The Fuel for SMEs

Today, many small- and medium-size businesses (SMEs) have a hard time getting financing for operations and expansion because banks are applying ever-more-strict lending criteria to their loans, especially in light of the US banking crisis which occurred in the first half of 2023, the repercussions from which are still unfolding.

Nearly half of US banks reported stricter loan standards for small businesses in the first half of 2023, with more than half saying they’re expecting to further tighten lending standards further in 2023.¹ Although this crisis originated in the US, effects are also being felt across Canada as the median value of bank loans to SMEs have fallen over 30% since 2019 and are now below 2012 levels (see Figure 1).

Figure 1: Median Value of Bank Loans to Canadian SMEs ($000)²

At the same time, institutional and high-net-worth investors are challenged to find an investment which offers both return potential and diversification in light of high interest rates and a potential recession.

Fortunately, both SMEs and investors can benefit from private debt.

“Credit in Canada is primarily controlled by six chartered banks. If the bank perceives the risk to be too high, a bank is going to prefer to curtail the credit rather than to price it,” explains Arif Bhalwani, CEO and Managing Director of Third Eye Capital, whose firm is the sub-advisor to the Ninepoint TEC Private Credit Fund II. “It’s easier for them to say no than for them to determine whether there’s a clearing price that can offset potential losses.”

While this degree of conservative underwriting has contributed to a stable financial system in Canada, he says it has also impaired innovation. Canadian business formation rates are pretty much on par with that of the U.S., but there are huge differences when it comes to financing.

According to The Global Competitiveness Report 2019, published by the World Economic Forum, Canada ranks 27th in terms of financing for small and medium-sized enterprises (SMEs). That’s not only lower than Finland (1st) and the United States (2nd), but also lower than Guinea (20th) and Azerbaijan (24th).³

Compared to other countries, Canadian bank loans to SMEs are at a below-average level, with just 12 per cent of business loans going to small and medium-sized businesses, according to 2020 data from the OECD. The OECD average is 44 per cent.⁴

In 2023, research from the Canadian Federation of Independent Business found that well over half (58%) of small businesses needed financing, compared to just over a third (35%) in 2012. That being said, an average of 15% of SME loan requests were denied, continuing a multi-year trend observed by the CFIB (see Figure 2). Additionally, most small businesses had to provide some form of personal guarantee, putting them at personal financial risk in the event of business default.⁵

Canadian SMEs don’t have many financing alternatives besides the big banks. Without an ability to get financing, their growth is handicapped and, in many cases, their ability to create employment for Canadian workers is similarly affected. Innovation, Science and Economic Development Canada notes that SMEs made up 50.4% of Canada’s gross domestic product in 2019⁶ so, clearly, this situation does not contribute positively to Canada’s overall economic growth.

Figure 2: Canadian SME Bank Loan Rejection Rate⁷

The benefits of private debt investing

Private debt involves raising pools of capital from accredited investors and using that capital to provide senior-secured loans to small- and medium- sized companies who meet strict loan criteria but who, since 2008, have had greater difficulties getting loans from banks (see Figure 3).

For investors, private debt offers a number of benefits. Private debt is low in volatility, the default and loss rates are lower than high-yield bonds, and it’s typically collateralized by assets. Another advantage is it has a low or negative correlation to traditional asset classes, which provides greater portfolio diversification. Return potential is another benefit. U.S. middle-market direct lending investments produced a net return over 9.3% from 2005 to 2022 while the standard deviation was approximately 4.8%. Not only did direct lending provide returns greater than the S&P 500 for the same period, but the standard deviation (or volatility) was also significantly lower (see Figure 4).

Figure 4: Cliffwater Direct Lending Index vs. S&P 500, 2005-2022⁸

That said, private debt should be considered as a longer-term investment that plays a specific role in an investors’ portfolio (e.g. diversification, alternate income source), because the multi-year nature of SME loans means that private debt funds are less liquid than public market investments.

In a private market investment, transparency is another consideration as pricing and the loan book are not typically as visible to investors. It is incumbent on the fund manager to provide investors with sufficient insight, transparency, and oversight to make them feel comfortable with their investment.

In all cases, a financial advisor should be consulted to determine the suitability of private debt for a given investor.

Lender and Partner

For certain private debt funds, companies who receive a loan from the fund get more than just capital to expand their business, they also get a partner. Bhalwani says Third Eye Capital considers itself to be more of a business problem solver than a lender. The firm builds a partnership with management teams and stakeholders, which helps build recurring business.

As soon as the firm extends a loan, it will add value by becoming involved in the company. “We’ll augment management, provide strategic direction, bring our industry contacts to bear, help manage costs, and streamline the information systems management relies on.”

Figure 3: What is Private Debt?

Most companies aren’t looking for a permanent partner that will own a stake in the business, they want someone that will help create value and are willing to share some of that value for a period of time.

Third Eye Capital typically invests $20 million to $200 million in a company with annual revenue of up to $1 billion. It’s focused on established companies that have experienced an interruption in their business and need capital to nurse it back to health, or rescue their underlying business. The firm will also look at companies wanting to expand or who are experiencing growth, but who have run-up against banks whose loan timelines and approval cycles are much slower than required.

The bottom line

In a world where investors are seeking better portfolio diversification and additional income streams, private debt presents a strong case for consideration within their portfolios. Beyond offering the potential of strong yields and excellent portfolio diversification, private debt can play a role in helping Canadian SMEs grow and, in doing so, benefits all Canadians by supporting and encouraging innovation, employment, and global competitiveness. Everybody wins.

1 https://www.wsj.com/articles/new-borrowing-hurdlesleave-small-businesses-in-limbo-89cf1ea3
2 Financing Main Street — Research Series, CFIB, July 2022
3 The Global Competitiveness Report 2019, World Economic Forum.
4 https://www.theglobeandmail.com/business/article-entrepreneurship-recovery-covid-canada/
5 https://www.cfib-fcei.ca/en/media/more-small-businessesneeded-financing-over-the-last-decade-but-collateral-requirements-and-interest-rates-make-it-harder-and-more-expensive
6 https://ised-isde.canada.ca/site/sme-research-statistics/en/key-small-business-statistics/key-small-business-statistics-2022
7 Financing Main Street — Research Series, CFIB, July 2022
8 https://cliffwater.com/files/cdli/docs/Cliffwater_Report_on_US_DirectLending.pdf