‘The evolution of the UK small and medium-sized enterprise (SME) direct lending market’ published in March 2018 examined the role of technology in promoting a revolution with respect to the provision of credit to the UK SME market. This short paper provides a practical example of how technology can be applied to a multi-faceted investment process designed to standardise, digitise and thus automate direct lending to small and medium enterprises.
SMEs are a vital component of the UK economy representing over 60% of private-sector employees and are recognised as a critical component of both innovation and economic growth. The essential problem for lenders is that the universe of UK SMEs is large (comprised of some 5.7 million companies), yet the credit approval process is the same for a GBP 500 000 loan as for a GBP 50 million loan.
Exhibit 1: UK SMEs account for a significant share of employment & turnover (% of the total)
Source: UK Department for Business, Energy & Industrial Strategy – Statistical Release (November 2017), BNP Paribas Asset Management, as of 15/06/2018
As a consequence, to construct a diversified portfolio of loans at the smaller end of the market requires resources that make the provision of credit to these entities economically difficult. As a result, most direct lending in the UK focuses on medium-sized enterprises where banks can generate the revenues that enable them to operate efficiently and where asset managers can construct portfolios of relatively few loans, allowing for faster draw-down of capital commitments. To operate efficiently at the smaller end of the market, the investment process is therefore required to be standardised and automated.
UK SME lending – paradigm shift due to technology
Exhibit 2: Traditional bank models continue to serve medium-sized enterprises with fintech offering micro-solutions
Source: BNP Paribas Asset Management, as of 15/06/2018
Originating and structuring UK SME loans
Small enterprises are defined as those with annual turnover less than STG 50 million per annum and less than 250 employees. To access this segment of the market requires scale, resources and coverage across the country. To achieve this, BNP Paribas Asset Management has taken a 10% equity stake in CAPLE, an SME credit specialist. With a network of more than 70 accountancy firms as business partners, its proprietary web-based credit approval interface is able to provide BNP Paribas Asset Management’s Advanced SME Solutions team with a standardised and digitised application process with the national coverage required to permeate across UK SMEs.
Eligibility criteria are supplied to CAPLE ensuring that loan applications meet strict financial and ESG criteria before they are sent to the Advanced SME Solutions team for the second phase of the credit approval process. Even with a standardised application process, the sheer volume of associated financial and company data needed to support formal credit approval requires further technological investment.
BNP Paribas Asset Management has worked with big data specialists to build a web-based quantitative credit approval model that is able to assimilate and visualise the breadth of data required to support individual loan approvals. Data is acquired via CAPLE’s application process, but supplemented with financial data from Companies’ House and, where applicable, commercial banks.
The application of big data technology allows for the processing of key financial metrics, ESG (Environmental Social and Governance) criteria and company data providing the Advanced SME Solutions team with a pool of pre-screened loans for qualitative assessment prior to formal loan documentation being sent to the borrower for signature. Here again, the process can be digitised using providers to simplify and speed up the signature process using secure and digitised formats.
Each loan agreement will typically incorporate three covenants which are required to be monitored on an ongoing basis:
- Net debt to EBITDA ratio
- EBITDA to interest cover ratio
- Cash flow available for debt service (CFADS).
While reliant on technology for the collection of the above financial and company data, ultimately, the credit approval process relies upon oversight from the Advanced SME Solutions team. Nevertheless, investing in technology across the origination and documentation process allows the team to process larger volumes of credit applications, making the issuance of loans from GBP 500 000 to GBP 5 million an economically viable activity. Similar distribution agreements may be possible with fintech and challenger bank companies operating in the SME debt market where the BNP Paribas Asset Management offering is potentially complementary to their existing offerings.
Portfolio contstruction, monitoring and reporting
The Advanced SME Solutions team has developed an Irish special purpose vehicle where loans will be warehoused prior to distribution to institutional investors. The team is responsible for booking, visualising and monitoring the portfolio of loans. Link Asset Services, a technology enabled financial infrastructure provider, and BNP Paribas Securities Services are responsible for the loan servicing and administration of the portfolio, with this data also integrated into the system used by the team.
As a result, the Advanced SME Solutions team are able to monitor the re-payment streams of the individual loans and ensure that borrowers remain compliant with the covenants embedded in the transaction.
The proprietary system that has been developed allows the Advanced SME Solutions team to monitor for events of default. These may include failure to meet the undertakings of the loan document (such as change of ownership or business activities), failure to deliver financial data, non-payment, breach of covenant, insolvency or cross- default.
Collating financial and company information on an ongoing basis for the duration of the loan allows reporting to institutional investors on the tangible impact of investment. Financial and company metrics may include:
- Number and value of loans disbursed
- Target beneficiaries by sector/industry and region
- Annual turnover
- Capital expenditure
- Full-time employees/part-time employees
- Jobs created
- Sales/units sold/revenue growth
- Gross margin
- Social and environmental targets
Factoring in ESG
Additionally, ESG is considered to be an important component of the credit risk process that can help improve the knowledge of a company in terms of reputational, operational and financial risks. The Advanced SME Solutions team has worked closely with the BNP Paribas Asset Management Sustainability Centre to ensure that borrowers who obtain loans granted by the platform are assessed to evaluate their ESG practices.
The use of technology and its application to direct lending has created a unique investment proposition for investors seeking cash-flow driven assets to meet with their financial commitments. An open architecture approach to origination, distribution and systems has digitised and automated the credit process offering information transparency, efficiency and scalability to borrowers and lenders alike. In turn, the use of technology has enabled a form of impact investing that is both measurable and additive to other forms of direct lending for institutional investors.