With lending conditions improving and an increasing appetite for alternative finance, the prospects for UK growth look healthy. Malcolm Small assesses the findings of an IoD survey on SME funding
After eight successive quarters of growth in the British economy, businesses are reviving the expansion plans which they put on hold during the depths of the recession.
Any business plan is uncertain, but for many companies the risks will not be even contemplated unless financing can be found. These plans may need investment to succeed and if finance is not available, or constrained, new businesses are unlikely to develop.
The risk of this happening is especially acute for SMEs. According to a recent report from the British Business Bank, small companies account for almost half of all turnover in the private sector and 60 per cent of employment. The same report suggests that nearly half of these businesses now have growth plans – emphasising the increasing appetite for financing.
We took the temperature of IoD members regarding finance for growth. Our plan is to run this research annually, and to track changes as they occur. More than 1,300 IoD members responded to the survey, giving over 60 pages of verbatim comments.
This response gives us a rich data source and strong qualitative insights. We’ll examine what members are saying later, but first let’s look at the survey results. Our first question sought to find the most important sources of business funding over the last few years, and the results were surprising.
Only just over a third of respondents used bank lending, with retained profits being reported by nearly two-thirds of respondents as their main source of funding.
We had expected a higher figure for bank loans. Other sources scored strongly as well, with funding from family and friends cited as being the main source of funds by over 17 per cent. Secured and unsecured lending, such as credit card agreements, were used by nearly a quarter.
The diversity of funding sources is also striking. Later questioning also exposed the early stage use of peer-to-peer lending and crowdfunding. There are clearly many businesses that want to avoid debt altogether when expanding, while many successful and growing businesses have never been in debt and sit on substantial cash balances.
For those that had sought external finance, we were interested in how easy they thought it had been to obtain. The jury appeared to be out here, with 20 per cent reporting the process to have been “easy” or “very easy”; 18 per cent “neither easy not difficult”; and 28 per cent “difficult”. Of this last number, 12 per cent said it had been “very difficult”.
Anecdotally, these results suggest a picture that is easing from what were difficult times for banks when the recession was deepest. However, there is also clearly some way to go, judging by reports we found in the verbatim comments.
“The banks have no appetite to lend” was a fairly typical response. There was reference to some sectors being singled out as unattractive for banks to lend to for whatever reason, with the construction industry being mentioned more than once.
Businesses recognised that at least some of the blame for adverse lending decisions can be laid at their own door. “My business plan simply was not robust enough” was typical of a handful of candid comments.
This sense of the lending landscape improving was borne out when we tested for views on those conditions strengthening or otherwise over the last three years. Seven per cent of respondents felt things were very much, or much, more difficult; 28 per cent suggested no change; and 29 per cent were experiencing better lending conditions.
However, this picture appears to be coming at a price. When we asked about lending costs and the security required for a loan, it became clear that banks are charging more for lending, as well as demanding more security.
Only two per cent of those questioned reported falling lending costs and lower security, whereas 27 per cent felt these had increased “somewhat” or a “good deal”, with 20 per cent reporting no change.
Although not good news for business on the face of it, on the flip side of policy this could be represented as greater “prudence” by lenders in the light of the lessons of 2008. At least lenders appear to be lending once more – even if they want more in charges and security to do so.
Clearly, business lending contracted sharply in the recession, which hit particularly hard the very banks upon which UK companies have relied. Policymakers identified that banks’ capital bases were too weak to withstand major market dislocations of the type witnessed in 2007/2008.
This led to an urgent regulatory requirement to recapitalise, a process still under way with the Basel III accords. At the same time, policymakers wanted banks to lend freely to restart the economy. They were subject to criticism for not being strong enough, not lending enough, mis-selling interest rate swaps and paying their staff too much.
This criticism continues to this day. However, there is only so much money in any bank. It can be used to make the bank super-safe, or it can be lent to businesses and individuals, but it is difficult to do both well at the same time – if not impossible.
Added to this have been a range of policy interventions to encourage lending or, effectively, to underwrite it by government. Some success is claimed for these initiatives but it is suspected that only hindsight will tell us how effective they have really been.
As we have seen, the effect of all this may well have been to make businesses much more self-reliant, storing up retained profits to fund growth.
The danger is, of course, that this approach can delay investment and growth until the necessary funds are built up, whereas timely and adequate lending can accelerate matters sharply. This has knock-on effects for growth in the wider UK economy and for employment.
Markets, however, abhor a vacuum, and as the traditional sources of funding have become restricted, new channels have opened up the lending market and some existing resources have become bigger.
