The New Challenges and Opportunities in Participation and Investment

(upbeat music) - Welcome to the LEK Financial Services Insights interview series, where we interview top leaders in financial services about trends, insights, opportunities in their markets. Today, we're talking to Richard McDougall, partner of Cabot Square Capital Private Equity Firm, which has significant focus in Specialist lending that will be the topic of today. Richard, welcome. I wonder whether you might first give us an introduction to yourself and Cabot Square.

- Thank you, Pete. Thank you for having me. Looking forward to the discussion. My name's Richard McDougall, partner at Cabot Square.

I've spent the last 18 years investing specifically into all different types of specialty lending businesses. As it stands today, I sit on the board of three Specialist lending businesses, namely Simply and Propel, who are in the SME Asset Finance space, and MSP Capital, which is in the bridging and development space. Looking forward to a good chat.

- So it's obviously been a rather challenging macroeconomic environment recently. What are the challenges and indeed opportunities that present themselves to lending businesses within these sorts of circumstances in your experience?

- So I think for the last 18 months, all the conversation has obviously been around interest rates and the impact that interest rates has in all sorts of different ways on the Specialist lending market, certainly the speed with which interest rates increased post the list trust quoting budget, I think took everybody by surprise. And most of 2023, I would imagine for most businesses and certainly the way we thought about things was how do you adapt and evolve to deal with what is, initially, a rising rate environment with an uncertain endpoint? And hopefully where we are now, some stability, but with still a lack of certainty of when that will change.

And we can certainly talk through how that has impacted everything from the consumer confidence and what customers are doing in terms of seeking borrowing from specialist lenders and clearly, that has been suppressed to some extent, although very variable by different sectors, through to the implications of funding structures and pricing that these businesses have had to approach in interacting with the market and originating that lending.

- Yeah. That's very consistent with our experience. And I suppose with interest rates in particular, the types of things that our clients have asked us about would be, what's been the effect of that on the funding environment? What's been the effect of that on customer's ability to pay in an affordability sense?

What's the impact on credit risk generally? All of those things, and those things, and presumably they vary between different types of lending institutions.

- Yeah.

- So I suppose if I broadly categorize it into large high street banks, smaller specialist banks and specialist lenders, and in your experience, how does that impact vary between those different types of institutions? And I suppose in particular, given your focus, how has it impacted particularly SME specialist lenders?

- So picking up the credit risk points, I think when interest rates went up initially, I think the reaction from a lot of participants in the market was "How do we underwrite from here? Because how do we attempt to work out what the potential credit impact is of rapidly rising interest rates on the customer basis?" And I think the expectation was that, you know, things would turn out pretty badly in 2023. And thankfully, that didn't come to pass.

In fact, in a number of our businesses, we're still experiencing levels of arrears and levels of credit losses actually below where they were pre-COVID, which I don't think anybody could have expected. So we're sort of sitting here thinking, "Okay, well, that has turned out to be more benign, but clearly, there's been other impacts." And thinking about how different participants in this market have reacted to that, and particularly with the focus on cost of funds, I would draw a distinction between really, current account franchise banks and non-current account franchise banks and non-bank lenders.

The current account franchise banks have had the, in theory, significant benefit of having a greater control over the underlying cost of funds that they're able to deploy into the market. And as I say, in theory, they should have been able to steal a march on others. That's not necessarily quite played out like that. But for the other part market participants, particularly ones who are reliant on either capital markets or other types of senior funding lines, they've very much had to think, and hopefully, we were thinking about some of these things before rates went up, but hedging, clearly, massively important in thinking about how to interact with the market, pricing to offset the uplift in, effectively, the gross cost of providing the lending.

And I would say that for non-bank lenders, that's probably been one of the larger challenges because as always, on the way up, swap rates go up quicker than market rates out to the customer. So you have almost a structural NIM squeeze on the way up. I think certainly a lot of our companies have been very successful in passing through rate rises eventually to their customer bases. And to some extent, you expect the opposite way around when rates start coming down again.

But certainly hedging, pricing, Understanding what your credit appetite is and the trade off between the amount of origination you want to be doing this slightly more uncertain credit environments are all things that I think all these types of businesses should be thinking about.

