Recent volatility has reinforced a simple truth: partnership is crucially important in a changing environment. At Quilam we are more than just a capital provider; we take an active management approach to supporting all aspects of business development including credit performance, operations, governance and capital markets, helping make it happen.
In recent years, we have gotten used to navigating through “once in a generation events” on what seems to be an annual or even more frequent basis. Our partner platforms, who we support through senior debt, junior debt and equity capital, have successfully navigated these challenges with extraordinary skill, innovation and enthusiasm of which we are extremely proud. Whilst we continue to see strong underlying asset performance and growing origination, we are seeing changes in some institutional lender behaviour reminiscent of 2008.
| “Only when the tide goes out do you discover who’s been swimming naked”— Warren Buffett |
In credit, these are the moments when relationships are tested. To borrow one of our favourite quotes from the great Warren Buffett, “only when the tide goes out do you discover who’s been swimming naked”. The tide has been receding since several high profile US fraud cases last year, accelerated on our own shores by the recent failures of MFS and Century Capital. What we have seen since has been a mixture of calm right through to outright panic, with lenders backfilling what we consider basic diligence. From the largest bank board rooms to the leanest private credit investment committees, the question on everybody’s lips is how has this happened?”
There are at least five possible perspectives:
1. We are not exposed to bridging finance and / or these names, nothing to see here;
2. Diligence standards are fine, if someone wants to commit fraud they will find a way to do so;
3. There’s never just one cockroach in the kitchen, time for a full investigation on the portfolio, re-underwrite all positions, but lending is selectively open;
4. Outright panic, mandate removed, exit all positions; or
5. The market has become too hot. Capital in a specialist asset class has become a commodity and there has been a blurring of debt and equity risk. To drive AuM deployment there has been a lowering of required returns, structural requirements and diligence standards.
It will not be a surprise to hear our perspective is bullet five. Our diligence requirements are honed from decades operating in these markets and we prioritise capital preservation over deployment. We have seen investors competing on equity risk with sub-mezzanine return requirements with little to no diligence. The market has been overly exuberant and the consequences are evident; we expect to see a reset on the availability of capital and management teams should plan accordingly.
| “We expect to see a reset on the availability of capital and management teams should plan accordingly” |
We have seen and heard of several instances where basic diligence fell short: no site visits, borrower instructed AUP audits, samples selected by the platforms, the list continues. Somewhere along the way, some institutional lenders seem to have forgotten a simple principle, ‘show me, don’t tell me’. This is not new; those of us who have operated in these asset classes through multiple cycles, have seen capital availability from banks and private credit enter and then leave. Not as predictably as the tide, but just as inevitably.
The alternative lending asset class across consumer finance, auto loans, small business lending, bridging finance, asset leasing and many other products is a fundamental part of the financial ecosystem. It provides essential access to capital solutions as well as product innovation in an exciting, diverse and sustainable asset class, to both work and invest in. For these and many other reasons, Quilam remains absolutely committed to the specialist finance market.
However, investing requires experience and discipline to analyse performance, regulatory and legal diligence, collateral cash testing and know the calibre of management teams you support. Recent dynamics point to a market in transition. Scrutiny is increasing, credit availability will tighten and now is the time for C-suites to ensure certainty of capital, as some of their peers will not. Barriers to entry will be higher and the opportunity for well positioned platforms will be significant.
The ongoing Iran conflict has reinforced inflationary pressures, contributing to a higher-for-longer rate environment and increasing the underlying cost of capital. At the same time, geopolitical uncertainty and supply disruptions are feeding through into broader economic conditions.
Despite the sustained headwinds we expect consumers and small businesses to be resilient given continued strong employment and productivity. As in prior cycles, outcomes will diverge. Businesses with strong capitalisation, disciplined underwriting, and aligned funding partners are better positioned to navigate periods of adjustment. Increasingly, competitive advantage is also shaped by the ability to harness data and technology, especially AI, to improve decision-making and operational efficiency.
In recent years liquidity has been abundant, spreads were compressed to historically tight levels, and some investors traded credit risk, returns and structural protections for capital deployment. Capital moved quickly, often masking differences in credit quality and underwriting discipline. The high-water mark of recent years has certainly been reached, and as the market begins to ebb the strong spring tides will follow.
In an asset class built on data analysis, technology, and receivable level audit and legal diligence, we can find the recent ‘cockroaches’ of great interest for discussion, but these appear to be sophisticated criminal enterprises run by individuals within a wider firm. Their actions erode trust in a structurally important asset class providing significant access to capital for consumers and small businesses.
Our outlook is this an opportunity to reset credit standards in respect of diligence and structuring, but we believe in the market fundamentals and the essential services specialist finance companies bring to consumers and small businesses. If there is a need across the capital stack for senior debt, junior debt or equity capital then we would love to speak to you. Swimming costumes preferred.
| “Quilam remains absolutely committed to the specialist finance market” |