While much has been made about the lucrative opportunities for private lenders in the U.S. small business market, a potentially even larger market opportunity for alternative lenders exists across the pond. Born out of the financial crisis and compounded by Brexit, the UK is filled with small- and medium-sized businesses in need of capital. But with traditional lenders like banks choosing to remain on the sidelines, the need for private lenders to step up to fill the void is growing.
After the Great Recession, large banks — in response to financial regulations and government pressure — clamped down and recapitalized across the board, drastically reducing the amount of risk they held on their balance sheets. In the U.S., Dodd-Frank forced banks to increase reserve requirements, limit speculative trading and pass periodic stress tests. This landmark legislation, passed in 2010, kept U.S. banks from venturing into the UK, whose banks were facing similar restrictions. In Europe, the implementation of Basel III in 2015 required banks to fund themselves with 4.5% of common equity, up from 2% as dictated by Basel II.
These restrictions resulted in a credit crunch as banks were forced to be more particular about who they lent to. Banks dropped non-rated loans and stopped lending to newly originated borrowers who did not have rated debt — which made banks gravitate to lending to larger businesses. With rates at historic lows and costs on par with large transactions, providing capital to small businesses was not an enticing business to be in. But this reluctance from traditional banks didn’t curb demand for capital, and new players began to fill the void.
Borrowers Fearful of Rejection
Small businesses in the UK are an integral part of the overall economy, as they are in the U.S. Of course, it’s much harder for these businesses to contribute to the economy if they don’t have access to the necessary financing.
Recent figures show lack of access to capital is a recurring issue. Not only was bank lending to small business flat in 2017, but, perhaps more telling, borrower sentiment in the UK is diminishing. Out of the UK’s 5.7 million small businesses, only 1.7% applied for a loan last year, the fifth consecutive year of decline since 2012, according to the 2018 Small Business Finance Markets Report produced by the British Business Bank (BBB). Many small business owners simply aren’t sure if they will be approved; only 43% are confident they will get a loan when they apply, down from 58% earlier in 2017.
This dearth of available capital for small businesses was exacerbated by Brexit. The UK’s decision to leave the EU created additional uncertainty for the country’s lending market and resulted in the migration of banking jobs away from London. Experts expect anywhere from 4,500 to 10,500 banking jobs to relocate to European financial hubs such as Frankfurt or Dublin in the coming years. The majority of the exodus is coming from international banking organizations, but domestic mainstays such as Lloyds and HSBC are not rushing to fill the lending gap. The problem is two-fold. Banks are wary of increasing their credit exposure given they do not know if and how the new post-Brexit banking regulations will affect them. They are also uncertain how local companies will fare following the transition. The impending departures will leave an even greater hole in the lending market.
Expanding the Search for Capital to New Players
Just because small businesses are no longer solely relying on banks for capital, it doesn’t mean they aren’t borrowing. The small business lending market saw double digit increases for many products, despite bank lending remaining flat. External equity financing saw the biggest jump at 79%, followed by peer-to-peer business lending at 51% and asset financing up 12%, the BBB report stated.
Bank lending remains the single largest form of external financing for smaller businesses and has grown on an annual basis — albeit at a declining level. Net bank lending stood at £0.7 billion ($995 million) in 2017, well down from the £3 billion ($4.07 billion) in 2016. And following 12 consecutive quarters of positive net lending, Q4/17 was slightly negative. With the traditional lenders opting to sit out, alternative lenders have a growing opportunity to capitalize.
Several new players have emerged to provide capital to small businesses, including “challenger banks” as well as alternative lenders. Challenger banks are small, private equity-backed banks which offer many of the same services and products provided by traditional banks, but with a greater focus on small businesses. These types of lenders have appeared in droves, as more than 50 institutions have been granted a banking license since 2008, according to the BBB.
European-based alternative lenders also have stepped up to fill the funding gap. UK-based LDF Group, which was recently acquired by White Oak Global Advisors, on behalf of its institutional investors, leveraged its more than 30 years of industry experience to complete more than £500 million ($678 million) of financing to small businesses across the UK in 2017 alone. The advantage of both alternative lenders such as LDF and challenger banks is they offer superior speed and flexibility in loan decisions when compared to traditional banks. Thanks to technology and sophisticated pricing and risk algorithms, these platforms can approve loans in days compared to weeks for traditional banks. They also can offer customized lending solutions, a popular option among small business borrowers which might not neatly fit into a specific box.
Despite these advantages, alternative lenders still need to fight to earn credibility in the marketplace. Small businesses are inclined to borrow from the sources of capital they are familiar with and trust, but if those are no longer an option, they will be forced to look elsewhere. At the same time, brand loyalty is a dying concept, especially in the lending space. Borrowers are increasingly willing to take capital from institutions which provide the most efficient products. As long as private lenders provide a reliable and professional service, they should continue to pick up market share.
The Growing European Market
The European financial markets have historically lagged behind the U.S., and following the financial crisis, this trend appears to be holding. The U.S. is beginning to deploy monetary tightening as GDP growth returns to pre-crisis levels, while the UK remains in a low-interest rate environment. But European Central Bank President Mario Draghi has signaled the EU could soon tighten the purse strings and begin raising rates, anticipating a surge in UK small business activity and private debt funding.
The evolution of the U.S. lending market following the financial crisis offers a useful model to estimate the size of the market opportunity in the UK and in Europe. The number of U.S. commercial banks dropped by nearly 2,300 in the last decade, resulting in a push toward private debt. Subsequently, this past year U.S. private debt funds raised a record $100 billion as investors searched for greater yield in the low-rate environment.
While U.S. banks may come back into the fray as rates increase and regulation loosens, the UK still has some ways to go in its recovery. This low interest rate, highly regulated environment should continue to provide ample opportunity for alternative lenders for the foreseeable future in what is already a strong small business market. SMEs account for 99% of the business in every main industry sector in the UK, according to the BBB, and, as previously stated, fewer than half (43%) of those businesses are even willing to apply for a bank loan. Once again paralleling the U.S., only 25.5% of big banks are currently accepting small business application loans, and fewer than half of small banks are taking them, according to the Biz2Credit Small Business Lending Index.
The ongoing Brexit negotiations provide an added benefit for European alternative lenders looking to enter the space, particularly in cross-border financing. The uncertainty over whether the UK will stay in the open market — or to what extent — suggests banks will be especially cautious dealing with companies which are dependent on trade. Alternative lenders, given their flexibility, are well-equipped to go after this market.
Countless alternative and private lenders have successfully ingrained themselves as a part of the small business lending market in the U.S. It’s only a matter of time before the same happens in the UK. The same factors which heavily contributed to the lucrative environment in the U.S. over the past five years — tight regulation, low rates and improved technology — are now taking shape in the UK. Additionally, unlike the U.S., the UK is also nearing an inflection point in Brexit which should create greater uncertainty and further enhance the market opportunity for private lenders.