- Well, I think on that last point in particular, and we'll come back to winning business models in downturns or difficult macro circumstances, you know, however you would describe what's going on currently. But I think certainly my experience looking at the markets over the last three, five years in particular is that different institutions have been very differently prepared or indeed unprepared for this situation, and that's made a huge difference to their relative success in this environment.

- Yes, and I think also, certainly in the non-bank lending space, the types of funding structures and the diversity of funding structures that non-bank lenders had, has been a very important signal of success in this type of volatility. So, you know, for the sake of argument, if you're wholly reliant on a forward-flow model, for example, you can run the risk that actually the economics of the origination you're doing into that forward-flow model just simply stop working and you switch off overnight. At the same time if you're in a product where you've got an unhedged back book and suddenly have a significant increase in your cost of funds, then you're squeezed profitability in all of the knock-on impacts that that has.

So we've always taken the view that actually a balance of on-and-off balance sheet funding in a non-bank lending environment is extremely important to be able to deal with these things. In theory, in a banking environment, I mean, actually most of the banks are awash with deposits. And in fact, the big banks have significant amounts of capital, so much so that they're handing back billions now to their shareholders. So for those businesses, it's a lot more about where the product sits in their overall strategy and credit appetite and their fear or otherwise of whether a particular sector is gonna be particularly damaged by, you know, in terms of future credit losses and how that plays through.

- I think it's interesting that we both naturally gravitated to funding first, which for people less familiar with Specialist lending may be a surprise. And it does remind me, of course, to say to those sort of less experienced here that, you know, following the great financial crisis, of course the UK industry was primarily influenced by lack of funding availability rather than credit losses.

- Absolutely.

- And so the U.S. situation was very different, where actual credit losses caused a lot of problems. With the UK, really, it was a collective loss of confidence, funders pulling out, and your point around diversification of funding and creating therefore resilience through a different set of conditions. So you don't know which source might switch on or switch off necessarily- - Yep.

- although you might guess. But having a range is very important and, or what one of my clients would describe as having enough will on your back to get through these situations is very important.

- 100%, and I think, as you say, I think people who weren't there in the financial crisis or didn't get under the hood of why lending businesses went bust, as you're absolutely rightly say, it wasn't typically credit, it was liquidity, it was funding certainty. And actually one of the big positive comparisons, if you can put it that way, of the way the market operated through COVID in comparison to the financial crisis was that actually, banks, funding counterparties, the infrastructure of funding of these types of businesses actually held up extremely well, was very, very supportive. You

didn't see anything like the same, even though you could have seen the similar types of outcomes as the financial crisis in terms of people pulling out and running scared of providing funding. So you're absolutely right. That's why probably I naturally go straight to funding because that's where you can kind of deal with credit events if you are sufficiently well capitalized, if you have the operations in order to be able to cope with that, and you have set your funding up in such a way that you can deal with holding defaulted assets and so on for a period of time. So, you know, if you get that right, pretty much everything else you can manage.

- And again, going back to that period of 2008, 2009, I mean, there were various projects we did in support of lenders trying to seek additional funding. And that was very, very difficult. And my experience at the time was at least certain funders were more looking for an excuse to come out because no one at that time was going to criticize them for coming out as Specialist lending- - Yeah.

- particularly if it was subprime. And of course, Specialist lending is much broader than just subprime, but any excuse to come of that was sort of through COVID and thereafter, the tenor of the conversation was much more around how do we support our customers and their end customers through that, not uniformly, but a lot more positivity around that. And I suppose dragging us back to one of the points you made earlier on about more benign conditions, do you have hypotheses around why conditions have been more benign? And I would suppose that that more supportive funding environment probably is an element of it.

- Yes, so I would say to some extent it was a surprise, but then you start trying to build the explanations for why it's the case. So I certainly think that the more supportive funding environments led to fewer defaults and administrations and liquidations, which were funding-driven. So generically, I think the provision of forbearance across the industry, both in terms of funding partners with non-bank lenders and non-bank lenders and banks interacting with their clients was very accommodative. And therefore, you didn't see that.

