ABSF Information Sessions | Sydney & Melbourne
Michael Bath, Head of Global Markets and Business Strategy
Good afternoon everyone. I’d like to start by acknowledging the traditional custodians of the land on which we meet today, the Gadigal People of the Eora Nation (in Sydney), and the Boon Wurrung and Woiwurrung Peoples of the Kulin Nation (in Melbourne), and to pay my respects to their elders, past, present and emerging. I’d also like to thank Chris, Rob and Lynsey from the Australian Securitisation Forum for arranging these information sessions, along with our hosts, Ashurst (in Sydney) and KPMG (in Melbourne).
Today I will provide an update on the AOFM’s progress in establishing the Australian Business Securitisation Fund, or ABSF, along with some information on how we see the project unfolding from here, including the process for submitting investment proposals to the AOFM. Here’s a rough agenda for the day.
By way of background, the ABSF was announced by the Government in mid-November last year, and its enabling legislation was introduced in mid-February and passed in April. $250 million is available for investment in the current financial year, and a further $250 million in July next year. From 1 July 2021 to 2023 inclusive, the available funds will grow by $500 million per annum.
The volume of funds available to the ABSF, relative to the purported gap within the small business lending market, along with the Government’s desire for an exit strategy, have caused the AOFM to interpret its mandate primarily as one of market development, with the aim of attracting additional private sector investment to this sector over time. This contrasts significantly with the AOFM’s last role in the securitisation market, which was to buy RMBS from the height of the global financial crisis until 2013. Indeed, with credit spreads currently not a great deal wider than their post-GFC lows seen in mid-2014 and again in late 2017, it seems to be a reasonable conclusion that if the market for SME loan securitisations has not thrived to date, it might be unlikely to do so in future without some assistance. The actions of policymakers in other jurisdictions, notably Europe and the UK, would tend to reinforce this conclusion.
It’s important then that the AOFM assists with the development of the market by using the ABSF to nudge things in the right direction. On one level, it can do this by providing visibility on the investments it makes on behalf of the ABSF so that they may act as model investments – helping to set market standards in such areas as documentation. Moreover, the ability to invest with subsidy provides the AOFM with a policy instrument that, used effectively, can enhance market development through compensating SME lenders for retooling their operations to assist with the standardisation of data collection and reporting, to support the development of a clear track record for the asset class. It is the absence of such a track record, built up from loan level data, that investors and ratings agencies alike have told us is a key impediment to attracting more private investment.
To be clear, we don’t want to go into the data storage business. What we do see though is an opportunity to influence the market in finding a common standard with regards to small business loan data and then very explicitly use subsidy to assist with the transition to that standard via the transactions we support.
Our engagement with the investment community has also revealed significant concerns with what can go wrong with well-intentioned Government intervention in markets. I think we’ve been on message on this front for some time, but for the avoidance of any doubt, we think injecting subsidy haphazardly into the SME lending market and hoping for the best might do more harm than good. At the very least, we see it as more likely to crowd-out existing investors than to crowd-in new investors, thus cutting across our need for an exit strategy. Moreover, we recognise that our ABSF investment could have a distortionary impact on the competitive landscape in the immediate vicinity of the originators who benefit directly from the transactions we agree to support.
Hence you can see that our market development strategy needs to dovetail with our investment strategy, to which I will now turn. To set the scene, I need to take you on a bit of a topographical journey through the market landscape.
The SME lending market covers everything from the secured end of the spectrum, such as equipment finance and loans to sole traders who use equity in their family home as collateral, through to invoice and inventory finance and on to unsecured cashflow or working capital finance. Importantly, market depth varies across this landscape. Starting with small business lending that is backed by the proprietor’s equity in the family home, the major banks seem to have that covered, to the point that you could be forgiven for thinking that this is how they define small business lending. Various push factors towards standardisation and centralisation mean that there is a degree of herding behaviour, so once a loan falls outside the underwriting criteria of one major bank, it will probably fall outside the criteria of all of them. This creates somewhat of a cliff effect, so ‘fall’ really would seem to be the operative word.
Close to this cliff there seems to be some lending going on in the secured market, away from the majors. The more homogenous and liquid the underlying security the better the market seems to be functioning. We can see term ABS* transactions coming to market backed by loans against cars and other reasonably mobile and liquid business assets pretty regularly, suggesting that the market for warehouse finance that sits upstream of transactions of this type is probably in reasonable shape. For less liquid underlying assets, there seems to be some specialist lending going on, for example where obligors are members of specific industries that are perceived to be low risk. Beyond the niche lenders operating in this segment, some of whom seem to have the scale required to price their loans at close to the marginal cost of delivery – that is, at a lending rate that will cover funding costs, a reasonable return on equity and a provision for expected net losses –there is a noticeable gap. On the other side of this gap, that is, the side that is further away from the cliff I described earlier, there exists a market for unsecured lending. This is where the lender may obtain some sort of floating charge over the small business and a director’s guarantee, but without explicit security beyond the ‘corporate veil’ of that business. These lenders seem, to us at least, to be characterised by their sub-scale nature and their desire to lend closer to the cliff but for the fact they can’t compete effectively on price due to their relatively high fixed costs and small size. What I’ve described paints a bit of a picture of the SME lending landscape, but there are exceptions – some lenders who are able to accept a range of collateral types can seemingly compete with the majors effectively on service for example.
