For more than 400 years, the banking sector dominated the international market for lending. Together with governments and mandated lead arrangers, these three groups have traditionally been responsible for the vast majority of issued loans. However, over time, their ability to meet changing market needs has gradually deteriorated. Between greater demands on banks to maintain their capital structure and governments being placed under increasing financial stress, issuing loans has become significantly more difficult.
As long as the default rate remains low, the volatility of the returns are extremely low, thus adding appeal for long-term investors
To counter this, other forms of lending are beginning to take prevalence in the market, offering the financial resources many businesses have recently been unable to access. Ernesto Lienhard, CIO of BAF Capital, said direct lending is one of the financial services that have emerged to fill this void.
Based in Switzerland, BAF Capital provides a broad range of financial services, specialising in the Latin America region. Primarily, the company provides working capital solutions to South American companies that mainly operate within the agribusiness, food and energy sectors. With a team of 120 professionals across five offices (Switzerland, Argentina, Uruguay, Brazil and Paraguay) and a management team with more than 30 years’ experience in corporate finance, the company has become one of the most active players in direct lending within the region.
“What we now call direct lending is lending provided by non-bank private entities,” Lienhard told World Finance. “The regulations and limitations to increase the leverage on a bank’s balance sheets opened an opportunity for non-banking independent private lenders to fulfil gaps in the global credit market.” Now, direct lending is set to continue to grow in both size and scope, gradually making up a far bigger proportion of the market. While the model presents some unique challenges, experienced direct lenders are now seeing significant opportunities in the years ahead.
The lending market changed significantly during the aftermath of the 2008 global financial crisis. Many of the world’s banks have been forced to restructure their balance sheets to accommodate the significant write-offs that were necessary. Changes to regulations, such as increased capital requirements, have also weighed on banks worldwide. Coupled together, this has reduced banks’ capacity to offer loans, cutting off much-needed sources of credit to many small and medium-sized businesses.
Lienhard added that while stricter regulations have been responsible for much of the impact on the industry, there have also been additional factors at work: “Although tougher regulations for banks played a role in the reduction of their activities, we should not forget that weak capital structures forced them to drastically reduce their capacity to hold all loans in their books.”
There are yet more factors at work behind the rise of direct lending. Global trade and the nominal value of the world economy have been expanding very quickly, mainly due to the increase in commodity prices over the past 20 years, as well as China’s ongoing growth. Lienhard explained: “Banks did not have enough capital to follow the pace at which the world economy was growing, which allowed other players to fill that space. Today’s environment of historically low interest rates and excess liquidity is driving investors to search for new sources of yield.” These many factors have combined to produce a surge in interest for direct lending.
Finding a niche
BAF Capital has been in the market long enough to see how much this has changed the industry. “BAF Capital started its activity in 1996 as an alternative independent lender,” Lienhard said. “At that time, we were seen as a marginal and exotic player within the financial services industry.” Now, BAF Capital maintains a larger and more important role within the market.
For the businesses that partner with BAF Capital, numerous opportunities can arise. According to Lienhard, reliability, flexibility and quick responses are among the most important: “By having an in-depth knowledge of the business that these companies are involved in, we are able to provide them with liquidity even during difficult times, which is very valuable for any company. In many cases, banks are more reluctant to lend during such periods, which allows BAF to build relationships with a broader range of companies, and with even better yields.”
Lienhard added that BAF Capital can also provide funding to a company operating in different jurisdictions at the same time, giving the company another significant advantage when compared with other lenders.
The benefits are not limited to the businesses seeking credit. Lienhard explained that BAF Capital also provides an excellent opportunity for investors to access a well-diversified, self-originated portfolio of private collateralised loans in South America. “We do not use leverage and all risks are in our books, therefore our interest is fully aligned with our investors.”
As with any loan portfolio, the key is to keep the default ratio well below the interest rate of the portfolio. “As long as the default rate remains low, the volatility of the returns are extremely low, thus adding appeal for long-term investors, such as insurance companies or pension funds.”
Despite these benefits, Lienhard agreed that so-called extra leverage from shadow banks can be a risky venture, but that by no means suggests the asset class is worth avoiding completely. “I do not recommend having more than a 1:1 ratio of leverage in a credit portfolio. Keep in mind that a bank’s leverage ratio is 10:1 on average.”
While risks do exist, the agribusiness sector presents a more stable market than others. “Within the markets in which we operate, the financial sector does not cover all the financial needs of companies, thereby creating a space for alternative sources of funding,” Lienhard explained. “Trading companies, suppliers and non-bank lenders are there to fill the gap. Here at BAF, we are part of the financial structure of the companies we are involved in.”
Lienhard added that low correlation with traditional fixed income and equity investments is another upside for an investor’s portfolio: “Regarding diversification in any investor’s portfolio, private debt provides superior protection against traditional bonds and equity-like return.”
Considering all of these factors, the direct lending sector is currently looking forward to a promising future. Lienhard said BAF Capital has already seen the direct lending industry generate significant momentum, with more growth on the horizon. “Nowadays almost all asset managers have a strong direct lending division, including KKR, Blackstone and Goldman Sachs. It will take a long time before the banking industry can increase its capital requirements in order to satisfy the increased demand.”
Direct lending may also be immune to some of the other forces currently rocking the financial market. Lienhard explained that the disruptions that have been caused by the rise of fintech are unlikely to have the same effect on the direct lending market: “The world is certainly evolving, and I don’t see fintech companies as a threat. I believe that both can benefit from each other, but the view of regulators will be important for this.”
According to Lienhard, banks are particularly vulnerable to fintech challengers, since their nature requires them to offer a generalised product: “Banks own the bulk of customer relationships, both personal and business. Fintech players can provide them with better technology to improve customer service, serve small businesses in a much more cost-effective way, and get them access to other customers as well. In addition, I believe that fintech platforms might even help increase direct lending. They will need financing to grow their business, and that’s where we can find synergies.”
Neither are tax barriers an immediate difficulty for direct lending. “You can’t stop globalisation. With a growing world population, countries with competitive advantages in terms of land and water will definitely benefit against others,” Lienhard said. BAF Capital also operates within a sector that is not particularly vulnerable to international restrictions, especially in the long term. “South America, especially Argentina and Brazil, will always be a food supplier to the world,” Lienhard said. “There are times in which countries can impose barriers on certain products to protect their industry, but in the long run, South America will always be a net exporter of agricultural products.”
Latin America is also a region with strong growth prospects in terms of direct lending, Lienhard said. “The demand is strong for bonds by the private banking sector, as it is a plain, vanilla investment for customers. On the other hand, big and sophisticated investors like insurance companies and pension funds are looking to invest in private debt because of their low volatility vis-à-vis bonds, and better returns.”
Considered as a whole, the direct lending sector is set for significant growth during a future that has the potential to be filled with consistent returns. As investors are looking for new solutions, investing in direct lending will soon be a must when it comes to constructing a balanced portfolio. Lienhard concluded: “For me, diversification is still the key word for any portfolio.”