I think the second thing is that I think the very positive impact of the government initiatives to protect businesses was very, very well received and protected the economy in a way that just absolutely should not be underestimated and we shouldn't forget as we sort of see that further and further in history. But I think, you know, we've almost had rolling problems for the last nine to 10 years to the point where what really is a normal time, you just have to gear your business up to deal with whatever the market circumstance is. And I think actually how you play that into the kind of SME and other customer base, I think they just much better at dealing with issues and they hold more cash in their bank accounts and they make sure that they have access to the various funding and liquidity that they need to ride through issues.

And so it almost feels like the SME community has upskilled themselves versus 10 to 15 years ago, and therefore, you don't get the same sort of whole scale rolling credit issues that you might have done historically. Now of course, that might be famous last words and all this is just pent up and we could see some increasing stress going forward, but certainly as it stands today, that's the feeling that we have around why it's happened in the way it has.

- Yeah. And I suppose one thing we haven't touched on yet would be regulation, whether prudential regulation around holding more capital that you've referred to that. So that means almost, in a way, that the larger banks in particular have kind of been forced to take a more protective approach- - Yeah.

- although I'm sure many of them would've done that anyway, following the experience they had during the global financial crisis and credit crunch and so on. There's also been, particularly on the, I suppose the consumer side, more protective regulation from the FCA around affordability checking, which I think is to some extent leaked across into how SME underwriters think about things as well, leaving a bit more space, more responsible attitudes, in inverted commas, around that. And relatedly, it seems to me anyway, that the large banks, having been blamed so roundly, so widely, so completely for what happened in the global financial crisis sort of felt in this period of responsibility to be part of the solution rather than perceived- - Yes.

- be part of the problem. So I think probably all of that contributed, but I wonder whether you have a perspective on that.

- Completely agree with that. Part of the solution, obviously, also banks are supported by governments in times of crisis, which is helpful. But certainly on the SME side, I think the input to the British Business Bank and the benefit they've been providing in providing consistency and support to lending to the SME community has been massive. On the regulatory front, I think, you know, generically, we think that regulation is good and we think that actually it's in everybody's interest if we remove bad actors from the market.

In certain circumstances, you do worry about slightly unintended overreach and unintended consequences of particular parts of regulatory intervention. But I think, again, if we think about risk in almost the infrastructure of the provision of funding to consumers and SMEs, absolutely, banks, very, very well capitalized for all the reasons that you gave. Within the non-bank lending community, I think there has been quite a lot of variability on that front though. And one of the trends over the last number of years has been either slightly, what's the word I would use, not quite appropriate capital being pulled into the Specialist lending ecosystem.

- So you mean different types of funding to what would've been ideal?

- Correct. So probably two examples I would give. One would be the attraction of, I call it venture capital, capital-type funding rounds into funding the build out of lending businesses. And actually that can neither be a bank or it can be a non-bank lending business, where often what can happen there, not always, there've been some successful examples of where that has worked.

But what can happen is a misalignment of shareholders' objectives, which actually then puts the business in a position where it can't raise the next amount of money and there is a capital buffer shock in there. So that's one example where there was a lot of money moving into that space historically, and we've seen a big pullback on that, certainly over the last 18 months. But another example would be where your, so referring back to what we were talking about before, either a singular point of failure on a funding front with a funding counterparty or potentially as bad, a very, very complex, multi-layered funding proposition where you have a number of different counterparties at different layers of the capital stack, but with a very thin equity layer underneath, which gives you no margin for error.

And I think some of that has been driven by a lot of capital seeking a home, but also the sort of seemingly attractive aim of, you know, really minimizing the equity provision by maxing out the funding. So I think one of the themes in terms of, you know, where opportunity might be looking forward is almost a resetting of some of those capital structures to put them back into a position where they can take advantage of where opportunity will now come out as, hopefully, interest rates, you know, are stable, and then maybe start declining and the confidence comes back into the market.

- But I think we probably both agree that the capital structure, the sources of funding are really important. Well, firstly, underpinning of a viable business at all, but secondly, differentiator. as you enter these circumstances where either something that is so simple that it's all eggs in one basket or so complex that it is, frankly, difficult to understand and unravel or replace with anything else.

