19 Jul 2018
In this article Mark Barnett highlights the investment opportunities he sees within the UK’s alternative finance market. He discusses:
Compelling investment opportunities often arise when companies identify, and are positioned to exploit, an un-met market need. One such opportunity currently exists in the UK credit market. Alternative lenders – a significant theme across my portfolios1 – are moving to service a gap in credit provision. Funding Circle, Honeycomb Investment Trust and Hadrian’s Wall Capital are establishing methods of allocating capital to small and medium size enterprises (SMEs), through new non-bank channels that have emerged since the crisis. These new finance models include peer-to-peer lending platforms and closed investment vehicles.
Selective exposure to alternative lenders, to my mind, has the potential to provide superior long-term income and capital growth relative to traditional lenders. This view is founded on the changes seen to the banking industry landscape since 2008 and the emergence of increasingly agile alternative finance models. Both factors are discussed in greater detail below.
In the aftermath of the Global Financial Crisis (GFC), increases to risk-weighted capital reserve requirements and increased regulatory scrutiny of the UK’s major banks led to a contraction in supply of credit. This left an opportunity in the sector to offer access to short-term loans and overdrafts to consumers and SMEs that were shunned by the traditional lenders. High street banks approved 94% of loan applications from SMEs they had deemed ‘high risk’ prior to 2008. In the years immediately after the crisis more than 22% of equivalent applications were declined.2
Against this backdrop highly cash generative and scalable alternative credit models have emerged. Alternative lenders have created lasting disruption, fundamentally changing the landscape for credit provision in the UK. Data available from the consumer credit market3 illustrates this phenomenon:
Figure 1: UK consumer credit provision
Source: Bank of England, Lazarus Research as at 31 May 2018. * Implied totals based on available data.
Figure 1 illustrates that overall supply of credit dipped in the years immediately after the crisis. Today total credit provision has recovered to pre-crisis highs, however the composition of lenders is notably different. Pre-2008 alternative lenders accounted for less than 20% of the market, now they supply more than a third. This trend has occurred despite a steady recovery in total bank lending over the past five years.
The market share gained by alternative lenders looks set to accelerate further. The value of peer-to-peer lending via platforms grew by more than 50% in the UK during 2017 – accounting for £1.78 billion of capital loans. The introduction of the Innovative Finance ISA is just one indication that alternative finance models are becoming increasingly mainstream. Industry data also suggests that awareness of alternative forms of finance is growing. The Small Business Bank’s 2017/18 annual survey reported that 45% of SME’s surveyed are aware of peer-to-peer platform financing, compared to just 24% in 2012.4
Alternative lenders typically operate leaner and more efficient business models than high-street banks. They benefit from more agile administration structures and lower cost bases – having minimal or no legacy systems and lower fixed costs. Post-GFC, traditional lenders have been forced through regulation to avoid risk, risk that alternative lenders have been able to embrace and make profitable. Via new technology they more accurately price credit risk and make better informed decisions around lending. These benefits enable alternative lenders to supply credit more rapidly and more efficiently than the market’s main providers. These factors facilitate superior cash generation.
Alternative lenders also operate within a less intensive regulatory framework. As they do not fund their activities with cash deposits, they are afforded less arduous regulatory scrutiny and have lower capital reserve requirements than banks. Company management therefore have greater discretion to return the excess cash generated to shareholders. To my mind, there is no convincing evidence to suggest that the regulatory framework that currently restricts banks will abate. Nor, that the regulator has the appetite to impose the same level of rigour on the industry’s alternative finance providers. The competitive advantage of alternative lenders is therefore likely to be sustained.
The UK market for alternative lending is well-supported. Exposure to selective businesses offers the opportunity to share in anticipated revenue growth, in an area of the financials sector that is less exposed to regulatory scrutiny. Given the evidence to support the industry’s long-term outlook, alternative lenders are an attractive area to seek selective company exposure.
1 Mark Barnett is the named portfolio manager for the Invesco Perpetual Income, High Income and UK Strategic Incomes Funds, the Edinburgh Investment Trust plc and Perpetual Income and Growth Investment Trust plc.
2 ‘Small Firms in the Credit Crisis: Evidence from the UK Survey of SME Finances’, Centre for Small and Medium-Sized Enterprises, 2010.
3 Consumer credit is defined as credit cards and personal loans, excludes mortgages.
4 Small Business Finance Markets 2017/18, Small Business Bank, 2018.
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