We’ve been discussing the increasing risk of a recession being triggered, as a result of continuing tightening of availability of debt funding from Banks to SMEs, for quite a while now (probably about a year or so); perhaps not publicly, but definitely on a weekly basis over coffees and by phone with many professionals in the finance, accounting and insolvency sectors. These concerns are now really coming out in the public sphere, so now might be the time to start making public comment.
We’re all now clearly seeing post-Royal Commission effects in the home lending space, which in turn is arguably the primary driver of the “unnormal cycle” rapid house value declines in Sydney and Melbourne (I say “unnormal” because we believe this is the first time in Australia’s history that house prices have declined materially in those locations in the absence of increasing unemployment and/or interest rates, so this is not a “normal” cyclical adjustment). The effect on SMEs though is not quite so obvious, as house value changes are much easier to measure accurately, or perhaps they’re just more news-worthy because everyone either owns or aspires to own a home, whereas only a small percentage of the population have a significant interest in the pain being felt by SMEs.
So the headline questions of interest I expect people have now, is exactly what we’ve been discussing with people for most of 2018, being:
1. What are we seeing on the ground?
2. Why is it happening?
3. What will the result be?
Matthew Cranston wrote a couple of notable articles earlier this week in the AFR (the main one being on page 1 – “Brakes put on small business”), which point to the headline issues. One particular subject (or person, if I want to pick fights!) are his multiple references to Kate Carnell, the Australian Small Business and Family Enterprise Ombudsman, which I think are particularly pertinent… To be brutally honest, I haven’t been Ms Carnell’s biggest fan – I think she has a bit of a case of wanting to have her cake and eat it too. More on that below…
What are We Seeing?
I’ll start with picking that fight about the cake. Back in 2016/17, the “Carnell Inquiry” was centred around a primary question – “Non-monetary default clauses offend basic principles of fairness. If a small business has done the right thing and made all payments to their bank on time and in full, why should the bank be allowed to default that borrower?”. Seems like a fair question, right? The problem is that this issue ended up being far too simple a question, which ended up in a typical case of making significant decisions without having sufficient insight or consideration into the ultimate consequences thereof.
One of the key outcomes of the Carnell Inquiry was the typical Australian regulatory response of over regulation. I have a bit of a bugbear about over regulation in this country – and it’s not because I want to be a cowboy financier – we do it with everything from the Police attitude of “speed kills” (no, our very poorly trained drivers kill – e.g. my partner Laura, who is from Finland, had to pay €2,000 and do advanced training including high-speed skid-pan manoeuvres to get her licence, here we just have to know how to parallel park and do a hill-start), to not being allowed to bring a dog to a café (in a country that has one of the highest pet ownership rates in the world, go figure). Sorry, going off on a tangent, back to a key outcome of the Carnell Inquiry…
So in the interest of protecting Aussie Battlers from the big bad banks – which, by the way, the Royal Commission found no material concerns with SME lending practices (official findings come out in a couple of weeks FYI) – a new rule kicks in officially on 1st July 2019 (but has already been adopted by most banks in advance), not allowing the banks to default a loan based upon Covenant breaches where a business has borrowed less than $3m (which covers a huge percentage of SMEs). Technically, banks will still be allowed to have covenants, they just won’t be able to act upon them (i.e. Bank: “You have to meet this covenant”, Borrower: “I don’t want to”, Bank: “Oh, um, gee, damn, ok.”).
Great, more protection for borrower, exactly what Ms Carnell was looking to achieve!
Oh, except for one little problem which it would appear they didn’t consider:
Banks don’t HAVE TO lend to people or businesses if they don’t want to.
What I’m really getting the shits (for lack of a better term!) with Ms Carnell about, is the rhetoric that’s now coming from her – “The big banks have about 80 per cent of the small business business in Australia, and the big four banks are not lending to small business unless they have significant equity in property… The banks will tell you there is plenty of money, but there is only plenty of money if you have bricks and mortar”. Now every single person that has worked in banking and finance won’t need me to explain this, because to them it’s simple common sense, but for everyone else I’ll spell this out:
There are two fundamental purposes for having Covenants:
- An early warning sign, a trigger for the banker to have a discussion with the borrower (and their professional financial advisors) to work out why the strength of the business is trending the wrong way. A well set covenant (and there are plenty of poorly set ones out there) has a reasonable buffer above the “oh shit point” – i.e. a breached covenant should hopefully not yet mean that it’s time for the Receivers to be sent in, rather it should be a point at which there is enough time to identify a problem and then have time to fix it.