- [Richard]

Yep.

- Both of those extremes must be disadvantageous and, you know, talk to a lack, you know, lack of sustainability in those business models.

- Yes, I mean, I actually, to put a real world example around this, in the last month I have spoken to two different businesses where they both have the same issue, which is they have raised venture capital money into their platform and they've tried to raise lending capital into an SPV, isolated from the platform. And in both cases, they can't raise additional capital into the SPV because all the capital providers in there want recourse to the platform and upside from the platform and all the VC investors refuse to take a down round and don't want to give any access. So the management team of the companies are just stuck in a holding pattern until you can resolve it all.

So it is those kind of situations where even though on face value, you think you've built an optimal funding strategy and an optimal capital strategy, actually you create a problem for yourself further down the track. And one of the ways we've tried to address that is, a, we try to minimize the number of voices around the table. So in almost every single case, we're the only capital provider and third party alongside the management team of our businesses' making decisions. And the second is, we will allocate what we believe to be sufficient equity to fund the entirety of the business plan for a five-year period all the way through to exit.

So at that point, everybody can just concentrate on building the business.

- And I think, so in the situation you described there, where the funding structure is much more complicated than that, with dependencies from independent parties that have no interest necessarily in serving the interest of the other one, you can have a perfectly viable, indeed winning business model industrially, as in the business of doing the lending and it's just, it's stuck.

- Yep, correct. You can have a good business, again, we saw this historically where perfectly good business, in fact, you know, growing well, providing a really interesting differentiated product, good technology platform, very diversified shareholder base can't raise funding round because nobody can agree on what the valuation is 'cause they're all at different valuations. I mean, just an absolute nightmare for the company because they're staring at all this opportunity and they're held back by things that are nothing to do with what the business is trying to achieve. So, you know, often when I get into conversations along those lines where the intro to me is, "Hi, can we have a chat?

We're interested in raising our series C." And I say, "Okay, that's great. Can I just understand the business first and let's talk about whether you actually wanna raise a series C or what you want to do is you want to raise some strategic capital to help you execute on a plan for the next five years." Some people engage with that very well, others don't and, you know, have the confidence in their plan, and that's absolutely fine.

I would always err on the side of, you know, in these types of businesses when you're in specialty lending, it's a risk business and we're doing everything we can to mitigate the risks. And once you've done that, actually, you should be building something that's very valuable.

- Yeah, but you can't just build a good lending business idea and then the funding will come just by assumption.

- Correct.

- I think that's the thing, that the whole thing needs to be planned well ahead with options.

- And I think one of the things that has happened in the, again, tends to happen in times of stress or crisis, is almost everywhere there's a flight to quality. So funders will prioritize providing their lending to businesses that they perceive to be quality businesses. And what is a quality business? Quality business is, you know, strong track record, well capitalized, high quality management team, proven ability to manage credit, stress, you know, all of these things.

So it's why it is always interesting to have conversations about debt availability, because I wouldn't really pitch it like that. It's not that holistically, debt has become less available. It is, debt has become less available to certain types of proposition. If anything, I think the stronger propositions are having, you know, lots of options in terms of what they do and are being probably actually even chased by funding partners to see them as platforms to help them put out their funding because obviously funders still have to have to provide funding.

That's what they do.

- Yeah, I mean, I was gonna go on to whether, on the whole, non-bank lending businesses are advantaged both versus bank lending businesses during this period or not. But I suppose part of the answer to that question, of course, is as you've just said, you can't consider non-bank lending businesses as one chunk. And I think my perspective on this question is for strong non-bank lending businesses with the features you described, so proven underwriting collections capability, ideally over a long period of time, including pi, you know, past crisis of a similar nature, strong teams, strong fund, all these things, if you have that, then you're relatively advantaged.

- [Richard]

Yep.

- Both versus banks, but also versus the other non-banks that don't have that who are likely to pull out while the bigger banks contract their credit appetite themselves. That's my view on it, but anyway. I dunno if I've asked you on it, left you anything to answer there, but...

