Should your business consider private debt funding?

Private debt funding is an important source of finance for smaller businesses in the UK.

A recent report by the British Business Bank, UK Private Debt Research Report 2020Link opens in a new window, revealed that, since the 2008 economic crisis, private debt has become a valuable source of finance for smaller businesses across the UK – with a combined total of £18.4bn of lending in 2018 (£9.0bn) and 2019 (£9.4bn).

Catherine Lewis La Torre, chief executive officer of the British Business Bank, explains:

“In a relatively short period of time, private debt has established a position as a viable type of funding for the UK’s smaller businesses at different stages of development. As the focus shifts from stabilisation to economic recovery, supporting business growth will be a fundamental driver of a thriving post-Covid-19 UK economy. Ensuring that businesses can access the funding best suited to their needs will be vitally important in the coming years and private debt has an important role to play.”

This article briefly examines why private debt is of use to small and medium-sized enterprises (SMEs), using information contained in the report.

What is private debt funding? +

Private debt refers to lending which is:

  • provided by a lender other than a bank
  • tailored to the borrower's specific needs

While high-street banks have some appetite for riskier corporate lending, most of their lending tends to be through more standardised products focused on lower risk.

As a result, private debt is often the only, or most viable, funding solution for SMEs and mid-cap firms who require flexibility in how their financing is structured.

How might it benefit my business? +

When a high-street bank lends to a smaller company, it typically does so through its business banking division, with the structure of the finance, and the way it's underwritten, designed to service a standardised product.

However, sometimes a borrower's needs are more complex, which is when more flexible and bespoke funding structures act as a valuable alternative. Private debt providers, who are regulated by the Financial Conduct Authority (FCA), specialise in offering such solutions.

Debt over equity

Although a business may choose to sell equity as a way of financing its growth, many established and profitable companies will only consider taking on debt. This is often because equity finance involves giving up some level of control over the business. Even in the current economic conditions, where recapitalisation (restructuring the mixture of debt and equity) can be crucial, this strong aversion to equity appears to persist across the UK.

Standard high-street bank lending products may not be suitable for some companies, as banks will attribute a higher risk rating to firms looking to implement step-change growth plans and alter their current business operations. This moves such borrowers out of standard bank lending appetite (either completely, or in terms of how much lending a bank would be willing to extend).

Consequently, private debt provides UK SMEs that are seeking to expand and scale up their business a wider, more competitive, choice of debt funding to finance their growth. This then can unlock the potential of many smaller and mid-sized firms seeking a more ambitious growth and development trajectory.

Flexibility

The flexibility of private debt is particularly relevant given the current market. Some private debt providers have strong restructuring skills that allow them to provide operational support in challenging economic environments. Private debt is also well suited to supporting firms in their recovery efforts, and beyond, thanks to its bespoke and adaptable structures.

With many small and mid-sized companies in the UK having taken out emergency loans to survive the immediate impact of COVID-19 on their finances and trading, “debt overhang” (a debt burden so large that it stops the business taking on more) is a key challenge and risk, requiring careful planning and consideration as the economy recovers.

Companies funded by private debt are better able to withstand a contracting economy and take advantage of opportunities for expansion, due to the flexible approach that lenders can take in supporting portfolio firms.

Deals are generally structured with a large proportion of “bullet repayments” (when the finance is paid back in one lump sum at the end, rather than in instalments). This gives SMEs access to the capital they need to invest in growth, rather than having to meet immediate obligations to repay debt.

As such, flexibility in repayment structures could help viable firms coming out of COVID-19, especially those that have already taken on debt through a COVID-19 emergency loan in the past few months.

Refinancing

Private debt may also be able to refinance some companies that are currently funded through bank lending and have a strong opportunity to grow.

While this may cost the borrower more, it would enable them to replace a COVID-19 emergency loan with a structured lending product whose repayment terms are more flexible. As a result, the borrower can focus on the recovery of their business before they think about repaying the loan.

Furthermore, when COVID-19 response schemes are no longer available and the high-street banks are once again lending on their own terms and doing their own underwriting, bank lending activity could fall below levels seen before COVID-19, despite a continuing demand for finance. This is because banks tend to tighten their lending during periods of economic uncertainty, potentially causing an acute funding shortfall for smaller companies. Private debt could have a crucial role to play in picking up the slack, supporting the recovery and growth of UK businesses.

Evidence suggests that in the wake of the global financial crisis, a greater prevalence of alternative lenders in the US compared to the UK, where alternative finance markets were then much less developed, contributed to a quicker national economic recovery.

Case study – Dovetail Technology +

Dovetail Technology is a Nottinghamshire-based computer hardware company that creates a series of laptop monitors to help improve the productivity of staff working remotely.

The idea for the company was borne out of the frustration of not being able to use two screens with a laptop when working away from the office. Since it rolled out its first monitor in 2015, the company has gone on to launch two new models.

It received a £250,000 investment from First Enterprise – Enterprise Loans through the Midlands Engine Investment Fund (MEIF)Link opens in a new window and the Community Investment Enterprise Facility (CEIF)Link opens in a new window.

The funding comes at a time when more businesses' workforces are having to resort to home-working. Dovetail Technology's monitors are seen as game-changing products for remote workers who need the benefit of more than one monitor when working.

The company will use the funding to grow its operations and fulfil orders across the UK and North America before expanding sales across Europe, Asia, Australia and South America.

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