- The bit that Ms Carnell wanted to “protect” businesses from – the right for banks to trigger a default and then take action, whether that be facility or securities restructures, through to appointing a Receiver & Liquidator. The reality is that in the vast majority of cases, banks don’t want to appoint Receivers, just ask any Insolvency Practitioner in the last few years – they’ve all be crying poor because the banks hate appointing them unless they really have to. They take drastic action when there’s just no other way out – when the value of their security is deteriorating so much that the bank’s likely losses are piling up to an unacceptable level with no realistically identifiable recovery in sight.
Now to tie this in with Ms Carnell’s comments about only lending where there’s bricks & mortar security – the instances where banks want covenants, are those where they’re not fully secured by bricks & mortar, i.e. they want covenants in place in order to be able to monitor the quality and value of their non-property security, and to be able to take action if their security position is becoming untenable.
So guess what? Take covenants away, and the natural response from banks is to say “well unless we’re fully secured, we just won’t take the risk of lending”. This isn’t speculation – I have had numerous bankers from numerous banks quietly acknowledge to me that their credit divisions are unofficially taking exactly that stance – i.e. every bank will continue the PR of “we haven’t changed policies, we’re still supporting Aussie businesses”, but the reality is that their true appetite, the decisions being made by credit managers, has significantly tightened (and likely to continue as we come to 1st July) for business lending under $3m that is not fully secured by bricks & mortar.
Summary – thanks to Ms Carnell protecting the Aussie Battlers, many more of them now can’t get money out of their banks. And as Matthew Cranston pointed out in his other article of the same day, declining house prices in Sydney & Melbourne (hopefully not elsewhere in the country) will only exacerbate that restriction of availability of business finance.
Alternative Lenders coming into the Market
Whilst I’m on my soapbox about Ms Carnell, now she’s strongly advocating for Superannuation Funds and Alternative Lenders – partially supported by this new $2b securitisation fund. Yes, the same person who played a major role in causing the banks to not want to lend to businesses without being fully secured, is now calling for others to come in and fill the gap that banks should be playing, which the government is supporting. Encouraging the growth of the less-regulated, almost “shadow banking” sector, over which APRA, the RBA, the Government, the ABS etc., will have very little visibility.
One of the big changes we’ve noticed as a result, is the growth of unsecured business lenders (often touting themselves as Fintechs, whether they genuinely are or not), who generally lend up to $300-500,000. Quite frankly, some of these are loan sharks with cute and friendly marketing. Their interest rates can be the stuff of proper toe-cutters – often they don’t quote an interest rate, they just quote something like “24 easy repayments of only $xxx”, knowing that most people (particularly their target market) wouldn’t have a clue how to calculate an interest rate from a set of repayments. We got a quote on one once for a client (which we did NOT accept!), which we worked out to about a 45% interest rate. That’s not a typo. I’ve been told of instances up to 70%. Seriously. The scarier story I’ve heard recently was that one insolvency firm (who will remain unnamed) is seeing nearly a third of companies that end up in their firm, having a loan outstanding to ONE particular lender. I’ve even been told a story about this particular lender’s real toe-cutting ways – a prospective borrower running the term sheet by their accountant, the accountant then calling the lender to tell them that there’s no way this company’s cash flow will be able to meet those repayments, to have the lender BDM respond with “I’ll pay you a 5% commission if you help me get it through”. Beyond the stuff of even the wildest cowboy lending.
Putting all of this together, I’m not an Economist and so I haven’t quantitatively modelled the hell out of this, but this all sounds to me like strategies and outcomes very contrarian to the long-term health of an economy.
What about larger businesses?
All of that covenant talk applies to businesses borrowing less than $3m. But what about the bigger end of town? Well, in our experience over the last year or so, it’s a mixed bag.
For the true corporate end – being companies borrowing over $20m or so – we haven’t really seen much change. Highly capable bankers, sophisticated borrowers, the regulators and business advocacy groups don’t consider anyone to be a poor Aussie battler getting beaten around by big bad banks, so they’ve been left to do their thing professionally. At this end of town, banks are used to being mostly unsecured, everyone knows that covenants are necessary, when breaches occur there will usually be professionals within the business and as advisors acknowledging and trying to fix the problem, or things are tanking and there’s no apparent saviour, so the banks won’t stuff around. Having said that, they won’t play hard-ball to the degree they would have 5 years ago – they are still hesitant to appoint Receivers unless they really have to.
In between $3m and $20m or so, we’re seeing a slowly evolving market.
Over $10m is still relatively ok.
