M&A time for specialist lenders

Over the past five to 10 years, a swathe of new entrants have stepped into the non-regulated property and SME finance sector to fill voids left by banks, leaving a fragmented market.

Family offices, hedge funds and specialist credit funds have got in on the act alongside or in place of wholesale bank funding. As Julian King of broker Arc & Co stated recently: “Leverage is increasing as rates are falling.” It is a great time to be a borrower and the number of market players is driving that.

Market fragmentation makes M&A scenarios likely in the next 18 months. Challenger banks are aspiring to break into the top tier, but as their cost of capital cannot compete with the so-called ‘big five’, they will struggle to achieve scale. Size matters, as a larger balance sheet brings cheaper equity into play and cuts return on equity, thus bringing down costs to consumers.

Challenger bank mergers will bring cost savings. Operational costs on the non-origination side are substantial, especially in complying with PRA regulation. For example, one bridger-lender-turned-bank made a loss equating to 20% of its equity, driven by the cost of compliance in its first year as a bank.

Bridging and development lenders will be acquisition targets for buy-to-let lenders, because the margins on BTL and regulated mortgages are very tight, whereas – despite the increased regulatory capital requirements – the net interest margin pick-up on banks’ short-term lending can be substantial (as well as being a gateway to ‘term’ business), driving up share prices.

Meanwhile, new fintech banks with banking licences but no lending infrastructure (or loans) to speak of will look at speciality finance acquisitions. Why spend 24 to 36 months building up a book when you can buy one, plus an origination and underwriting team, and achieve your aim faster?

At the SME end of the market, many £50m to £100m lenders will come on to the radars both of each other and specialist PE buyers. Larger books can attract cheaper capital, whereas SME speciality lenders are more reliant on more expensive challenger banks for funding.

With pricing under pressure, SME lenders are being forced to write higher-risk business or to reduce loan book sizes. There is an opportunity for PE-backed acquisitions of specialist lenders to achieve the scale and diversity of coverage that attracts competitive capital costs.

Other M&A drivers for smaller players could be cost/efficiency savings and the threat of regulation over the coming years. The increased costs of compliance may make smaller lending businesses unviable, unless costs are absorbed across a bigger revenue base.

A final threat to SME lenders could be the ‘Americanisation’ of the UK specialist finance market, whereby institutional funders ‘white-label’ their funding via larger brokers/packagers and bypass SME specialist lenders.

A good defence against this will be driven by cost of funds and product differentiation (eg development lending vs bridging/BTL), which is more complex to originate and service. Mergers of lenders covering complementary sectors may take place as a result.

Michael Dean is a principal at Avamore Capital