Why invest in direct lending?

Despite making up nearly half of the UK’s private sector employment and contributing £1.8trn to the British economy every year, SMEs often struggle to secure the working capital they need to reach their full growth potential. This situation has become more acute in the wake of the financial crisis. Over the last decade, direct lending from specialist providers has become an increasingly popular way for smaller companies to access vital funding. Such lending has filled the gap left by traditional lenders and, thanks to the growth in alternative investments, has become an increasingly attractive asset class for those looking to diversify their risk and generate higher returns.

So, what exactly are the benefits of investing in direct lending to small-to-medium sized businesses?

Outsized returns

In exchange for low levels of liquidity, direct lenders receive what is known as an ‘illiquidity premium’ that can considerably boost their yields. As such, direct lending can represent an ideal asset-class for those long-term investors who are looking to improve their returns during this era of low yield. Indeed, First Sentinel’s secured business loans to SMEs usually generate returns of up to 25pc for investors.

Protection from rising rates

Ever since the Federal Reserve hiked interest rates for the first time in nearly a decade in December 2015, central banks around the world have been positioning themselves to “normalize” monetary policy. With global Zero Interest Rate Policies coming to an end and central bank rhetoric becoming increasingly hawkish, the floating rate features of many direct lending loans can provide vital protection and insulation against rising rates and any associated volatility.

Diversification

If the financial crisis taught investors anything, it was the importance of ensuring true diversification within their portfolio, with equities, bonds, and many other types of investment all falling in tandem. Like cash, loans made by direct lenders are not correlated to changes in market sentiment or pricing, factors that have a large influence over the performance of many other so-called diversified asset classes. However, unlike cash, direct lending can also provide a generous level of income, something that is vital in the event of a bear market.

It is no coincidence that major asset management players like Blackrock, L&G, and Aviva, have all entered the direct lending space as a way of diversifying their wider investment portfolios.

Risk management

As direct lending has entered the mainstream, growing competition and stricter regulations have ensured that investors only get exposure to the highest quality loans on the market.

To mitigate default risk, specialist direct lenders like First Sentinel will carry out thorough due diligence and establish lasting commercial relationships to ensure it only lends to SMEs with the best chance of long-term success. First Sentinel ensures that its loans are secured and properly diversified by size and type across a wide portfolio of different companies, ensuring the best chance of success in any market environment.