Sweden’s Handelsbanken and other ‘challenger’ banks have grown larger or have entered the market. Innovators such as Atom Bank will launch this year and, even if entrants such as Metro Bank are not really about business lending, the sheer fact of their arrival should encourage us in the belief that free markets work.
However, the challengers received little mention in the verbatim comments, and we should not underestimate the “inertia” effect in business banking, with evident reluctance among many businesses to “shop around”. There was some feeling that doing so might terminally upset existing arrangements and make the situation worse rather than better.
Genuine innovation is arriving in business lending, and respondents to our survey had a lot to say about it. We’ll return to this topic shortly, but first, let’s look at some of the sources of alternative finance business is using. We tested for use some of the established, and relatively new, sources of finance.
Rise of alternative finance
Dragons’ Den-style angel funding by private individuals has been around for many years. However, there is a sense in the markets of it having become more widespread and organised in recent years, with local and national associations to support angel investment emerging – often seeking to connect funders and borrowers.
This has combined with the online world effectively to create investment platforms. Similarly, private equity funding has been known and used for many years, but the scale of its reported use feels more substantial than might perhaps have been expected.
The emerging story for business finance is in peer-to-peer lending and crowdfunding. These are two distinct markets, with the first being about interest-based loans and the latter focused on taking equity positions in start-ups or established businesses.
This is itself a sweeping generalisation; the market is characterised by a huge variety of business models, but all are predicated on the internet as a tool to create online platforms to connect willing investors with businesses seeking funding.
Although the headline numbers – with an aggregated five per cent using these routes to obtain finance – look modest today, we know from other sources, such as a recent report from Nesta, that this market is expanding exponentially.
This is also borne out by the extensive discussion about these funding sources in the verbatim comments, which is far out of proportion to the reported actual use of peer-to-peer lending and crowdfunding.
It seems to be an approach whose time has come and is regarded with favour by business. One comment was “The bank took too long to provide a promised £100k in funding – seven months. We needed this funding to complete a project and crowdfunding was provided within three days.”
The commentary from respondents is overwhelmingly favourable in terms of their experience, but one downside statement was “Very quick, but not cheap”, suggesting that competitive pressures may have some way to go to develop in this market.
Equally, there is a sense of a desire to use anything that is “not a bank” for business funding, and there is also a sense of the same sentiment from policymakers, who have been supportive of the development of this market.
This is not to say that the market is perfect. There is a clear risk of, and potential for, fraud – particularly with crowdfunding.
The Financial Conduct Authority has also voiced concerns about the way in which risks to investors are disclosed (or rather not revealed in some cases) in promotional material.
Strategically, however, all the indications are that these markets will become increasingly significant for business finance over the coming years and that this is a process that may happen quite rapidly.
Invoice financing also appeared in verbatim comments as a source of finance, although not frequently. Online invoice financing businesses, such as MarketInvoice.com, report rapid growth.
Government-supported funding initiatives were only rarely mentioned and then in negative terms. “Government funding support is incredibly complicated” was typical of the commentary.
A director’s loan account was mentioned just once as a funding source, which is surprising given the tax advantages to a company which takes this approach.
Enterprise investment schemes were similarly cited only once, although five per cent of survey respondents claimed to have obtained such funding. Overall, the tone was very much of businesses funding their own growth internally.
The key findings
Businesses rely strongly on retained profits for funding: This finding surprised us. Whether it is the effect of the recession making companies averse to debt, or the slowdown restricting bank lending, businesses seem keen to avoid debt where they can.
A typical proud comment was “We have no borrowings and use cashflow to fund growth”. There was a strong sense of nervousness around debt of any kind among many commentators, including bank debt.
Business lending is easing: Business lending is becoming easier to obtain than it was in the depths of the recession, but there remains a sense of restriction.
Some sectors appear unattractive to lenders and many survey respondents still seem to be experiencing problems in obtaining loans. However, the situation seems to be improving from a low base.
Free markets are working well to produce alternative finance sources: As traditional sources of lending have contracted, new avenues are emerging – sometimes supported by policy initiatives.
Challenger banks and online platforms are enjoying success and expanding their services to business. Further innovation can be expected so long as traditional lending sources are perceived to be restricted.
Peer-to-peer lending and crowdfunding will grow exponentially: There can be little doubt that these sources will get ever more important to business and it is significant that the banks themselves are starting to take an interest in them.
Business needs to be able to readily access funding for growth. Any restriction in such finance, where there is a good business case for it, is bad for growth, and employment.
Lending conditions for UK plc do now appear to be easing and new sources of funding are appearing. So long
as this situation continues, the prospects for the growth story look good, but policymakers must understand that banks cannot be asked to do two things at once – recapitalise and lend more.
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