In the wake of the 2008 financial crisis, banks faced a raft of regulatory changes and were generally required to increase the amount of capital they held (an attempt to protect against insolvency). In turn, this decreased the banking sector’s appetite and capacity for certain types of lending, creating a vacuum and in turn allowing private capital to step in to fill the void. Ultimately, this has led to a decade and counting of increasingly rapid growth in the ‘alternative lending’ universe. 
What is alternative lending?
This broad term has come to encompass a wealth of non-traditional types of lending, including peer-to-peer consumer lending, lending backed by real estate and infrastructure assets, and lending aimed at facilitating international trade and commerce. The lenders themselves are equally diverse, including specialist managers, direct lending platforms, and club deals (where lending is conducted by one or more private parties in partnership). For businesses – particularly those in the capital-starved small- and medium-sized space – this is a crucial source of funding, and one which can also have positive knock-on effects for wider economic growth.
As multi-asset investors, we always look to explore as much of the investment universe as possible, which often means delving into niche areas and seemingly disparate markets. We believe that for investors worried about high share price valuations and weak yields on bonds, the private debt covered by the alternative sector can provide a good addition to a portfolio, with both yield-enhancing and diversification benefits. Indeed, the diverse nature of alternative lending creates a range of distinctly different strategies for investors to consider, each with different levels of credit and default risk, types of collateral (used to secure lending), and ways of accessing the market. At Heartwood, we focus primarily on areas where we perceive an ongoing imbalance between the supply and demand of finance. This imbalance can lead to more attractive yields than those offered by public market debt, accompanied by relatively attractive levels of risk in the form of over-collateralisation, additional creditor security, and diversification.
Finding opportunities in the alternative lending sector
We have played various parts of the alternative lending market over time, including infrastructure debt, structured commodity trade finance, and invoice factoring.
Infrastructure debt
This involves lending to companies involved in the building or operation of infrastructure assets and projects. These companies often provide essential public services such as transport, energy, utilities and telecoms infrastructure and, increasingly, renewable energy projects. Loans are serviced by long-term revenues and contracts and backed by a secure pool of hard assets.
There is increasing competition for these types of loans, but with the right sourcing, investors can continue to access attractive yields and strong security terms, creating additional yield whilst diversifying risks.
Structured commodity trade finance
Structured trade finance products are primarily used to fund different stages of a commodity’s life cycle. For example, a commodity producer may require short-term financing to fund transportation from a production site to a buyer’s warehouse, with the buyer paying a pre-agreed price at point of receipt. A trade finance lending specialist will provide this much-needed capital at a set interest rate, being repaid when the transaction is complete.
Though resource-intensive and operationally complex, this space can provide attractive yields, short duration loan terms and a relatively high level of security (with the commodity as collateral).
Invoice factoring
Invoice factoring (which involves the sale of corporate invoices to a third party) is a well-established form of short-term financing for small- and mid-sized businesses.
A host of efficient digital platform businesses have emerged to enable fast execution, stronger risk management solutions and increased capacity, providing a good example of how fintech (financial technologies) can reform traditional lending models.
Navigating the risks of a diverse investment space
As with all investment opportunities, when it comes to investing in private debt, it is important to be selective. Alternative lending is a relatively new asset class, with many unique, opaque and operationally complex sub-sectors. Crucially, some opportunities can carry more risks than are apparent at first glance. Key risks include losses through loan defaults, deteriorating yields, and even fraud – these are critical determinants of performance for alternative lending investment strategies, and must be considered closely. We believe that undertaking the right level of due diligence on both underlying loan books and the specialists providing access to these lending strategies is crucial. A significant amount of investor capital has entered the space in recent years, with the side effect of driving down yields in this investment space, though we believe attractive returns are still available with the right research and selection criteria.
It is worth noting that some of the additional yield offered through alternative lending strategies versus their more traditional counterparts is driven by an ‘illiquidity’ premium, where investors are paid extra for the risk of locking in their capital over a specific period of time. This is usually a fairly priced risk, but must always be considered in the context of an investor’s wider portfolio. Keeping this balance of risks in mind, we continually seek out opportunities in these compelling (but often challenging to access) non-traditional investment markets, aiming to build genuinely diversified, sustainably growing portfolios for our investors.
Charu Lahiri is investment manager at Heartwood Investment Management. The views expressed above are her own and should not be taken as investment advice.