By Tom Lloyd-Jones, co-founder & principal at Zenzic Partners, a merchant bank founded in 2014.
The Covid-19 crisis has seen an unprecedented outpouring of public funds, with trillions having been spent globally through various liquidity measures as economies all over the world fight to stay above water. In the UK for instance, current government initiatives are already in excess of £130bn and there are almost daily calls to go further and faster.
Despite the urgency of demand for capital, discussion about the role and potential of private capital has been noticeably quieter. Why this is the case is not all that clear, but what is more certain is that the depth, diversity and expertise of private capital will be vital for both the short-term rescue and longer-term economic recovery.
Particularly in terms of private credit, as shown through a comparison with the capital markets in 2007-2008. In 2007, more than 90% of all corporate lending was delivered via the banking sector; now it is less than 60% with billions of lending activity shifting to private funds. The direction of travel is towards the US where only a quarter of all corporate debt is bank provided.
There is an estimated £250bn of dry powder in private debt funds. They have proliferated across sectors, asset classes and capital structure carrying specialism in leveraged finance, direct lending, ABLs, bespoke asset financings, and special situations, to name but a few. With the growth of these funds has also come an increase in the expertise, ingenuity and, perhaps most importantly right now, entrepreneurialism of private credit markets.
They are able to evaluate changing situations quickly and can invest in structurally innovative ways across the capital structure. Further, they have the capability to offer solutions to businesses in times of stress and uncertainty, while also providing the catalyst capital necessary to drive the innovation and growth that will be the only true route out of these present difficulties.
We have started to see this in practice already with well-known companies like Airbnb, United Airlines and Expedia given funding that will help them weather the storm and hopefully resume even more strongly. But even in less well-known industries, it is private capital that will be the answer.
For example, private capital will be essential to help businesses match the growing demand for e-commerce. Life science funding will be needed to develop tests, vaccines and treatments – all of which will be vital in the post-Covid world. The challenge of connectivity in a remote working environment will be met and overcome by new technologies built and funded by private enterprise.
This brings us to the question of what can be done to ensure we maximise the potential of private capital. Valuations will be difficult. Business and asset owners will have to accept that there will be a new funding environment for some time. There is also a risk of a form of deflationary spiral where private capital delays, fearing that fundamentals may move further downwards.
Lessons may be able to be learned from valuation mechanisms in venture capital industries and the use of convertible debt to bridge valuation gaps. Private fund managers are willing to be brave but not reckless. It is tempting and often easiest to adopt a wait-and-see approach or to batten down the hatches and focus on existing portfolio investments. But our experience is that where transactions represent value they are being pursued.
Fiscally, there is a range of initiatives governments could consider such as a form of tax shelter linked to the amount of a principal investment in a given company. This would have similarities to the UK's Enterprise Investment Scheme and Seed Enterprise Investment Scheme, but at a much larger level in terms of the amount of investment and directing the tax relief towards the recipient rather than the investor of funds.
Capital investment could be accelerated by making 100% capital allowances in the first year of incurrence across all such expenditure. More obviously, National Insurance contributions on new hires could be removed for a defined period, giving employers a ‘use or it lose it’ incentive to hire. Such tax shelters will aid cashflow and boost investor returns without an immediate cash hit to the Exchequer.
Finally, in terms of securities markets, there is a range of initiatives already in existence but whose potential has yet to be tapped. Social bonds for instance could subsidise pharmaceutical R&D and support growing businesses in development of technologies and products necessary to adapt to a post-Covid environment. The first Covid social bond was issued by Bank of China to support SME enterprises – it raised US$638m-equivalent and we would expect more to follow. The stage is set for them to move from a niche funding strategy to the mainstream.
In the UK, this thematic could be adapted through revisiting the high costs and regulatory burdens of the UK’s existing bond market. Even with the advent of the Order book for Retail Bonds, those costs make it suitable for large companies seeking to raise debt of £100m or so. Instead, a dedicated bond exchange for SMEs (equivalent to AIM on the equity side), where businesses can raise quickly and cheaply sums from £10m-£50m, could kick-start SME investment.
There is clear international precedent for such a market. In Italy, hundreds of companies have raised more than €1.5bn in bond issuances averaging just €8m per issue. SME funding must not be ignored. The overwhelming majority of UK firms – some 99.9% - are SMEs. They generate £1.8trn in turnover and are responsible for 60% of private sector jobs.
Government funding has certainly assisted in the peak of the crisis, but the recovery will depend on private capital markets. It is essential that they should be encouraged and even lionised to lead that recovery.
Zenzic Partners is a merchant bank founded in 2014. It focuses on delivering best-in-class advice to its clients across three strategies: debt advisory, growth equity and capital markets. Zenzic also makes principal investments across numerous asset-backed sectors to support high growth businesses.