One of the more enduring and regretful legacies of the collapse of Lehman Brothers and the global financial crisis is the decrease in lending to SMEs. In the 10 years since Lehman, the recovery of SME lending by banks has been, at best, anaemic. Mike Schozer, chief investment officer at Hadrian’s Wall Capital, believes banks are being over-cautious.
Some might argue that the drop in lending is understandable, as SMEs are considered a risky prospect.
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However, a study that we at Hadrian’s Wall Capital have just completed suggests that this view is an oversimplification, and is just not supported by the data.
The study actually shows that lending to SMEs can be less risky than other higheryielding investments such as high-yield corporate bonds, and provide better returns than lending to much bigger companies issuing corporate bonds.
Net losses on UK SME loans have actually averaged just 0.3% since 1990, which has been far outweighed by the 4.6% per annum after losses net yield on these loans compared to the net yield, after losses, of European high-yield bonds of 1.9% and 1.8% for US high-yield bonds.
That gap between SME yields and highyield corporate bonds is more than significant enough to be meaningful. Breaking the figures down in more detail, we can see that the default rate on SME lending is lower than on high-yield bonds, and where there is a default, the recovery rate on defaulted SME loans is much higher than on high-yield corporate bonds.
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By GlobalDataOne of the reasons that default rates on SME loans are so low is that the borrowed money is normally invested directly into the business – for example, for new machinery or other hard assets, additional staff or expanding into new markets.
When lending to SMEs with an established product in an established market with a good cash flow, these loans can increase output and strengthen a business in spite of weaker economic periods.
In contrast, high-yield bonds often fund corporate finance activity, such as acquisition by a private equity firm, mergers or management buy-outs. Frequently, these types of transaction add debt onto a corporate business’s balance sheet without substantially adding to the productive capacity of the business.
The recovery rate on the default of European and US high yield corporate debt has only been 51%. Because much of the lending to SMEs may be secured against real assets such as machinery, property or other assets that a lender can liquidate if the need arises, the recovery rate on lending to SMEs stands significantly higher at 80%.
In May, Bank of England research showed that net bond issuance in the UK hit £11bn – the highest amount on record – and this was largely driven by M&A activity. Meanwhile, data from the Bank of England shows lending from banks to SMEs is static, or even falling – and these businesses are rarely over-leveraged. All of this makes it clear over where we should be allocating lending from our fund.
