Could Private debt be the new theme for SMEs to access capital?

The global financial crisis has been the turnaround for the private debt market as it is now widely accepted as an asset class of its own. The increase in both supply and demand is having a significant impact on how alternative lending funds are being used. In recent years, there has been an influx of new entrants and greater diversity of investment strategies. The banking industry is forced to re-evaluate less-profitable and high-risk sectors, which has resulted in private debt markets gaining prominence since a decade.

The SME sector in the GCC accounts for $360bn per year, or about 26% of GDP. It is expected to grow rapidly and more than double to reach $920bn over the next five years (Waha Capital). Most of this growth is expected to come from the UAE and Saudi Arabia. A majority of SMEs in the region will require financing needs over the next couple of years.

From a credit perspective, SME access to formal credit from the banking system in the GCC is low. Banks in GCC are not best positioned to finance the capital due to the nature of the financing that usually involves long tenors, absence of amortization and equity comparable returns. Historically, this financing requirement has been filled mostly by equity, but may sometimes involve a dilution of the promoter’s equity. This provides an opportunity for innovative credit solutions that make sense for both investors and borrowers. Investors are now starting to take notice, and one can see definite green shoots emerging slowly but surely. For instance, the implementation of the Bankruptcy Law in the UAE is an important step along with the setup of the UAE Credit Bureau. While the legal and regulatory environment still lag behind when compared to more advanced markets, there has been a visible progress. Banks also lend to companies based on their track records and exercise much more precaution on riskier loans. Certain companies therefore may find it difficult to secure loans due to lack of credibility and look for private debt as an alternative.

The Middle East has experienced a period of softening growth along with a rise in fiscal deficits, which has led to historically-low returns across asset classes since 2014. As a result, the hunt for higher yields has entered a new territory within the MENA region in general and GCC in particular, which has led to the emergence of private debt, albeit selectively among investors with longer-time horizons with the aim to exploit the current illiquidity crisis. The importance of private debt as one of the core components of funding cannot be underrated for fast-growing, medium-sized companies in the GCC region.

For regional SMEs that are exploring non-traditional debt sources, there are a series of options that have emerged over the past couple of years. There are tailor-made products such as peer-to-peer lending, crowd funding for fast-growing small- and middle-segment companies that have leveraged low operating costs, minimal regulations and big data technology to provide quicker access to cash.

However, GCC businesses with riskier models or those which are currently distressed and cash-strapped are the ones which now have a new avenue to gain capital through private debt. Additionally, the private debt market is going to be a crucial vehicle in the region, with the UAE being the first nation to approve a bankruptcy law.

For example, under the new UAE insolvency law, the advantage of exploring the private debt option for a borrower will enable them to focus more on structural customization to match their financing needs compared to bank financing. Private lenders have also earned a reputation for being faster, more flexible and more predictable counterparties than banks. The disadvantage is generally the pricing as private loans tend to be more expensive than bank loans.

However, lack of proper regulations in place and a failure to comply with Islamic law within the region demand a cautious approach for successful implementation of newly-formed lending strategies. In addition, brand presence and perception play a crucial role in the region. Nevertheless, with banks slowly stepping back from the debt segment and demand for direct funding outpacing supply, the private debt sector is only going to rise further. This does not mean a complete exit from traditional platforms such as banks from the lending space, but rather a potential for more collaboration with private lenders.

Although the private debt market is at a very nascent stage, it has the potential to become an attractive asset class similar to the success witnessed in the US and Europe. Further, the positive change in sentiment towards alternative lenders has also opened opportunities for SMEs and institutions alike.

The most likelihood sources of private debt will include public and private pension funds, foundations, endowments and insurance companies. In real estate sector, as historical limitation of terms on lending from commercial banks remain, up to 10 per cent of the total real estate debt market could come from private debt providers within the next decade. Collective investment vehicles may also emerge as debt providers since investors see debt as an attractive capital stack for taking real estate exposure, especially given the current interest rate cycle (JLL).

As the private debt offer more flexibility and are tailored in nature, there is a general recognition that these instruments will be priced at a premium compared to more traditional bank lending. Private debt could be priced between 100 -150 bps above conventional bank lending in GCC, suggesting private senior debt’s pricing in the range of 6% to 7% on core transactions (JLL).

Private debt has the potential to become a dominant lending avenue for development of fast-growing SMEs. However, the regulatory environment will be critical for growth going forward and the private debt market’s ability to operate and adhere to stringent and rapidly changing regulations will be key to its success.