- Well, I think there is some advantage, there's also some disadvantage, but there's some advantage in being effectively a monoline, non-bank lending business that is focused on one core sector as opposed to be typically in a banking environments where you're at the very least multi-product. You're even probably not just lending products, you're providing other things to a diverse customer base because it allows you to very, very precisely focus on what needs to be done today for that particular customer base. So that focus and also the ability to be nimble in that environment has to be helpful.

You know, case in point, when interest rates start going up, it sounds simple to say, "Well, can we just increase our pricing on our lending by 1%?" Well, it's significantly more complicated than that.

- There's no just about it.

- There's no just about it, but what you can say is if you don't have three or four layers of bureaucracy above you to make a decision on that front, at the very least, you can react a lot more rapidly. So I think the ability to react is there. I think the other thing as well is if you're monoline, you're in. If you're multi-product, you can choose to be in or out.

And actually quite often what happens is for particular asset types where there is some stress, even if they're not really seeing it, banks can choose to be out. And I would say that originally, one of the reasons that we, as a firm, started, you know, investing a huge amount of time and eventually a lot of capital into different Specialist lending platforms was coming out of the financial crisis where banks were retrenching from all sorts of products and we were building businesses to effectively replace that. I think there's an interesting difference this time around, which was historically, the big banks have always found SME lending quite difficult and it sort of sits in the middle of, on the one hand, you know, products which they find attractive and sort of slightly more straightforward to do, which are high volume, very simple underwrite typically, you know, mortgages and things like that, or the other hand of the spectrum, very big ticket, complex, but you've got, you know, relatively highly-paid staff working full time on trying to get those over the line.

SME kind of sits in the middle and so falls between two stools. And so they found that relatively difficult. I would say now, we are experiencing, and certainly through a number of our businesses developing partnerships with the big banks where SME is the front and center of their strategy. And what they're doing is they are, which we always thought would eventually happen, is you're taking the best of the Specialist technology platforms, the Specialist lending and credit underwrite capability that you can build in a non-bank lending environments and partnering it, clearly, with the liquidity, the funding size, in fact, in a lot of cases, the customer reach, and that creates the best of all worlds.

So in some respects, I think a lot of what's happened over the last two, three, four years has driven that agenda within the big banks, which we think is a very positive outcome actually for SMEs as well as some of the businesses who are playing in this space.

- Yeah and I think where you can combine the different strengths and capabilities and access to resources is, you know, of the two organizations with each activity sitting where it's done best can be extremely effective. And I think one of the things I've found is if you consider a whole large bank, it may very well be unhappy to participate directly in the lending activity, but very happy to provide funding to someone else doing it where they are- - Yep.

- knowledgeable, clearly knowledgeable enough to understand what's going on. They just don't want to do it themselves because it's not suited their particular skillset, but they can judge a good one. So I guess you've found the same.

- Absolutely, yeah.

- So we talked a lot about the business of doing Specialist lending. I wonder whether we might move for a few minutes to the topic of investing in it, which is obviously what you spend most of your time thinking about. So in broad conclusion and 'cause I think what we're saying is non-bank lenders, which are strong, well supported in the ways that we've talked about are advantaged in this part of the cycle. And I, you know, I agree with that perspective, that's been my own experience as well.

But from an investing perspective, obviously, it's different operating these business to investing in them. And does that translate into an attractive environment for placing investment in non-bank lending or does it make it more difficult?

- So I think what the way we would look at it is we would say, generically speaking, there is always an opportunity somewhere within specialty lending to think that there is an interesting investment opportunity. In simple terms, when we look at opportunities, and this is irrespective of what the market environment is, we're really focused on, probably, at least four key attributes. The first is can we prove that the business can originate and continues to grow, originate attractively wielding assets on a risk-reward basis? So effectively, is the underlying unit cost profit production of a piece of lending attractive?

So if we can do that, if we either have sight of, or the ability to build a best-in-class tech platform that can operate and manage that, tick. Thirdly, is there funding capacity available on a diversified basis to fund that? Quite a lot of businesses actually almost think that that's a byproduct of building the platform. But actually the number of times we've looked at ostensibly attractive lending propositions where you actually just can't get funding for it is relatively surprising.

