The annual conference of the Asset Based Finance Association (ABFA), the body representing the asset-based finance industry in the UK and Ireland, held in Birmingham in June looked at the SME market, with a number of speakers analysing its current performance and its future prospects.
In an interview with Leasing Life earlier this year, ABFA’s chief executive officer Jeff Longhurst highlighted that the association’s members aim to attract more small businesses. The SME market has also been targeted by various large banking groups and independent lessors, through advertisements and new products.
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This market has captured the interest of funders because of its strong performance and growth potential.
According to the SME Finance Monitor, published by research consultancy BDRC Continental since 2011, a large proportion of SMEs were profitable in the last two years.
In the first quarter of 2015, 79% of SMEs – excluding the ‘don’t know’ answers – said that they recorded a profit in the last 12 months, up from 69% in Q1 2013.
The strong performance of SMEs is also evident through their improved risk ratings. D&B and Experian risk ratings appended to the Monitor data, have shown that the proportion of companies with worse than average risk rating has dropped from the latest peak of 56% in Q2 2013 to 44% in the first quarter of this year.
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By GlobalDataDespite improving results, the use of external finance by SMEs has been declining over the past few years across all size bands. It has plummeted from 51% in the first two quarters of 2011 to 36% in the first quarter of 2015.
First stop
The first stop for the majority of SMEs when seeking finance is the bank. Loans, overdrafts and credit cards – also known as ‘core’ forms of finance – are the most popular finance products used by these companies.
After the financial crisis, a notion emerged that banks’ reluctance to lend to SMEs caused their low use of external finance. This ‘supply-side’ explanation to the issue was reproduced extensively by the UK press.
The government recognised the problem and launched a number of initiatives – like the British Business Bank – to increase the supply of credit to this segment of the market.
Bill Robinson, chief executive and chairman of economics and regulation at KPMG, said at the ABFA conference that the UK banking crisis which started in 2007 with the bank run on Northern Rock is still "in a sense with us".
He said that loan impairments are an important reason why banks haven’t been lending, as they reduce equity capital. "They are not lending, their equity basis has been eroded," said Robinson.
He also emphasised the effect of regulation on the amount of equity capital banks can lend. The amount of shareholder capital and the amount of loans that banks are allowed to make, is set by the regulatory system.
"Regulators have taken the view that because of the collapse of the banking system they want to reduce the risk of the banking system and that means a far smaller ratio of loan-directed capital," said Robinson.
Under Basel III – a set of reform measures on bank capital adequacy, stress testing and market liquidity risk – banks should hold more equity capital for a given amount of lending.
The SME Finance Monitor found that the use of the ‘core’ forms of finance by SMEs has declined significantly from 40% in the first quarter of 2012 to 29% in the first quarter of 2015.
On the other hand, it revealed that success rates for loans and overdrafts applications have been increasing over time, reaching 76% in the first three months of the year, which was the highest rate ever recorded by the survey.
Application success
BDRC director, Shiona Davies said: "Even first-time applicants who have always been the least likely to be successful, often due to a lack of credit record, have been receiving loans and overdrafts. At one point their application success rate was 35%; it now stands at 55%.
"We can’t simply say that the rise in success rates was a result of better-quality applicants. Even when you consider the quality of applicants, it does look as if success rates are doing a bit better than we would expect."
This illustrates that the decline in the use of loans, overdrafts and credit cards cannot be fully attributed to a lack of lending from banks, but also to a lack of demand from SMEs.
The Monitor also tracks the reasons why ‘would-be’ seekers have not applied for loans and overdrafts. A number of firms said they felt ‘discouraged’ when seeking finance. They had asked informally but felt put off or assumed they would be turned down. While many found the process of borrowing a key barrier, they thought that it was too expensive and too much of a hassle.
In addition, the fact that SMEs have not turned to alternative finance sources to obtain funding could also be interpreted as a sign of a reduced appetite for funding. Although it could also be due to a lack of awareness among these businesses of other finance routes.
The Department for Business, Innovation and Skills (BIS) found that small businesses are unaware of alternative sources of finance and analysed the financial costs.
"This is a market failure, of imperfect information, resulting in SMEs that are viable loan propositions not receiving the finance they need," wrote the BIS.
Decline over time
According to the SME Finance Monitor data, the drop in the use of ‘core’ finance products has caused the overall declining use of external finance over time. Other sources of finance, including – among others – leasing, invoice finance and crowdfunding, have declined at a lesser extend over the same period, from 22% to 16%.
Davies told Leasing Life that there could be a number of reasons behind the low use of external finance. She said that there has been an increasing number of small and medium-sized firms who hold credit balances above £5,000 (7,000).
Another possible explanation could be SMEs’ access to trade credit. "We know that overall a third of SMEs have access to trade credit, so they are getting credit terms from their suppliers. Those who receive trade credit are likely to say that this is reducing the need for external finance," said Davies.
The low appetite for external finance can also be seen through the substantial increase of the ‘permanent non-borrowers’, those firms that are not using external finance and show no inclination to do so. The share of SMEs who classified themselves as permanent non-borrowers increased from 30% in Q1 2012 to 48% in the first quarter of the year.
As a result, there has been a polarisation, since the group of SMEs neither using external finance nor a permanent non-borrower has shrunk to 16%. Members of this group have been more like to become permanent non-borrowers than using finance.
To the question whether this figure should worry financiers, Davies replied: "It certainly presents a challenge for them, because we do not know how ‘permanent’ these permanent non-borrowers are. They are currently half the market, so anybody who is looking to offer the service, if half the market seemed to be a long way from wanting what you have to offer, then that is going to be a challenge."
