Direct lending – A profitable way of supporting the SME community

Since traditional SME financing ground to a halt in the wake of the financial crisis, direct lending has become a popular way for smaller firms to ensure they have enough funding in place to realise their growth potential. By carrying out thorough due diligence and taking a long-term focus, direct lenders can ensure regular repayments and high returns while allowing SMEs to continue providing vital support to the UK economy.

Vital sector

According to the Office for National Statistics, SMEs (small and medium-sized enterprises) currently make up 99pc of the UK’s 5.5m companies and employ 60pc of all its private sector employees. Despite driving Britain’s growth and productivity, SMEs struggle to engage traditional lenders like banks because of their historically high default rates and their inability to provide the necessary assets demanded as security.

Over the last decade this has created a significant opportunity for direct lenders, with new option like crowd-funding, peer-to-peer lending and challenger banking changing the face of this traditional market. To ensure their success, such lenders have had to be willing to establish long-term, growth-focused relationships with borrowers and go the extra mile to ensure firms meet the right profile for repayment.

To meet this objective it is crucial that the direct lender understands exactly how its money will be used. This cane be challenging, as SMEs often have very different funding requirements to more established businesses. Indeed, small enterprises can require funds for anything from project financing to working capital and equipment costs. By being thorough in understanding their clients’ needs, this helps direct lenders ensure they lend to those SMEs with the greatest chance of success.

Win-win

There are numerous, clear advantages of direct lending for both parties involved. For SMEs they receives critical funding, to fund their growth without having to surrender any equity ownership. Unlike venture capitalists, which receive a stake in a business in exchange for making an equity investment, a direct lender does not typically take equity. Instead they make their returns on repayment of the loans plus interest.

Another advantage of specialist lenders is that they are able to provide loans more quickly than traditional, red-tape-heavy banks. Often, they can also offer preferable terms, greater customisation, and superior flexibility.

At the other end, by effectively managing risk areas like liquidity and duration, direct lenders can enjoy interest rates that far outperform returns in the fixed income space and many sectors of the equity market. What’s more, direct lenders also get the added satisfaction of seeing the direct impact their money has in helping companies grow, something that even equity investors can often miss.

Stepping forward

With annual growth rates of 100pc, the direct lending sector is now firmly in the mainstream. As it continues to expand, regulation is ensuring that solutions are becoming more secure and more flexible for both lenders and debtors alike.

For example, regulations recently brought in by the UK’s Competition and Markets Authority aim to increase competition in the SME lending sector by forcing banks to share their data on customers’ financials. Direct lenders will now be able to compare their own data sets with those held by banks to evaluate whether a business is creditworthy. This will also help monitoring ongoing affordability of repayments throughout the life of loans, better managing risk.

Changes like this, combined with increased use of technology, ensure that direct lenders will be able to make speedier, more reliable credit decisions going forward, benefitting both SMEs and the UK economy in the process.