We have all seen the figures about this huge explosion in the size of direct lending and it’s been untested through a full credit cycle. No one knows what the true risk of this lending is going to be and whether there is a fair compensation for some of this illiquid SME lending.


I might be wrong. It could be that when this credit cycle ends, because we know that there will be an economic downturn, SME credit does better than cynics like me think. Nobody knows the answer to that and caution is wise at this point, especially as we are getting towards the end of the cycle and spreads don’t seem that exciting once you have paid manager fees. We don’t know what the credit losses are going to look like when we get that downturn. Halfon: We have some analysis on the spreads. In SMEs you can get about 700 to 900 basis points above libor, and sometime more, net of fees. Basically, you are doubling the size of your loan portfolio every six to nine years. Historically, the average level of default is around 1% to 2%. If the economic environment gets very bad, we will probably have other things to worry about, like hunting for food. The extreme scenarios are probably very far out, but many of those SMEs have pledged assets like houses and a downturn could materially impact the lives of the entrepreneurs. Pickford: In 2008, the epicentre of the credit crisis was not corpo- rate loans or SMEs. The danger is that the epicentre of the next cri- sis shifts to where we’ve seen credit build up.


Sometimes we see attractive spread offers, but from the econom- ics side of this, the risk is quite uncertain because it is an unprec- edented cycle. We don’t know how it’s going to evolve. Therefore, when we allocate to private credit, we tend to like cautious manag- ers. When looking at bank capital relief, it looks an attractive risk/ return-trade off, but some of the riskier untested business models look more questionable. Wilgar: I’m not sure if I have ever believed in the notion of an illiquidity premium. If something as definable as that does exist, then it is not necessarily always a premium. It can be negative. At the end of 2018, the illiquidity premium was probably nega- tive. On a risk-adjusted basis you would have been better paid for high-yield credit. It comes in waves and troughs and is not reliable. Pickford: It’s certainly time bearing. If the illiquidity premium exists, it is relatively depressed at the moment, perhaps not as depressed as it was at the backend of 2018. Cielinski: You need to make sure not to confuse the illiquidity pre- mium with true credit risk. There has been a tendency in the past few years to believe that anything illiquid yields more. Disruption is setting new peaks and the ability to forecast if an SME will be around in five to 10 years is as low as I can remember. This is the disruptive force that we are seeing in many industries. As a believer in sectoral economics, you seldom find the next cri- sis occurring in the same place as the last one. You get a build-up


We have seen lenders fighting for a deal and so the price becomes economical in its risk. Ben Shaw, HNW Lending


14 March 2020 portfolio institutional roundtable: Fixed income


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