So can you fund the assets? And then finally, who, and you think about this right on day one, who actually is going to buy this business in the future and what is the likely valuation metrics that you're going to apply to that? Now one of the things that's made investing in, I would say particularly different flavors of the banking community over the last, well, however far you go back, has been the arguably complete disconnect between what the public markets value banks add and what the assumed almost FinTech valuation that funding rounds apply into banks. And you know, I wouldn't sit here to make an opinion about, you know, who's right or wrong in terms of whether they're good investments.

I think our view is just simply if we can't look at a five-odd-year plan and by assuming a very achievable exit multiple, let's say, that we can't deliver a sensible sort of two and a half to three times return, we just won't take the risk on exit multiple. It's actually that that has been one of the main impediments to finding interesting opportunities in a sense is the conviction and confidence around what exit multiples are likely to be. I think part of the reason for that has been, as I say, the valuation situation within banking markets. But I think the other piece has been over the last two to three years, a bit of a reduction in appetite of investors in looking at these platforms.

We think this is changing now actually, and we're starting to see strategic buyers coming back and showing a real interest in not bank lending platforms. We're starting to see and I think actually, there have been some transactions already. They start setting sort of value metrics and comparables for future acquisitions. And as soon as that starts happening, then the investor community builds their confidence up and then suddenly you get into a nice virtuous circle again.

So I think over the next year, if we start to see some transactions happen, I think that'll be very positive for the investment thesis of Specialty lending.

- Yeah, I mean, it's interesting how that exit part of the story I think across private equity generally has come into sharper and sharper focus recently. You know, impact of interest rates and so on is part of that, but not only that, you know, lack of assumption that you'll be able to continue to build multiples at the next cycle automatically as it were. But in particular, and now, I mean, if you look at the public markets valuations of banks, as you say, it's hard to say whether public markets are right or wrong, but certainly those valuations are much lower than they have been. And

looking at those whereas 10 years ago you may very well have been reasonably confident of a good public markets exit. Now, it's only one of several options, and it's probably not prima facie the most attractive.

- Yeah and also to the extent that there have been Specialist lending IPOs in the past, they almost universally haven't necessarily performed that well from a pure share price performance, which again, hasn't been helpful in supporting the valuation story. But having said all of that, the sort of counter to that is that one thing that the Specialist lending platforms do extremely well is originate yielding assets, which there is a wall of money trying to access, and actually, not that many very high quality origination platforms that are able to originate that for them. So again, I think given that dynamic, I think the high quality businesses do actually deserve a sensible valuation that isn't coupled to what a listed bank might be doing.

- Yeah, agreed, but it just can be more complex now to identify where that might come from. And I think that's, well, my observation would be that fewer wider strategy or more generalist private equity investors are now interested in specialist lending assets than were 10 years ago. However, those who are truly skilled and experienced in it are equally committed.

- [Richard]

Yep.

- Whilst also cognizant of the exit opportunities or indeed in some cases lack of them that might present.

- Yeah, I mean, I would generally say that, irrespective to the sector, specialty lending or otherwise, if you're not a true expert in the sector that you're investing in, I would slightly question why you're taking the step in there. I think take that and multiply it by three for Specialist lending because it's a completely different thought process, is a completely different consideration around current and future capital requirements and how they develop based on how the business performs. So it's right that specialist financial services investors are the ones who are focusing on this front.

And I think also, from our perspective, the most natural homes for most of these businesses are actually sitting within banks and other types of trade player who have access to the liquidity and the funding to really drive the increased performance within those platforms. So that is a separate point, which is, again, you can't just think about these businesses from the perspective of, can I grow them with what they're doing? It's, does it have the governance, the regulatory platform, the ability to sit within a bank and all of that entails. And you know, most of the time, particularly at the point that we're investing into a business, they almost certainly don't have that.

And so you have to take them on a journey of building that to make that a credible exit route.

- Yeah, I mean, certainly in some of the IMs in specialist center I was reading, say 10 years ago, they would say one of our key advantages is that we're not regulated.

