Alternative finance: Helping Britain’s 'gazelle companies' to leap the funding gap

Small businesses can't get money from the bank, and their needs are too large for crowdfunding platforms. Mini-bonds are the answer for them but are they good for investors?Take it from me there's a funding gap in British business. The high-street banks can bamboozle you with all the data they want. But anyone who's ever dealt with our small-to-medium-sized enterprise (SME) sector knows there's not enough capital to go around. Alternative finance is trying to plug this gap and it's succeeding, to an extent.

A recent survey from the UK Bond Network revealed that 68% of SMEs would consider using alternative finance to raise funds. This rose to 94% of those with annual turnover above £1.1m. More than 75% of these SMEs reckon poor access to funding is holding them back.

This point on size matters. When people think of alternative finance, they tend to think of peer-to-peer (P2P) lending, or equity crowdfunding. It's all very glamorous but also fairly untypical of the bog-standard British SME, especially the medium-sized ones. These businesses range from family firms, many of which are happy to grow at a steady rate, to "gazelles" growth-style businesses that will be the UK versions of the German Mittelstand (Germany's industrial and business bedrock). These businesses many of them profitable, with turnover in the tens of millions aren't interested in selling equity via a crowdfunding platform, and their funding needs are usually a bit too chunky for online loan platforms. They typically want to raise £0.5m to £10m over three to five years.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

So what do they use instead? Good old bonds. The lines between a loan and a bond have become blurred in recent years, but the draw for investors remains the same lend to an established business for a decent time period at a coupon (annual interest payment) that should be well above the average savings account. The UK boasts a huge corporate bond market where well-known names borrow at ridiculously low rates these businesses don't have to worry about haggling with their bank manager. Further down the food chain, there's the retail bond market, run by the London Stock Exchange. This has opened up funding opportunities for mid-to-small-caps who can issue a bond for up to six years at rates only marginally above levels they'd have to pay on the wholesale capital markets. But many of these retail bonds come in issues of at least £50m by the time all the fees have been paid, far above the funding needed by much of the SME sector in the UK.

Hence the rise of the "mini-bond". This is effectively a form of retail bond for the "juniors" ie, a bond structure for smaller businesses who can't afford to pay the associated fees. Mini-bonds are typically used to raise £0.5m to £10m. The market is growing in the UK. But we are still a long way behind continental Europe. In Germany, a Mittelstand bond market has been operating in Stuttgart, Dusseldorf and Frankfurt since 2010. This gives businesses with turnover of between €50m and €1bn access to funding from retail investors. If your German is up to it, have a look at anleihen-finder.de. More than 280 businesses are issuing bonds more than €7bn has been raised. The average yield for a six-year term is around 7%, partly reflecting the risks the Financial Times last year noted that many issuers have gone bust, with 26 corporate defaults and four selective defaults across Mittelstand bond markets since 2010. Yet the market hasn't shut down despite these setbacks, and businesses are happy to pay an extra 2% a year in loan expense over bank lending because it's an alternative funding source.

So the UK still has some catching up to do, but alternative finance is making headway in mini-bonds. Crowdfunding platform Crowdcube has probably made the most noise one of its campaigns featured the Chilango Burrito bond, an 8% bond that closed in autumn last year. But Crowdcube is far from the only player. Wellesley & Co has dipped its toes into the mini-bond market, with its own product secured on Wellesley Finance Plc and its book of secured lending to businesses and property owners. This pays 6% for three years and 7% for five, and can be held in a self-invested personal pension (Sipp). The underlying asset backing is Wellesley's own book of loans, in turn based on assets well in excess of the value of the total loan book. Meanwhile, CrowdBnk has an innovative bond from Hambledon Vineyard. The English Fizz Mini Bond is a secured and convertible offering paying 8% a year over five years. There are three key differences. Firstly, the interest is rolled up and paid out at the end of the term. Secondly, the bond investors can convert into equity at the end of the term at a "discount" price. Lastly, investors can also get free bottles of said English fizz if they invest enough.

