ELAINE SECURITIES PLC was founded in February 2015 to initially identify opportunities within Investment Management. In early 2016, the Directors resolved to amend the company’s strategy to predominantly focus on medium-term, asset-backed loans to body corporates that meet the necessary eligibility criteria. Although the average investment length may vary from 3 to 5 years, it is the Directors’ intention to mainly target investments of a 3-year duration that will be funded by way of the issuance of a 10-year 5.0% bond
Market overview: UK Corporate Finance
Traditional financing techniques, based mainly upon debt and guarantees, have only limited applicability to new, innovative and fast-growing SMEs (small to medium enterprises), companies seeking transition in their activities or those aiming to deleverage and improve capital structures. A range of non-bank financing instruments available to SMEs, in particular mezzanine finance, has proven effective in supplying ‘growth capital’ and has the potential for wider usage, especially in the post-financial crisis environment of reduced bank lending. Mezzanine finance, incorporating elements of debt and equity in a single investment vehicle, is most relevant in the later phase of a company, and complements rather than replaces other forms of finance. (See OECD Business and Finance Outlook 2015)
Structurally, mezzanine finance is subordinate in priority of payment and security to senior debt, but greater in rank to common stock or equity.
Mezzanine lenders generally comprise a mixture of asset fund managers, corporate and investment banks, hedge funds, property companies, sovereign wealth funds and high net worth individuals.
Since the recession tighter credit conditions have led to debt funds becoming more established in Europe offering a variety of flexible debt products to growth orientated companies. The UK remains the largest market for private debt funds in Europe with 47% of the transactions, followed by France with 25% and Germany with 12%. (See British Business Bank 2014, Small Business Finance Markets)
Despite continuing global downside risks the economic recovery is now well underway. The UK economy has grown for the last seven consecutive quarters and such growth is forecast to continue.
Smaller businesses are of paramount importance to this recovery. Small firms account for almost half of turnover in the private sector and 60% of all employment and are expected to remain an important source of job creation and growth in the economy. In addition, nearly half of smaller business (46%) have indicated their intention to grow over the next year suggesting optimism about future prospects. (British Business Bank 2014, Small Business Finance Markets)
Ensuring smaller businesses with growth potential have access to appropriate sources of external finance is vital if these businesses are to realise their full growth potential. Senior debt from a bank or peer-to-peer lending platform meets the financing needs of the majority of businesses seeking external finance for working capital and investment. However high growth businesses can soon exhaust the available collateral that is required by senior debt providers. In addition, interest payments on senior debt can constrain the cash flow of smaller businesses in the early stages of growth.
The 2009 Rowlands Review identified a funding gap in the supply of growth capital for funding amounts of between £2m and £10m and suggested mezzanine finance may offer a solution.
British Business Bank analysis suggests there are around 16,000 companies in the UK that have characteristics that make them potentially suitable for a type of growth loan such as mezzanine finance. The potential for the use of mezzanine finance is related to the size of a business, with larger businesses significantly more likely to be using mezzanine finance compared to businesses with no employees.
In addition, only around 1% of mid-sized businesses used mezzanine finance in 2013. The use of mezzanine finance was found to closely correlate to the size of a business with companies more likely to seek mezzanine finance if they had a turnover of between £100m to £500m (4%).
The use of Mezzanine finance in 2013 by turnover band
|All||£10m to less than £25m||£25m to less than £50m||£50m to less than £100m||£100m to £500m|
Source: British Business Bank (2014) “Access to Finance of Mid-sized Business”
An asterisk (*) denotes any value less than half a percent but greater than zero.
The low use of growth loans by smaller businesses may be explained by a lack of awareness of mezzanine finance compared to other sources of external finance. While 15% of smaller businesses were aware of mezzanine finance, a lower proportion (only 5%) were aware of a specific supplier. This is significantly lower than other types of finance, including crowd sourcing and export/import finance. As with the use of mezzanine finance, awareness significantly increases with the size of a business, with 38% of medium sized businesses aware of mezzanine finance and 19% aware of a specific supplier.
