An undiscovered yield opportunity

SME Alternative Finance (AltFi) lenders have been set up to target the underbanked markets within the Australian business landscape to provide financing solutions to Australian SMEs.

The underbanked market includes businesses which have passed on potential growth opportunities due to difficulty in receiving finance, although not necessarily due to poor credit, but potentially due to its lack of size, or where, from the business' perspective, there is a lack of human resources to complete the application process.

Some lenders in the AltFi SME sector use technology applications to collect data from borrowers and monitor the financial health of the business on an ongoing basis, whilst the loan is still live. This allows the lender to have an insight into the ability of the counterparty to repay the loan on an ongoing basis. A further extension to this is the ability to work with the borrower on their forward cash flow projections and tailor funding solutions to the business.

Lenders may use application programming interfaces (APIs) to plug into cloud-based accounting software and bank accounts to share data and reduce much of the friction in the application process, saving time for the borrower and making borrowing funds a less manual and much smoother process.

According to the Australian Banking Association Economic Report, September 2019; “Australian Banking Association data shows a 33 per cent decline in (SME) business loan approvals over the past five years, while approval rates remain around 94%” (4).

Given approval rates have remained relatively steady over the past five years, the 33 per cent decline in loan approvals can only be explained by a reduction in loan applications made by SMEs. This data in combination with ABS Counts of Australian Businesses data (5), which shows a 6.96 per cent increase in the number of Australian SMEs over the five-year period to June 30 2019, suggests the reduction in applications is not due to an off-setting decline in the number of SMEs. Rather, the data suggests SMEs are looking elsewhere for their funding requirements.

Lenders in the SME AltFi sector will predominately apply risk-based pricing to their product set. Risk-based pricing is simply pricing according to the risk of the lender, so a higher rate for a higher risk borrower, and a lower rate for a lower risk borrower. This pricing methodology is not used in the bank models, where rates are offered at each product type.

Loans made by SME AltFi lenders are typically structured in the manner outlined below:

Asset Backed

• Invoice Finance
  Originators in the invoice finance space will lend to an SME as either an advance on the value of an invoice where the invoice is used as collateral, or will purchase the invoices from the SME and run credit risk against the organisation the invoice is issued against.

• Secured Term Loans
  This segment is a bank like loan where the lender will require specific assets (most commonly property or business assets) as collateral against the funds being lent. The differentiating factors between a Fintech lender and a bank is generally the ease of application and a risk- based pricing benefit.

• Prime
  Loans in the prime unsecured market are loans that are made to high quality borrowers or those that are most credit worthy and are not secured by any assets. These loans have the lowest probability of default in the unsecured segment, thus the rates are generally the lowest in the unsecured space. The borrower will benefit from a clean credit record.

• Near Prime
  Near prime unsecured loans are a rung down from prime loans. The borrower may have had repayment issues in the past or a higher deemed risk due to a lack of credit history.

• Sub Prime
  Sub-prime unsecured loans are made to those borrowers who may have had difficulty maintaining a repayment schedule. These are the highest risk SMEs in the unsecured market segment and the risk is reflected in the highest rates charged in the market. 

The Australian SME AltFi market continues to grow in terms of volumes lent, as SMEs preference for non-banks to fund growth has now surpassed traditional banks. Whilst the banks focus on larger lends, Aura expects this sector to continue to grow. SMEs are actively utilising the greater choice in the funding landscape to support their growth, which is a positive for the wider Australian economy, and the 66% of the workforce that is employed by Australian SMEs.

While SMEs awareness and use of these lending products and lenders have significantly increased in recent years, the primary constraint for the industry is funding for the lenders.

Stay tuned

The intention of this piece was to set the scene and help you understand the Australian SME AltFi market. Over the coming days, Livewire Exclusive will feature a series of videos in which I discuss how investors can access the sector, Aura's strategy for providing funding to AltFi lenders and our approach to managing risk and generating return. 

Find out more about the Aura High Yield SME Fund here

Footnotes

1. Source: 8165.0 Counts of Australian Businesses, including Entries and Exits, June 2015 to June 2019
2. Source: 8155.0 - Australian Industry, 2018-19 – Table 5
3. Source: Financial System Inquiry, December 2014
4. Source: RBA Bank Lending to Business – New Credit Approvals by Size and by Purpose – D7.4, Aura Funds Management, September 2019
5. Source: RBA Bank Lending to Business – Total Credit Outstanding by Size and by Sector – D7.3, Aura Funds Management, September 2019

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