Business loans gap spells investment opportunity
Small and medium-sized businesses need capital but consistently fall through the cracks, often ignored by big banks. In Australia alone, there’s a more than $200 billion shortfall in the capital requirements of SMEs – a problem that’s only going to worsen in the current environment of rising cash rates.
“We expect the funding gap to continue expanding as well as the demand for non-bank lenders in the Australian SME debt space,” says Aura Group portfolio manager Brett Craig.
As the need for high-quality non-bank loans is magnified further, Aura Group is preparing to launch a new retail-focused fund. This is based on the wholesale-oriented Aura High Yield SME Fund which has a track record of delivering stable monthly income returns since launching in 2017.
Increasing credit spreads – the growing difference between the cost of buying and selling credit assets – is a key aspect of this, as Craig explains. In the following interview, he also:
- details some of the risks in the space and how Aura’s approach attempts to mitigate these
- explains why his team has chosen to launch the new fund now
In 2017, Australia was the largest alternative finance market in APAC (excluding China). Where is the market positioned now and what is the outlook for the next six months?
There is a growing trend in the SME lending space, with debt financing moving away from the banks and towards non-bank lenders.
Banks continue to operate utilising legacy systems with drawn-out application processes. These processes favour lending to large corporates rather than SMEs looking for loans under $2 million and a timely, tech-driven application process.
The regulatory capital requirements on SME loans remain unfavourable for banks unless they can take specific security over property, which often does not suit SME borrowers. SME debt financing continues to trend in favour of non-bank lenders.
According to the Scottish Pacific Business Finance November 2020 SME Growth Index, 27.4% of SMEs will choose a non-bank to fund their next six months of growth, as opposed to 17.4% of SMEs choosing a main bank.
Looking forward, we expect this funding gap to continue expanding as well as the demand for non-bank lenders in the Australian SME debt space. In the Judo SME Banking Insights Report for 2021, Judo Bank acknowledged the widening gap present in SME lending needs. Businesses with a turnover of $1-$20 million rose to $94.4 billion in 2020 up $4.6 billion from 2019. Those with turnover from $20-$50 million revealed a $119.2 billion lending gap.
What makes the private credit – SME space valuable now in a rising inflation environment?
The Aura High Yield SME Fund’s absolute returns should benefit from the rising level of inflation as the RBA lifts the cash rate further in an effort to curb inflationary pressures. Assets are either priced as a floating margin above either the RBA Cash Rate (BBSW), or a fixed rate on relatively short duration exposures, enabling capital redeployment at a higher interest rate as the principle is returned to the Fund.
In addition, the Fund’s assets are not marked to market. Therefore, assets are held at par value, unless a loan is impaired, resulting in a stable $1 Net Asset Value on a post distribution basis. As at 31 May 2022, the Fund has retained a stable $1 Net Asset Value at every monthly pricing window since its August 2017 inception. Comparatively, many public and over-the-counter assets which are marked to market have seen considerable mark downs in valuations, as investors build higher inflation and interest rate assumptions into their valuation modelling.
What opportunities do you see in the current market environment?
Given the recent levels of volatility displayed in public markets and increasing forward guidance around the factors driving the sell down, we broadly expect to see a pull back on allocation to risk assets.
This could present an opportunity for the Fund as credit spreads expand and allow the Fund to negotiate a greater credit spread over the RBA Cash Rate or BBSW on its investments. This phenomenon is already occurring in the investment-grade corporate bond market, as measured by the iTraxx Australia Index. The iTraxx Australia Index is comprised of 25 liquid Australian entities with investment-grade credit ratings that trade in the CDS (credit default swap) market or have significant domestic bond issuance. The Index is broadly used to track interest rate spreads above 1m BBSW for investment-grade corporate bonds. As at early June 2022, the Index is sitting in the 120s range, up from its pandemic low in the 50s range late last year.
What are the risks and challenges for investors in the private credit – SME space?
The higher inflation and interest rate environment presents an increase to SMEs expenses. While some SMEs are able to pass most of this increase in their expense line onto their customers, businesses which are not able to do so in full will be forced to absorb the cost. This presents a default risk, where SMEs may become more likely to default on their loan repayments.
The key challenge for investors will be to thoroughly understand the nature of SME borrowers’ businesses and the factors which drive their revenue and expenses. The Aura Private Credit team looks to partner with lenders who back growing SMEs with an expanding ability to service debt repayment obligations.
What criteria do you consider essential in identifying companies in this space?
The Aura Private Credit team looks to partner with leading Australian non-bank lenders. The Aura Private Credit team’s due diligence is dual focused on both the business characteristics of the lending business as well as their credit and underwriting standards.
With respect to business characteristics, we look to ensure the lenders we work with are well capitalised with strong, experienced leadership teams and sound governance, reporting and IT infrastructure.
Our assessment of lenders credit and underwriting standards is extensive, delving into risk management frameworks, historic portfolio performance, procurement processes, servicing models, loan portfolio management and systems, lending authorities, oversight, arrears management, and reporting. It is not uncommon for the Aura Private Credit team to request alterations to lenders' credit and underwriting processes.
You are launching a new fund investing in SME loans for retail investors. Can you discuss the drivers for launching this fund?
The key driver for launching the retail fund, which has a lower risk and return target than the original wholesale fund (Aura High Yield SME Fund), is that it enables us to continue the funding relationship with lenders as they prove themselves and rightly demand a lower cost of capital.
With most deals we enter into in the wholesale fund, we build in a right of first refusal on any new debt raised by the lending business. This provides the retail fund exclusive access to deals with lenders and management personnel that the investment team has already completed extensive due diligence on and maintained a funding relationship with for some years. We see this as a key strength of the new retail fund over competing funds.
What type of investors is this strategy for and how can they use it in a portfolio?
The strategy is most suited to investors seeking a product with regular, stable income, uncorrelated to public markets and a proven history of capital stability, with an investment team experienced in managing the strategy throughout turbulent macroeconomic backdrops. We have seen advisers use the strategy as a core component of their allocation to fixed income.
Strong risk-adjusted returns
The Aura High Yield SME Fund has a track record of delivering stable monthly income returns via exposure to a diversified portfolio of loans to small to medium businesses.
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