The expected financial returns from investing in growth loans lie between senior debt and equity. Whilst equity investors are looking for an Internal Rate of Return (IRR) in excess of 20-30%, and debt interest rates are currently in the region of 4-5%, growth loan investors are aiming for overall returns in the region of 8-20% comprised of interest and possible performance related payments.
During the period of 2008 to 2014, mezzanine lenders, private equity funds, insurance funds and pension funds stepped in to fill the void left by traditional bank finance and considerably increased their respective market share. Alternative finance providers have been responsible for 50% of all new property lends in the last 3 years resulting in a greater spread of providers across commercial real estate lends.
De Montfort Commercial Property Lending Report for 2014 suggests that over the last six years the diversification of the UK commercial property lending market has steadily increased. Insurance companies represent 12.7% of total debt where other non-bank lenders, including mezzanine finance providers, represent 6.5%, almost doubling their share of 3.7% in 2013. The report contends that “secured lending to commercial property became more attractive to these organisations due to regulatory changes and business opportunities created by the withdrawal of banks from this sector”.
Melanie Leech, chief executive of the British Property Federation, said: “The increasing diversification of lenders has been marked over the past year, and we feel this is broadly positive for the market. Not only will a larger presence of non-bank lenders provide our sector with alternative sources of finance – lenders with different investment horizons and business strategies; a more diverse finance market can also contribute to financial stability by spreading exposure to UK real estate among a greater range of investors.”
CBRE’s UK Debt Prospects report for Q1 2015 states that the changes in forecast returns to UK lenders for senior debt are generally exaggerated for mezzanine debt lenders (here assumed to be 65-80% LTV junior tranche). The gap between risk adjusted returns on senior and mezzanine debt has thus shrunk to 1.5% from 4.1% in 2013.
The Elaine Securities strategy
- Elaine Securities will primarily focus on providing mezzanine finance and asset backed lending to established UK corporates that have a proven track record. The company will also provide funding to SMEs through asset-backed lending.
- Corporate borrowers must demonstrate a proven management team and if possible be supported by 2 years of accounts.
- Security for a loan must include immovable non-liquid assets and consent to covenants to maintain the agreed loan to value ratio of debt to security throughout the term of the loan. Types of assets considered for collateral may include, but may not be limited to, real property, chattels, stock, options and equity.
- Elaine Securities may provide junior debt with the inclusion of loan notes and/or equity, targeting a 10-12% p.a. return on the equity investments and a 7% p.a. return on the fixed notes over a 10 year period.
- For a loan secured against real property the company will require a first charge or may consent to a second or subsequent charge provided there is sufficient equity. Properties should also be located in areas where the value in the security can be realised.
- For development projects a borrower must have a track record in property acquisition and development and demonstrate that prior projects have met agreed completion deadlines.
- An SME borrower must demonstrate that the board has control of operations and that the debt and receivables are managed. The investment risks will be mitigated through lower loan to value ratios, personal guarantees from directors and key stakeholders, and asset-backed securitization, primarily though charges against real property.
- SMEs tend to consolidated their financing requirements between 1 or 2 institutions. In 2014 the largest four banks accounted for over 80% of UK SMEs’ main banking relationships. Regulatory changes, such as Basel III, now makes it unlikely that one institution will be a “one stop shop” for an SME or offer the most competitive price. Whilst many SME loan applications are rejected by the largest banks – in the case of first time SME borrowers the rejection rate is approximately 50% – the reason is often that they do not meet the high level risk profiles of these individual banks. Elaine Securities may vary it’s risk profile to fit individual circumstance and thus allow a proportion of these rejected SME to become viable borrowers. Elaine Securities will seek to benefit from this funding gap as the UK lending market continues to de-consolidate.
- Elaine Securities will engage a network of experienced and respected professionals that will include specialist firms in legal, property, accounting and valuation.
- Particular attention will be given to the risk management to achieve the lowest risk profile for each investment.
Elaine Securities PLC Finsgate,
5-7 Cranwood Street,
London, United Kingdom,
Telephone: 0203 637 6616