beasts can be fed. In this respect they should be careful, but as long as the credit origination process remains robust these deals will perform.
Either a Lender or a Borrower Be
Borrowing short to lend long – maturity transformation – is of course the perennial bogeyman of credit crises who never actually gets killed off. The marketplace lending platforms, however, are not yet deploying this practice. Their own balance sheets are still heavy with venture equity. If they start to play the maturities, either in their own balance sheets or with SPVs, we know the woods are once again becoming less safe to go into. A virtue of the sharing economy ethos which infuses the platform lender model is that little manipulation of financial structures is done between lender and borrower.
While leverage on leverage may not yet be a feature of the marketplace lenders, there may be some lenders on the platforms who are themselves leveraged and borrowing capital to lend to SMEs through the platforms at higher rates. The leading marketplace operators, however, are taking in large pension funds, insurers and funds of funds as direct lenders to the SMEs. Institutional investors of this type are not typically leveraged entities.
Also, these funds’ capital, if anything, is longer-term than the loans the platform lenders are making, which are typically less than 5 years in final maturity. Moreover, some platform lenders are able to make amortising loans so that the actual duration is less than three years. The investment vehicles the MPLs are offering to institutional investors are therefore also able to be shorter in some cases than those of the 1.0 debt funds.
"A mantra among investors which has proved important in the past is ‘alignment of interest’."
Check Your Alignment
A mantra among investors which has proved important in the past is ‘alignment of interest’. It is here that some investors still have concerns about the MPL platforms. When inviting institutions to use the platform to act as direct lenders the platforms in many cases are not charging the usual annual management and performance fees in the private equity/private debt fund model. The platform will take a one-off payment each time a loan is originated. A borrower will borrow 100 and receive 97, with the platform taking the difference. The investor will have provided 100 and is expecting 100 plus annual interest in return. There may also be an annual servicing charge to the investor for the operation of the platform. Beyond these contractual payments there typically will not be any other direct performance fee charged by the platform to the investor.
So what incentive does the MPL platform actually have to make sure that the loans they make perform well and are managed intensively during their term? Here, some institutional investors more used to the private equity model will be in the mind-set that asset managers only do great if they get rich for doing great. The lending platforms, however, like banks, above all need to be disciplined. The machines need to source and crunch all the right data. The humans need to act on the data they see. Finding ‘alpha’ and outperforming benchmarks is not the name of the game. For this reason the alignment of interest for investors is in the platforms needing to run the most disciplined operations in the market with the lowest default rates for a given return level, to be able to attract the most investors. Unlike banks, which levered up equity to increase return for shareholders, the platforms’ game is to increase size and therefore profitability through operating leverage not financial leverage. They only increase size by showing as little volatility in their lending as possible to the lenders they bring into the platform.
Incentives are never perfectly aligned in asset management. For credit investors it seems to me that they have as much of a fit here as they do in credit funds where outperforming a hurdle may encourage extra risk taking.
Through Evolution, not Revolution, this Credit Market Will Make Progress
Mary Shelly wrote that ‘no man chooses evil because it is evil. He only mistakes it for happiness, for the good he seeks’. As long as we stick to the principles of markets which have been proven indispensable over time, institutional investors can safely ‘seek the good’ of yield, diversity and a regular income through the well-run tech platforms. This should probably be through investing in a combination of the traditional direct lending funds and the market place lenders. Many bell-weather institutional investors, such as Railpen in the UK, are already doing so. In the UK in particular the regulators and the government itself are firm supporters of the model.
I think we will therefore see an investor surge into the market place lenders this year as direct lending 2.0 takes shape. Growth is sustainable ultimately if it is spurred by evolution, not by revolutions. Financial innovation cannot alter or disregard the fundamentals of credit and of markets.
If we evolve by finding better ways to apply these principles to new participants who previously we couldn’t reach with finance, then we may even help the stagnant economies of the West to return to growth.