We’re certainly seeing borrowers at that level needing professional help (from some firm such as, oh I don’t know, STAC Capital) to get funding across the line with banks, particularly to do so on advantageous or even reasonable terms. What we’re also seeing is an increasing number of alternative lenders (generally large fund managers), or Debt Capital Market dealers of varying forms, who traditionally may have been in Private Equity or in larger Corporate Bonds, now coming down from the bigger end of town to start writing debt down to $10m or $15m. At this level, I’m quite happy with the prospect of an increasing number of alternative players entering the market – borrowers are generally sophisticated enough, or willing and able to learn to become so within a short period of time – and Australia’s credit market is well overdue to start maturing beyond being heavily reliant on just 4 major players. In the US and Europe, banks only provide up to about 30% of the corporate debt market’s funding, whereas here it has been closer to 90%. Our current balance creates problems at some debt levels and in some sectors – if the local banks don’t like the deal, the prospects and/or cost of alternative funders can make the deal pretty challenging (lack of liquidity = lenders/investors looking for a high yield). So bring it on!
$3-10m is more challenging at the moment.
Here we have a cheque size that is too big for the newer “fintechs”, but too small for most fund managers, bond writers etc. to bother with. Compound that with being at a level where it’s not in the banks’ corporate divisions, so whilst the borrowers aren’t necessarily Little Aussie Battlers, it’s still a level at which the banks aren’t willing to play hard-ball – so they are being more conservative than they were a few years ago. Compound again on that the fact that at this level, most borrowers don’t have enough equity in real property for the bank to be fully secured. Sure the banks can still have covenants without Ms Carnell’s misguided new restrictions – and they will continue to use them – but they’re simply becoming increasingly fearful of the regulator and any adverse PR from being tough on borrowers. Add to that, the level of experience within banks is not quite what it used to be, whilst some banks have over-stretched their credit divisions’ employees to the point where they simply don’t have the time necessary to devote to a complex cash flow-based deal; nor do the bankers themselves. So it’s easier and safer to say no.
There are certainly a number of well-established and reputable cash flow lenders in the invoice/debtor finance space (i.e. will happily lend x% against issued invoices), however there are a number of industries or types of businesses that this doesn’t work for – ones whereby the real need is a true cash flow lender, one that is willing to lend on a multiple of EBIT or discounted future cash flows. Which is what good bankers used to be willing to do. So what’s the solution here? We see it as two-fold:
- New entrants – however we don’t believe this is the be-all and end-all. This is still very much a fledgling, thin market. We absolutely look forward to more players coming in (provided that they’re reputable, of course), but it’s not the solution we would like it to be just yet.
- Believe it or not, there are still good some good bankers out there; the ones that we at STAC Capital are very choosy about using. When we approach a bank with a proposed deal for one of our clients, we don’t just go to “the bank” – we very specifically choose a certain banker at each bank, whom we know has the experience and capability to understand and support that specific industry and deal. FYI, they’re not the ones that tell you, in the first 10 minutes, that the deal is easy to do; they’ll actually often start by not saying whether it’s a deal or not until they’ve properly understood the facts and the risks. They’re not necessarily easy to find either and rest assured, if you approach a less “appropriate” banker, being salespeople marked against KPIs, they will not likely hand over to a better qualified banker.
IN THE END…
We’re undoubtedly facing headwinds and hurdles, which are unlikely to ease in 2019. Whether you read or watch the news in Australia, the US or UK/Europe, this year there will be a lot of talk about risks of a recession, which unfortunately are not, in my view, just a case of fear mongering – there are real risks of this.
So what do you do about it? Well, as I said in a recent post, and I’ll keep saying over and over again, the answer is not to run for cover because the sky is falling in. Australia and the world have been through recessions before – most of us will remember just over 10 years ago when the GFC hit; whilst many did get hit hard and some even went under, guess what? Most made it through ok, many even made it through much stronger than they went in.
As I pointed out in that recent post, in uncertain times, it is the time to:
- look at your business model,
- objectively look at the risks in your business and industry, to work on
- whether you need to protect your business from potential threats, or even
- whether there will be opportunities to take advantage of when the cycle turns.
And I say when – not because I’m a pessimist or fear mongering – but because if there’s one absolute truth in economics, it’s that every possibility in business and economic cycles is not a case of if, but when.
Those who understand and respect that fact, and act upon it, are the ones that will succeed through all cycles.
Which is what we’re actively doing with our clients. If you’re growing, facing headwinds, or somewhere in the middle and would like to look at funding options to support you get through as strong as possible, whichever way you’re heading, get in touch and we’ll be happy to discuss how we may be able to help.
– Mark Trayner