How Epsilon is taking advantage of opportunities the banks can't reach

A common narrative in the world of private credit is that major banks are retreating from business lending as it is more complex for them to provide loans to corporations as opposed to homeowners.

However, Joe Millward, Founder of Epsilon Direct Lending, challenges this view, pointing out that the major banks are not retreating but rather expanding their corporate loan books. In fact, both Commonwealth Bank of Australia and National Australia Bank have reported significant growth in their corporate loan portfolios over the past year.

While banks' loan books are growing, they still face challenges in certain areas, primarily due to regulatory constraints and the increasing need for more bespoke, flexible solutions. This is where private lenders like Epsilon Direct Lending come in.

Epsilon specialises in providing loans to medium-sized businesses, particularly those looking to grow through acquisitions. With a focus on faster, more efficient decision-making and personalised service, Epsilon is positioned to seize opportunities where traditional banks struggle to compete.

In this episode of The Pitch, Millward offers insights into the dynamics of corporate lending, the challenges faced by banks, and how private lenders are managing risk and identifying valuable opportunities.

Edited transcript:

Joe, a lot has been made of the banks retreating from corporate lending, but you've got a different take. Can you share the facts with us?

Sure - it's not just me that has a different take, it's the publicly announced results that the major banks publish that have a different take, so it's interesting that the narrative suits a number of private credit funds.

We believe that the banks are retreating because that creates a natural opportunity for them to suggest that they're playing where they used to play, but the data doesn't support that, the facts don't support that.

I've actually brought some data points with me and anyone can look these up, they're freely available. Just going off the most recent results from CBA and NAB, CBA's corporate loan book, which is the area of the world is where most private credit funds are playing, that's grown 10% in the last year. It's gone from $160 odd billion to over $170 billion in one year alone.

NAB, similar kind of numbers, $197 billion up to $217 billion, corporate loan exposure. The banks are not retreating.

While they aren't retreating, they do have limitations when it comes to private lending, is that right?

I wouldn't call them limitations, I call them shortcomings and restrictions that are placed by regulators. They're two very different things. So the regulators, mainly APRA, set the amount of risk that banks can take and the amount of capital they have to set aside in order to take that risk. 

That means that it's very expensive from a return on equity perspective for banks to pursue certain segments of the market; normally the riskier segments.

Then there are what the shareholders of the banks and the board of the banks are seeking to achieve, which are improved returns on capital, return on equity and return on shareholder funds.

So if you're a CEO of a major bank, you're going to be focused on cost to serve customers, automation of decision-making, simplification of the products that you offer the market. Banks are more inclined to offer homogenised products and less customised products, they're less efficient at delivering highly customised products and riskier products to the market.

What opportunities is this creating for Epsilon Direct Lending within private lending?

We focus on providing loans to medium-sized companies for the purpose of growth. The banks want to support this segment, they want to fund medium-sized companies in supporting their growth. 

Typically, these companies are growing through acquisitions, and acquisitions are quite complex to structure for, to lend for, so that creates an opportunity for a non-bank lender like Epsilon to participate in that market.

The banks aren't as efficient, as I mentioned, in providing capital to less homogenised assets. Assets like mortgages are easy, because they're standardised terms and conditions. Acquisitions are different every single time, and so we compete based on a service, a value proposition, a service proposition to borrowers.

If they want efficiency of decision-making, they want speed, certainty in the provision of capital and they want a direct relationship with the decision-makers, that's what we offer that we don't think the banks are as good at offering.

How do you manage risks within your portfolio given the unique nature of each borrower?

The purpose of the loans is to support growth, so that's a positive purpose. We're not refinancing an existing loan, we're taking a view on the company's sustainable, predictable earnings after the acquisition has taken place, and we're really unpacking all the risks that might impact the sustainability and predictability of the cash flows that the company generates, and that is what underwrites our loan. It's the future cash flows that we believe the company can generate.

We typically partner with private equity firms who will be contributing a significant amount of equity capital, first-loss capital, in seeking to acquire the company alongside us when we provide a senior secured loan. 

We ensure that those loans, when we structure them, when we execute the loans after we've originated it, those loans have really strong buffers,  equity contributions, servicing levels, interest cover ratios, debt service cover ratios, and so on, are in place.

Then on an ongoing basis, we ensure that we have great access to the company after we've performed substantial due diligence in providing the loan. So we get monthly P&Ls, cash flows and balance sheets from all of our borrowers, we regularly speak with the management team, we regularly speak with the owners of the business to ensure things are on track, and then we seek to assist. 

In the most extreme scenarios, use our security positions, our documentary protections to protect our downside when things aren't going to plan.

Why are private equity deals a good indicator of quality in a portfolio?

Let's first define what we mean by private equity sponsor from our context. These are sponsors that are buying performing medium-sized companies, that's who we deal with. There are sponsors that deal with underperforming companies or larger companies, but that's not our segment. What they're doing is committing equity capital in order to buy a company. 

That's first-loss capital, and they're seeking to see that company grow through a combination of improvement in margins and earnings, and then potentially grow through acquiring more competitors and expanding into new products and geographies.

Because a private equity firm is putting in equity capital, first-loss capital, and we're providing a senior secured loan, they've got a lot more to lose than we do if things underperform. Typically, these private equity sponsors that we deal with, all instances in fact, have really strong investment track records, they're supported by institutional investors and they've got very well-established due diligence processes before they make an investment.

When we decide to lend to a company, we have access to all of that information, which helps our underwrite case, and then we overlay our own additional level of conservativeness in ensuring that the company can repay us ultimately. 

Contrast that with a non-private equity-owned firm, you might not have the same level of institutional capital, rigour around due diligence, professionalism, track record in repeatedly buying and growing companies to support you, and so therefore, we believe it's a good indicator of the strength of a company.

How do you find these deals?

We've worked with a lot of the established medium-sized private equity firms in Australia over 15-20 years through our careers together, the three founders of Epsilon, and we've all worked in Australia for quite some time, and so a lot of the private equity firms come to us, we get a lot of repeat business.

But outside of that, mergers and acquisitions, M&A lawyers, M&A advisors, there are some intermediaries that source debt financing for companies, they're all sources of deal introductions, origination for us. 

We also know a lot of businesses, because we've been around and we've lent to a lot of companies, and so you find that shareholders, CEOs, CFOs, they move around in the industry and they normally seek quality offerings from lenders and that's why they come to Epsilon.