But investors should take care. Too many of the recent issues have offered equity-style risk with wholly inadequate returns. Investors need to do their homework on the issuers themselves and demand more transparency from the platforms (see the box for tips). Lending, even to established, profitable "gazelles", is risky. If Zopa and RateSetter will offer 3% to 6% for lending to consumers, with a protection fund thrown in, I can't see why anyone would lend to a private, smaller business for much under 7%. Maybe a very established mid-sized business could get away with 8%. But if you are buying a single-issuer bond, 10% is the minimum. For smaller, earlier-stage businesses like those on the big crowdfunding platforms, I'd want well over 10% a year.

Smaller, more specialised players are in fact offering this level of returns, especially the UK Bond Network. In March it offered its investors (sophisticated private investors and institutions) a form of mini-bond that could become very popular. The borrower was a well-established, profitable firm called CIP Recruitment, which wanted to borrow up to £1.5m for two to three years at rates between 7% and 10% a year. The £30m turnover business has earnings before interest, tax, depreciation and amortisation (Ebitda see page 44) of just under £2m. There's also in effect a revenue kicker. This option gives investors 15% of any of the rise in profits over the loan term. This bond ticks many boxes for me. It's a solid, reputable business, with profits and real growth potential. There's also some participation in the upside, and the yield looks fairly attractive.

Abundance Generation is also worth a look. The platform has been building a portfolio of renewable energy-based debenture issues it's currently got one for a solar project in Berwickshire that offers a 7.5% return. These debentures are longer-term investments usually 20 to 25 years but they are backed by income-producing assets, while the financial structures are transferable (unlike many mini-bonds). Crowdfunding researcher All Street has just put out a free report on this new product you can find it here.

Read more about alternative finance at my website, altfi.com.

The risks to watch out for

Mini-bonds are at least as risky as small caps, with none of the equity upside. I concentrate on four key factors.

1. Issuer risk

Get the accounts and think about the longevity of the sector is the industry faddish? If you are confident the business will still be around in a few years, focus on the cash flows and see if there's enough coming in to pay the bond back.

2. Security and subordination

Most bonds aren't secured against any assets. They may even be heavily subordinated other lenders might have a more secure claim should the firm go bust. So you need to understand the hierarchy of security.

3. Liquidity and transferability

Most mini-bonds cannot be transferred, unlike retail bonds issued on the London Stock Exchange. In other words, you can't sell you have to wait for maturity. Over time, platforms might offer a secondary market, but this needs to offer genuine liquidity (ie, you need to be able to buy and sell at a decent price) to be of any value.

4. Main market opportunities

An 8% yield might sound great, but yields on some other asset classes admittedly specialised aren't much lower than the headline rates on some mini-bonds. Many listed, asset-backed, closed-end funds, offer 5%-6.5% and these are very liquid instruments with high transparency. Retail bonds are similar you can get 5% for lending to well-known names. Is 8% really worth the extra risk for a mini-bond?

M&G's James Tomlins adds his take at bondvigilantes.com. He suggests any mini-bond issuer should tick these boxes.

1. Call option protection

If an issuer wants to redeem early (the "issuer call option"), the investor should get a premium to the bond's face value to offset the loss of potential coupon.

2. Adequate financial disclosure

Historical audited accounts including full balance sheet, cash-flow statement and profit and loss must be disclosed and a commitment made to update investors with new accounts on a timely basis.

3. Explicit security and/or collateral over assets

In the eventof a default, the ranking of the bond in the capital structure should be made explicit with reference to any balance-sheet assets.

4. Equity participation/return

In the absence of any security or collateral, if an issuer wishes to finance aggressive expansion, it is only fair that an investor who risks their capital shares in the upside either via a high coupon, or some equity participation.

5. Restrictions on payments and leverage

A company's ability to strip cash out in the form of dividends at the expense of bondholders should be explicitly limited, as well as its ability to raise further debt that poses a risk to existing creditors.