Another interesting indicator of SMEs’ lack of appetite towards external finance, is that seven out of ten (72%) SMEs agree that they are looking to be as debt-free as possible.
SMEs often use external finance in order to fulfil their growth plans. The percentage of firms planning to grow in the next 12 months is the lowest of the last two years at 43%, which shows that the negative trend in the demand for external finance is unlikely to reverse in this period.
The data illustrates that the view that the decline in borrowing events by SMEs is triggered by a limited supply of credit is losing value. While the substantial rise in permanent non-borrowers shows that it has become a ‘demand-side’ issue.
With competition in the external finance market rising due to the increased number of alternative funders, finance companies face a shrinking market to promote their products and services.
Leasing holding up
"In a market where fewer SMEs are using external finance overall, leasing held up reasonably well. It is doing slightly better than the market overall," said Davies.
The proportion of SMEs that used leasing in the first quarter of the year was 7%, up from 6% in Q1 2013. Taking into account that the share of SMEs using all non-core forms of finance stood at 17%, leasing holds a significant position.
There have historically been large variations in the use of leasing within the SME market, becoming more popular as the size of businesses increase. In the first three months of 2015, only 5% of firms with no employees – the largest segment of the SME market – used leasing, whereas the figure was 26% for SMEs with 50-249 employees.
"This trend can be identified across all forms of finance," said Davies. "As companies get bigger, they are more likely to have someone in charge of their finances who is qualified, which potentially increases their ability to look around at the different forms of finance the business might need."
Over the past year there has been a decline in the share of large SMEs (50-249 employees) using leasing for finance. In the first quarter of 2014 the share was 36%, whereas in the same period this year it was 10% down.
"The decrease in the use of leasing among large SMEs is part of a general decline in use of external finance by this segment of the SME market," said Davies. "This can also be seen from the proportion using ‘core’ forms of finance which dropped from 65% in Q1 2013 to 53% in Q1 2015."
The SME Finance Monitor also asked SMEs with plans to apply for finance in the next three months, whether they are considering leasing as a finance option.
In the first quarter of the year, one in four (25%) respondents answered that they are, which is an increase of 3% compared to the first quarter of 2013. Looking into the figures, the increase was triggered by a rise in consideration of leasing among SMEs with up to 9 employees. On the contrary, among larger SMEs there was a fall, particularly for those with 50-249 employees where figures fell from 45% to 34% in two years.
At the ABFA conference, ABFA’s chairman Peter Ewen told the audience that the loss of market share by traditional lending is permanent and that asset-based finance is the "real alternative".
Ewen said: "Traditional lending is still falling far short of pre-recession levels, and banks and other funders are rightly more cautious of unsecured lending. With invoice finance and other forms of asset-based lending offering borrowers so much flexibility it’s hard to see why the trends of the seven years should reverse.
"That makes asset-based finance the real alternative to traditional loans and overdrafts, as it is anchored to the solid foundation of real assets, which is deeply attractive in the wake of Basel III."
The UK asset-based finance industry is currently providing funding to 43,000 businesses, of which the vast majority are SMEs.
The use of invoice finance by SMEs, according to the SME Finance Monitor, has been relatively stable between 2% and 3% since 2012, standing at 2% in Q1 2015.
There weren’t significant variations in the use of invoice finance across the different sizes of SME over the past few years, apart from those with 50-249 employees. The proportion of those companies that used invoice finance dropped from 16% in 2012 to 9% in Q1 2015.
Consideration of invoice finance among SMEs planning to apply for finance has been broadly stable over time. For companies with up to 9 employees, consideration of invoice finance rose from 8% in 2012 to 11% in Q1 2015, whereas it dropped from 14% to 12% for companies with 10-249 employees over the same period.
Ewen talked about the increased competition from new types of alternative finance companies, like peer-to-peer lending and crowdfunding. He said that the asset-based finance industry should "welcome" these competitors, as competition would help it become more efficient.
"We must rise to the challenge of increased scrutiny or risk losing out to newcomers," he said.
Crowdfunding and P2P lending
The SME Finance Monitor found that crowdfunding accounted for 2% of external finance used by SMEs in the first three months of 2015, with its awareness reaching the highest level to date.
Thirty-eight per cent of SMEs – excluding permanent non-borrowers – have been aware of crowdfunding, up from 18% in Q2 2012 when the question was first included in the survey. Despite the increase in awareness, the majority of SMEs remain unaware of this finance option.
"Around 12% of SMEs are using, or would consider using, crowdfunding. Although consideration is going up, because overall awareness is improving, there hasn’t been an increase in conversion rates," said Davies.
At the ABFA conference, a panel of financial technology (Fintech) industry professionals expressed the view that financial technology platforms will attract more SMEs in the near future, as more market players get to know about their activities.
The panel claimed that these platforms are more suitable for the SME market than ‘traditional’ lenders, as the process of accessing finance is easier and less time consuming.
A long process
Henning Holter, head of business development at electronic invoice network Tungsten said at the conference: "To make people aware of what we do is a long process. The level of awareness and knowledge about financing within SMEs is very low. The companies without any employees don’t have the skills in-house or the knowledge to evaluate or seek an alternative solution. The first stop is always the bank which may not be the right way."
Holter said that one of the comparative advantages of alternative finance compared to the rest of the finance routes is that it removes the ‘hassle factor’.
He said: "One of the purposes of Fintech is to lose the so-called ‘hassle’, as you can make screening online, as well as to give easier access to financing for people who do not have a finance director on board – a straightforward, paperless process. People want a quick decision that will take the least time away from their everyday work."