- Yes.

- 'Cause they're in a certain area of the market and you gotta be careful how you interpret that.

- (chuckles) Absolutely.

- [Peter]

Yeah.

- Partly because, a, you might be in a few years time.

- [Peter]

Yeah.

- And secondly, it's always been that that thing about, "Okay, so I've got a non-regulated business, I've got a regulated business. Am I actually going to approach those in different ways?" You know, the reality is that the regulation is predominantly there for customer protection and all of those kinds of those good things. And so, you know, what you're actually saying by making a comment like that is, I can get away with not really thinking about that too much.

So we take the view that, actually, whether you are unregulated or you're regulated, actually the aspiration here is to build a business that could be bought within, probably the most regulated environment you could have, which is within a bank. And then, you know, that gives you the best chance of not having to worry about, you know, whatever issues somebody thinks that might entail.

- Yeah, and I suppose thinking through to exits, I mean, even if you're minded to think that that regulated trade buyer is the right exit, nonetheless, being capable of being bought by those entities of course, increases the options that you have, and therefore, your prospects and valuation, at sale anyway, even if you don't end up in that regulated environment after the transaction, yeah.

- Absolutely. I mean, that's the other thing. I mean, to your point about what is the universe of buyers of a Specialist lending business? Well, I'm fairly certain that the universe of potential buyers is smaller than some other sectors.

And so you know that one buyer group is a kind of trade bank buying group and another buying group is a specialist, you know, private equity or credit fund type buyer. And you wanna do your best to maximize the breadth of that, otherwise all you're doing is you're shooting yourself in the foot and reducing your potential exit risk.

- Yeah. I think many of the things we've discussed here around whether this is a good investment opportunity now, I mean, they're not particularly related to the cycle. I mean, there are a few things that vary with the cycle and macro circumstances, but I think in a way what you're saying is, well, it's always attractive to invest in the best things if you know what you're doing. And now is a circumstance where there are some different weightings perhaps of different criteria you might look at, but the diligence process is fundamentally the same.

What you're looking for in a good business is fundamentally the same and all those things.

- Yeah, and I think one of the helpful things in, let's say we're in an environment where there is an element of risk off by either market counterparties or investors in the market, is it reduces the probability of some market distortion caused by over competition or, you know, otherwise into the sectors. So, you know, when interest rates were low, when there was loads of VC money piling in everywhere, when you had, you know, banks trying to push into various sectors and trying to buy business, you suddenly had some disconnected pricing at the front end, which wasn't reflective of risk. By

definition, if the competition for lending is not quite as intense, then you have a better ability to build profitable lending books. So it's probably likely the case that actually from an investment perspective, you should be slightly countercyclical versus the wider macro environment, but ultimately, a good platform is a good platform and a good asset class is a good asset class and then it's really about building that out and working out the optimal time to eventually monetize that, irrespective of when you've entered.

- And the way I say the fundamentals are pretty similar, but in a circumstance like this where newer platforms, less experienced platforms are looking, you know, it's harder for them to get going in various ways, particularly funding. And there's less, well, there's less experienced capital around looking to invest in this area because there's an easy headline, which is, you know, lending in macro, tough macro circumstances is obviously stupid as it were, which of course neither of us would agree with, but nonetheless, lots of people would. You'll be, industrially, as in the business of lending, less well competed.

So some of the best opportunities to develop these businesses quickly and with less competition going on can be now. And I think if I look back at the track record of investment in these businesses over a couple of cycles now the best and the worst deals get done in the toughest macro times. But on average, you would tend to be doing slightly better if you invest in these difficult circumstances than if you were investing in very benign circumstances where everything is much more highly competed.

- I think that's right. And the other benefit of being, you know, a true specialist firm who has been in this space for a long time is that you've kind of seen every iteration of any product and you can very, very quickly deduce whether the IM that you're looking at is something that's worth looking at or not. And it's not, you know, even simplistically, if something shows a massive hockey stick in origination growth, you know, alarm bells everywhere, that's obvious. But even things like, you know, it almost became a running joke that if we got an IM through the door from somebody that said "We are about to disrupt the SME lending space," and that was their sort of tag headline at the top, it is like, Right, that's probably an instant no.

