Why investing in SME loans is a great way to invest? Part 1

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The other day I was talking with someone, and they asked me what makes lending to small and medium businesses a great way to invest. Let’s just say my response to a question like that was more than just “profitability”. I told them, to answer a question like that we do need to make some assumptions because all small to medium loans are not the same.

Before comparing investments in small to medium businesses you need to consider; the risk factors, what an investment into small to medium businesses consists of and what security needs to be provided.

What is discussed ahead is not all inclusive and is simply an opinion, so despite how convincing I think I may be some may feel they disagree. As there isn’t just a simple one-page answer to this question make sure you stay tuned for the follow-on article. Lending to small and medium businesses is not as simple as just giving them a loan to grow their business.

Key questions that come to mind are (and bear in mind these are not all of them):

  • What does the business do?
  • Do they have a niche that allows them to remain competitive?
  • What is management like:
    • are they able to deal with challenges,
    • are they experienced,
    • are the interests of the business put before personal financial gain?
  • Where is the business going?
  • What headwinds are expected and how have they anticipated them?
  • What sector do they operate in, and does it have the potential to grow?
  • What is the result from the credit risk assessment model?
    • Is it like the proprietary one used by Marketlend that takes 80 or so risk factors to determine the risk profile?
    • Does it say there is higher likelihood of repayment?
    • How trusted is that model? For example, is it like Marketlend’s model that has operated for 8 years with a 2% loss factor based on its results?

After answering these questions, one might then consider what security you have if they don’t succeed to realise your investment.

In the Australian market it is common for the banks to take real property as collateral. This can make it a challenge for small to medium businesses to obtain sufficient funds because the real property may not match the funding needs of the business. To overcome this, you will need to consider other security.

The questions you need to ask will revolve around the type of security given, for example where it is:

  • a security over the entire company,
  • a security over goods, or
  • a personal guarantee, or
  • all of them;

After considering all of these, you may ask yourself what additional credit enhancement risk measures are taken to ensure that the business will be able to repay the loan, For example:

  • Is there insurance to protect credit fault risk,
  • What additional loss provisions is the borrower or say Marketlend providing to protect the investment?
  • Marketlend at a minimum invests 1% or more as a first loss protection and requires the borrower to commit to paying an additional 1.5% loss reserve to cover any litigation or enforcement expenses if required.

If you assume that the investment being offered has the below attributes of an investment in a loan to a small to medium business:

  • Secured with all money security, and personal guarantees;
  • Insured in the credit risk default event; and
  • Has reserves to cover enforcement costs, and possible loss

Then you can look at these attributes and compare them to other investments in the market and really identify a few key points that can make investing in small to medium businesses attractive.

To be continued… check out our next blog for the continuation of this discussion.

5 August 2022