The harsh economic environment has once again put the financing of small-to-medium-sized enterprises (SMEs) under the spotlight. Though supply chain finance can help SMEs, it is only a partial solution to their problems. But in some cases there are other avenues companies can tap into for funding. Justin Pugsley looks at some of the alternatives.

The liquidity drought and the flight to safety have left many small companies stranded for cash. However, specialist lenders such as Davenham could provide part of the solution.

Davenham is among a shrinking band of lenders focusing on the SME sector, yet their services are needed more than ever as the crisis entrenches itself deeper into the economy. An increasingly familiar tale is that of the bewildered managing director of a small, but profitable company, complaining that their perfectly reasonable loan application has been mysteriously turned down or that the overdraft facility has been reduced despite there being no issues over servicing it.

Even obtaining trade finance – a relatively safer area – has been difficult, as has raising finance against letters of credit. And of course all these services now come at a much higher cost. Around 30% of all loans to SMEs comprise asset finance, which sits just behind overdrafts as the second most important type of loan.

It’s all symptomatic of banks wanting to reduce exposure to risk, and the fact that SMEs are seen as risky. It’s also more efficient for them to lend a large sum of money to a single large corporate borrower than dividing it between dozens of smaller borrowers – all of which requires separate administration.

Despite all the admonitions from the UK government that banks must support SMEs, anecdotal evidence suggests this is so far not happening on any kind of scale.

One of the reasons for this could be that the credit quality of the bulk of SMEs has deteriorated dramatically due to the recession – making it hard for banks to lend. After having lost so much money elsewhere, they’re hardly in any hurry to go and lose a bundle more with all the consequences that has on their core capital ratios.

This is however leaving an opening for smaller specialist lenders for whom SMEs are their bread and butter. Davenham, which was established in 1991 in Manchester, was founded specifically to support the sector and actually gets many referrals from the big high street banks and local accountants. The firm, which took a hit on real estate loans, is in the process of restructuring and has successfully refinanced.

As part of its restructuring, it is focusing more on trade finance and asset-based lending, is shutting several offices, beefing up its risk teams and reducing its head-count by 31%. As part of that restructuring, it reduced its loan book to £221mn as of March 24, 2009 from £284mn as of June 30, 2008. The property loan portfolio, where it has had some problems with bad loans, has been reduced to around £130mn from £154mn.

Putting it in a stronger position to boost trade finance lending to SMEs, Davenham has completed a two-year facility to March 31, 2011 at 300 basis points over Libor, which starts at £215mn, reducing to £90mn over an 18-month period, reflecting repayments mainly from the shrinking property loan book. The facility, which was arranged by the Royal Bank of Scotland with Hawkpoint Partners advising, is tailored to support the asset and trade divisions’ working capital requirements.

“We like trade finance; we see it as relatively safe and there’s nothing really new about the principles of it,” says David Coates, chief executive of Davenham. “Much of it is about providing working capital against invoices, stock in transit and letters of credit.” Currently, many SMEs are experiencing tremendous difficulties with obtaining enough working capital to function properly.

And there may also be structural issues, which are hindering the flow funds to SMEs relating to the fact that the banking industry has changed dramatically over the last 20 years.
“These days, it’s much less about the friendly bank manager who is part of the business community and knows everybody very well,” says Coates. “Because of their local knowledge, they had a strong sense of who to lend to and who not to.”

Today, loans are often made remotely out of call centres, and banks instead rely on credit scoring to decide on suitability, a trend which started with consumer finance.

“Davenham has a bit of that old-fashioned touch. We’re a bit like the local bank manager of the past. We very much rely on our local knowledge to assess prospective borrowers,” says Coates.

Of course, this much more hands-on approach does come at a cost. “We charge bigger margins, we’re a specialist lender, we’re not a scale business,” says Coates. Indeed, in a regulatory announcement on March 24, Davenham said that it is increasing the pricing of new client facilities to protect its margins in view of the increase in the cost of funding resulting from its own £215mn refinancing. That is also a reflection of the tight credit conditions across the board.

So has the reliance on credit scoring by the big banks failed? “No, not really, but a lot has to be learned,” says Coates, who points out that there are limitations to credit scoring. “You can learn a lot by visiting the premises of a company and getting an understanding as to how their business works,” he says. “You’ll pick up things that may not be reflected in a credit rating.”

He explains that much of what credit scoring is about is finding evidence of stability and calculating probabilities of loan performance. “Though credit scoring has not failed, it still has a long way to go and needs to be more precise,” he says.

Another issue, less related to credit scoring, is bank lending policies. Banks tend to over react in their lending policies at different points in the cycle, explains Coates. “When it’s on the up, they tend to over-lend and under-lend when it goes down, which tends to exaggerate the cycle,” he says.

Supra help?
One interesting development during the downturn is the greater engagement of supranationals, such as the European Investment Bank (EIB) to support corporates as private-sector funding has retreated.

The UK government recently declared that large tranches of European funding were being made available for UK SMEs. Though there has been some confusion as to how those funds would be made available to SMEs. The normal channel is through banks. The independent lenders, which focus on SMEs, felt strongly they should also participate in these programmes. “Firms like Davenham would be ideal for channelling EU funds destined for SMEs,” says Coates.

But many Finance Leasing Association (FLA) members reported that they had trouble getting access to the funding. FLA members tend to be independent lenders often specialising in SME finance.

A spokesman for the FLA told GTR that it had asked the EIB for clarification as to whether its members could apply for its SME funds. “They confirmed back around February this year that they could indeed apply, but we’re not aware of any of our members doing so,” he says. “But there is anyway a long process to apply for these loans.” It could be those very processes which are proving off-putting for specialist lenders.

In the meantime, the recession is likely to prove particularly tough for SMEs. However, their importance to the economy in terms of providing jobs and GDP growth should not be under-estimated. Viable SMEs deserve all the support they can get.