THE LATEST Project Merlin figures from the Bank of England show that the lenders have made available £158bn of new lending, or 83% of their lending target. However, most small and medium-size enterprises seem unable to attract funding on acceptable terms. So is the root cause an unwillingness to lend or the lack of investable business plans?
My contention is that actually the whole issue of SME funding is more structural, and we will not solve the problem by the target-oriented approach set out in Merlin.
Banks run a pretty simple business model. They borrow money from depositors which they need to loan out. For this they charge a modest return. Portfolio theory suggests that risk and return should be positively correlated, so it seems fair that this return should attract a low or modest risk profile.
Above all, banks need to ensure they get their money back. So it follows that they are quite fussy about who they give the money to and what it will be used for. For this reason the bank’s credit committee is detached from the customer and will look dispassionately at the application. Typically they will look at the management team, whether the lending falls into no-go segments (eg pubs, and commercial property are not in favour at the moment), and the strength and risks in the business plan. If all of these factors tick the boxes, then the bank will also look at what security is on offer. Unless the loan is for physical assets which the bank can use as security, they will normally look to take personal guarantees from the entrepreneurs. At this stage, most entrepreneurs find the idea of personal guarantees deeply unpalatable, and the conversation ends there.
In fairness to the banks, they typically look for a return of a few percentage points above the base rate and also take an arrangement fee. All told, their return at the moment would probably cap out at 5 per cent. At this level of return, they just can’t risk losing their capital.
Outside debt finance, venture capital is the other avenue open to an SME. This is normally used in scenarios where the capital invested is more at risk. It is a very different animal from bank finance. For a start, the return expected can be quite eye watering (an IRR 30% would not be unusual). For this reason, a venture capitalist will only be interested in very high growth businesses which can generate this level of return. They will need the company to sign an investment agreement which puts controls in place, and will give the VC complete control if things go badly. Also, the investment itself is an expensive process with typical investment fees in excess of £80K for lawyers and due diligence. In order to be worth doing, this effectively limits venture capital to quite large sums.
Is there a third way?
Basically we have a situation where banks are able to offer lending under very restricted circumstances for a very modest return, and we have venture capitalists offering funding which is high risk for a much more aggressive return. My contention is that there needs to be a third way which offers funding to companies who find themselves in the middle. This kind of finance would work with business plans which offer strong returns, are too risky for banks and don’t meet the criteria for venture capital. We can look abroad for some of the answers. For example, I don’t think it any coincidence that Germany has a very strong SME segment (Mittelstand) and also one of the most supportive funding models for SMEs.
George Osborne recently announced that the government was looking at addressing this area with ‘credit easing’, although the details were sketchy. My view is that this would be a fantastic way of getting the economy back on its feet; however, it would need to be done in the right way.
If it were my decision, I would create a bank network (perhaps using some of the branches hived off from RBS or Lloyds) specifically focused on SMEs. These banks would have the ability to make marginally more risky investments than conventional banks, and would be able to countenance loans with security from the government if there was a lack of security in the company itself. In certain circumstances, the bank would also be able to take equity as well as debt. They would not interfere with the way the company was run in the same way as a venture capitalist might expect to, but would have certain power of veto (ie to prevent owners drawing excessively until the loan is repaid etc).
These SME banks could expect much higher return on invested capital than a conventional bank. I would also go further and offer some tax breaks to the SMEs who were chosen for these investments (for example, lowering their rate of employer’s National Insurance), hence helping to ensure all the money goes to making the business plan a success, not immediately back to the exchequer. In return, the SMEs would be required to spend the funding on UK-based projects, and/or create employment of UK workers.
I am not particularly confident that any of the ‘credit easing’ measures will go this far, but until we address some of the structural issues, we will be starving good business plans of the investment they need to the detriment of the British economy.
Patrick Murray, principal, The FD Centre