We don't even need to read the rest because it is highly unlikely to be something that we will have conviction around. But what we do see is very powerful is very credible, experienced management teams where there's an opportunity to actually build cutting-edge, best-in-class tech with no legacy issues on that front. And therefore, what you're doing is you're taking good, strong, existing customer relationships with a clearly proven ability to run and manage lending, but actually you're supercharging it by applying the best-in-class technology into the origination, the servicing, the underwriting, the reporting and the funding management, which partly gives you a much improved operational cost structure and therefore cost-income ratio, but actually is delivering what everybody's trying to deliver, which is an exceptional customer experience.

And it's really the exceptional customer experience is what allows you to win business.

- Yeah, I mean, I think that the emergence of tech is sort of a mainstream feature of Specialist lending businesses, is relatively recent, probably one of the things that is different from, you know, 10 years ago in GFC and so on where you would have some people saying, "Well, we're doing tech, man," as if that was inherently an advantage, which, you know.

- Yep.

- And sometimes that would create high valuations at that time. And then you had a sort of second wave of thinking on that, which is, well, Specialist lending by its nature is, it's too complex to do in an automated fashion. So anyone's saying, "I am a fully automated lending business or "substantially automated lending business" can't be doing it right. Whereas I think now we're emerging into a more mature phase where both of those elements of thinking are present, but you've got a much more developed sense of where tech actually helps and that's more agreed.

And so now it's no longer optional I would suggest to have these types of things. If you don't use it in most of those obvious applications, then your cost structure's simply too high and you can't compete at the front end.

- And you can't respond quickly enough. And I think also probably one of the changes over the last number of years, which is almost universal across the industry is, you know, six, seven, eight years ago, it was almost seen as a badge of value to have 300 developers in your workforce who are spending their whole day trying to build bespoke tech platforms in there. You know, technology moves on so quickly. Data sources move on so quickly.

The idea that you are going to keep ahead in capital spending if nothing else of Amazon and some of the other big tech operating platforms is a little bit pie in the sky. So actually, in a lot of cases and in our businesses is very much a modular approach where you take the best of what's out there in the market, but you API it all together such that you are both resilient and you can add and swap things out as, you know, superior products become available or additional data sources become available. But everything is angled towards, how do I make things significantly efficient? And you know, one of the things that I find quite interesting is, so if I take Simply and Propel as an example, they would both say to you that they do a manual underwrite.

Now a manual underwrite to, and obviously we won't know many names here, but a manual underwrite to some legacy businesses, let's say, would mean an underwriter downloading a PDF version of an Experian report, digging into 14 different databases and pulling together over a course of about two days, all of the credit information they need to make a decision. And Simply and Propel, by entering three pieces of information, the company number, the director's name, and the director's address, you can instantly populate a screen which shows all of the credit information, open banking, all of the AML, KYC, and all of the historic data that the business holds on the client in one place.

So that in theory, an underwriter can turn that round in, you know, minutes. So again, when you're looking at these businesses, you have to dig underneath what people actually mean when they talk about the use of tech, but fundamentally tech is only useful if it allows you to actually do more and better lending.

- Yeah, and yeah, being very clear about, you know, what it's for rather than it, per se, I think is a big thing. It's moved on a lot. Yeah. Well, Richard, thank you very much.

Have a very wide ranging set of insights and topics we've covered. I just had one more question of a more lighthearted nature if I may. So Specialist lending is a specialist business, I suppose by definition. I wonder whether you had a particular unexpected...

What's your most unexpected experience in this industry as you must have dealt with many businesses over the nearly two decades that you've been working with them?

- Unexpected. Actually, I think possibly the most unexpected thing that's happened to me was have a business meeting interrupted by the members of Dire Straits. (Peter chuckling) That was pretty unexpected. But then I think probably very few things surprise me now, given all the time I spent in Specialist lending, but that's definitely one that was memorable.

- (chuckles) Perfect. Well, thank you very much indeed for your time.

- Thank you. (upbeat music)