What non-bank lenders must consider before issuing a private loan

Australian non-bank lenders are making incursions against the big banks, but have many considerations during the loan decision making process to ensure proper loan structuring.

While the big banks dominate both business and consumer lending, non-bank lenders (NBLs) are making significant inroads into the Australian lending market. NBLs target a variety of segments of Australia’s corporate loan market, including specialising in providing bespoke financing to high quality, credit-worthy Australian middle market companies by being able to provide proper loan structuring and management that takes into account security and covenants.

Epsilon Direct Lending’s founding partner, Mick Wright-Smith, spoke at The Inside Network‘s Income & Defensive Assets Symposium and gave investors a broad overview of the NBL market in Australia, as well as how private loans are structured. Epsilon manages an open-ended fund which has grown materially since its commencement in June 2021. 

Wright-Smith described the Australian corporate loan market as being half the size of the ASX. He explained a corporate loan as being a privately negotiated loan between a borrower and one or more lenders that isn’t  traded on a public exchange. Lenders typically take some form of security but not always.

“The corporate loan market in Australia is huge,” he said. “It’s about a $1 trillion market, which is about half of the market cap of the ASX. It is still dominated by the banks in Australia. In the US and UK this is not the case. It has changed since the GFC.”

“Corporates borrow money to support working capital or to grow, whether its capex or buying assets or event driven in nature. The term can vary between one and five years. The lender gets back fees and interest costs which is essentially income from the loan. The cost of this income is based on the lender’s credit assessment.”

According to Wright-Smith, Australian banks have been primarily focused on the more profitable consumer lending sector rather than business lending.

“Banks are encouraged to lend to risk weighted assets such as residential mortgages. They make way more money on mortgages than they do on a business loan. From being weighted towards corporates, banks have shifted towards consumers,” he said.

“The mid-market is a $70 billion subset of the trillion dollar loan market. Businesses that have EBITDA of around $5 million to $25 million. The vast majority of M&A is in the mid-market. There are 32,000 companies that fit this space whereas in the large cap space there are 2,000.”

Structuring a loan

Wright-Smith explained the process of structuring a loan involves determining the risk/reward profile, as well as taking into account security and covenants and evaluating the value of the business in various scenarios.

“We do a lot of due diligence in answering many questions regarding the business operations from profitability to cashflows to its operations. We use accountants and lawyers and sometimes we ask for insurance due diligence” he said.  

“The second way out for a lender is to sell the business if required or even liquidate the business’ assets. And that’s where the security structure and covenants come into play. The covenants within loans  alert you to underperformance within a borrower before it’s too late.”

Loan management  

According to Wright-Smith, loan management is a vital component of the entire process, which involves deciphering monthly performance information from the borrower business.

“Loan management is a crucial, fundamental tenet of the investment process. Because we are direct lenders, we get monthly information from our borrowers. It’s the P&L, cash flow and balance sheet from our borrowers on a monthly basis. This allows us to gain insight into any underperformance of the borrower’s business so that we can intervene quickly,” Wright-Smith said.  

When it comes to structuring and security, he also paid particular attention to how well the borrower was capitalised according to their gearing levels. He also looked at the debt in the capital structure, based on a reasonable valuation of that company.  

“In mid-market, companies sell at around 7x EBITDA. It doesn’t vary that much but it can vary a lot in the large market such as tech stocks,” he said.  

“The best indication of valuation is the M&A transaction that we are lending into. We will cross check that with comparable transactions in the market and also listed comps. That gives us a good idea of the enterprise value of the company. And then we can gauge where our debt sits in the capital structure.”

Covenants are important

An important part of loan structuring is setting appropriate covenants. Wright-Smith said covenants remained a strong feature in the Australian mid-market but were less a feature in the US and Europe. “Covenants are slowly coming back in the US and Europe, but they’ve remained strong in Australia because there’s a lower supply of NBL capital here relative to offshore.”

“Covenants measure the performance of the company,” he continued. “We will set leverage ratios plus interest cover ratios, plus debt service ratios. These measure the company quarterly so that if there is any underperformance these covenants will be triggered, it brings the borrower and the lender back to the negotiating table to fix and resolve its problems.”