Wednesday, 24 January 2018 03:16 GMT

UAE- 'Dry powder' is critical for GCC SMEs' growth pangs

(MENAFN - Khaleej Times) The global financial crisis has been a game-changer for the private debt market as it is now widely accepted as an asset class of its own.

The increase in both supply and demand is having a significant impact on how alternative lending funds are being used. In recent years, not only has there been an influx of new entrants, but there is also now a far greater diversity of investment strategies. The banking industry's thrust to become leaner and clean up legacy problems have forced banks to re-evaluate less-profitable and high-risk sectors, which has resulted in private debt markets gaining prominence since 2012.

Additionally, central banks resorting to reduced interest rates to near zero to stimulate economic activity have reduced the attractiveness of fixed income securities, which has boosted private debt markets as an asset class consideration for investors. According to Preqin's recent survey, the weighted average return on private equity (PE) stood at 7.5 per cent, while it was seven per cent for private debt coupled with stable cash flow streams, thus taking it into newly emerging asset allocation models.

The private debt market is not a new phenomenon, but has picked up pace in Europe, overtaking the US to become an integral market for investors.

On the demand side, the private debt market is driven by the fallout of the banking industry's thrust to adhere to changing regulatory environment and tightening liquidity. Hence, the changes in the lending space have emerged as a drag on growing SME businesses, bringing alternative investments in the form of private debt to fill the incremental lending vacuum. The supply side has been clearly driven by the diminishing yields in the traditional fixed income markets, especially investment grade bonds, which is leading investors to explore alternatives to shore up average returns of investment portfolios.

In addition to demand from global PE managers, demand for private debt is also increasing among pension funds, insurance companies and endowments who value high-yielding assets in which they can invest for the medium to long term. For pension funds and insurance companies, it provides a level of protection and return to meet their needs, while start-ups and SMEs have easier access to finance for long-term investment and structuring.

According to a 2015 Preqin report, the private debt industry has nearly tripled in size between 2006 and 2015 as assets under management have grown from $152 billion to over $500 billion during that period. In 2015, private debt witnessed strong demand from institutional investors, with fund raising reaching a six-year high of $85.2 billion in capital commitments compared to $72.2 billion in 2014. Distressed debt funds recorded growth for the first time since 2012 in fund-raising activity to reach a total of $23.3 billion across 16 funds.

Investment hubs

Additionally, emerging markets have grown to be the potential investment regions in the last few years, with Asia being the primary geographic focus garnering around 54 per cent of total investment. Countries like India, Hong Kong and South Korea, in particular, appear to be providing valuable opportunities with most of the Asia-focused funds investing in the region. Factors such as growth of SMEs, combined with macroeconomic factors such as low interest rate, relatively predictable yields and economic recovery along with minimal regulations, continue to reinforce the growth in private lending in the wake of banking disintermediation across the globe.

The Middle East is experiencing a period of softening growth along with rising deficits, which has led to historically-low returns across asset classes since 2014. As a result, the hunt for higher yields has entered a new territory within the Mena region in general and GCC in particular, which has led to the emergence of private debt, albeit selectively among investors with longer-time horizons with the aim to exploit the current illiquidity crisis. The importance of private debt as one of the core components of funding cannot be underrated for fast-growing, medium-sized companies in the GCC region, which is currently witnessing a grassroots revolution in building a strong SME structure.

Developing the region's SMEs has so far moved in a positive direction, with every GCC country establishing specialised bodies and developing regulations to support them. Most notably, the GCC SME industry is becoming an increasingly important contributor to the GDP due to the much-laid emphasis on economic diversification.For regional SMEs that are exploring non-traditional debt sources, there are a series of options that have emerged over the past couple of years. There are tailor-made products such as peer-to-peer lending, crowd funding, etc, for fast-growing small- and middle-segment companies that have leveraged low operating costs, minimal regulations and big data technology to provide quicker access to cash.

However, GCC businesses with riskier models or the ones which are currently distressed and cash-strapped are the ones which now have a new avenue to gain capital through private debt. Additionally, the private debt market is going to be a crucial vehicle in the region, with the UAE being the first nation to approve a bankruptcy law, paving the way for cash-strapped businesses through effective debt restructuring mechanisms, with an aim to end imprisonment or criminal prosecutions in case of insolvency.

For example, under the new UAE insolvency law, the advantage of exploring the private debt option for a borrower will enable them to focus more on structural customisation to match their financing needs compared to bank financing. Private lenders have also earned a reputation for being faster, more flexible and more predictable counterparties than banks. The disadvantage is generally the pricing as private loans tend to be more expensive than bank loans.

However, lack of proper regulations in place and a failure to comply with Islamic law within the region demand a cautious approach for successful implementation of newly-formed lending strategies. Also, brand presence and perception play a crucial role in the regions, such as the UAE, where severity of penalty is associated in case an expatriate fails to pay the private loan, putting a question mark on the integrity of such financial institutions. Nevertheless, with banks slowly stepping back from the debt segment and demand for direct funding outpacing supply, the private debt sector is only going to rise further. This does not mean a complete exit from traditional platforms such as banks from the lending space, but rather a potential for more collaboration with private lenders, bringing opportunity and growth to the private debt segment driven by aggressive fund-raising.

Although the private debt market is at a very nascent stage, with selective pockets providing such lending facilities, it has the potential to become an attractive asset class similar to the success witnessed in the US and Europe. Further, the positive change in sentiment towards alternative lenders has also opened opportunities for SMEs and institutions alike.

Private debt has the potential to become a dominant lending avenue for development of fast-growing SMEs. However, the regulatory environment will be critical for growth going forward, and the private debt market's ability to operate and adhere to stringent and rapidly-changing regulations will be key to its success.

The writer is founder and CEO of Al Masah Capital. Views expressed are his own and do not reflect the newspaper's policy.

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