In practical terms, the implications of the market gap that exists between the cliff and the unsecured lenders are important for SMEs. Specifically, the borrowing rates they face vary significantly between one side of this gap and the other, and by a lot more than can reasonably be attributed to differences in expected credit losses.
So I hear you asking yourself, does this mean that the AOFM will seek to fill this gap by starting with the sub-scale unsecured lenders?
No, is the short answer.
The AOFM will seek to address this gap, but will attempt to do so from the other side, at least initially. There are a number of reasons for this, but the main one is that the unsecured side of the gap seems to be relatively crowded and the sub-scale nature of lenders in this part of the market leads us to believe that there are likely to be fragilities that we would be loath to exacerbate. This brings us to what we call the ‘kingmaker’ problem. Recognising that there will be a ‘halo effect’ that comes with ABSF investment, we fear that the benefit that comes with this will come at the expense of the would-be king’s closest competitors. Supporting one sub-scale lender in the relatively crowded unsecured market segment could thus also be considered to be doing harm to those operating nearby who are not chosen. This is the case regardless of whether we look to choose those who are closest to achieving scale or those who have the greatest ‘need’ for support. Indeed those who have followed the evolution of our guiding principles will have noted that we are not proposing to make ‘need’ (on the part of the SME lenders) a criterion for selecting investments. An alternative approach would be to seek to share the love around this part of the market, however our view is that it will make sense to limit the Fund’s initial $250 million to a small number of transactions.
This gives you a sense of our concerns as we approach the operational phase. In the same way that you only get one chance to make a first impression, we can only undertake one initial round of investments, so we want to get it as close to right as possible. I have been known to describe our intent as seeking to make a splash in the market akin to that of a stone in a pond, rather than that of a boulder in a bath-tub (or a grain of sand in an ocean). I now like to think that the stone in a pond analogy might be able to be extended to that of a stone that is skipped across the surface – touching many points lightly and diffusing the impact it has on any one part of the pond (and perhaps giving the observer a warm feeling in the process). There’s a chance I might be stretching the analogy. But perhaps it is worth finishing on this thread by saying that we would be open to receiving proposals that pool the loans of some of the lenders operating close to the cliff into some sort of multi-seller vehicle that can achieve some of the benefits of scale while diffusing the impact on the market so as to moderate the kingmaker problem.
To be clear, we do plan to move towards the unsecured lending segment. After all we want the ABSF’s market development benefits to raise the tide for all ships away from the cliff I described earlier. Clearly it would be difficult to cause the market to establish a track record for unsecured lending without investing in some unsecured loans. However we see that the path of least regret is consistent with an investment strategy that starts close to where the major banks are operating and moves methodically away from that over time.
I mentioned the guiding principles that we put out for comment in May. I’ll now provide a bit of feedback on the process. First, we received six responses and we would like to take this opportunity to express our gratitude to those who took the time and effort to respond. As well as specific suggestions about their drafting, several respondents offered insights relating to the application of the principles, which we have taken on board. Those that focused on the challenges of investing with subsidy while attracting new investment certainly resonated with us.
The AOFM released revised guiding principles on Monday. I’ll now briefly describe the six main changes that resulted from our consultations and deliberations.
- The Sustainable impact principle has been adapted to ensure that claims to market development are material and can be substantiated. Lenders and investors alike viewed this as important to the success of the program.
- The Transparency principle has been broadened to allow for an iterative approach to disclosure based on what will best serve the market at each stage of the ABSF program. The AOFM is conscious that the market will need to work towards aspirations for transparency incrementally. Inter-creditor agreements were previously mentioned by way of example, and still remain a candidate, but have been replaced with a broader reference to transaction documentation. The focus on improved data reporting, broadly seen as the most crucial step for attracting new investors, has been explicitly mentioned to give weight to this objective.
- The Additionality/additivity principle has been shortened, and the Demonstration/convergence principle has been removed, in order not to discourage innovative thinking that may progress the market’s development. It remains the case that transactions with co-investors in non-equity tranches will be viewed more highly than those seeking 100% of their non-equity funding from the ABSF. However, we don’t want to inadvertently steer proponents to a single, existing type of structure.
- An Institutional quality principle has been incorporated to make prominent the proponent’s operating model. As outlined in the explanation of the Role of the principles in the ABSF investment assessment process, shortlisted investment proposals will undergo a more detailed assessment process, including comprehensive due diligence and risk analysis, at a later stage.
- The Transaction risk profile principle has been changed to focus on the fundamentals of the transaction pool and structure, and remove the reference to an investment grade risk profile. This reference caused some confusion and the AOFM would like to clarify that unrated and sub-investment grade proposals will be considered.
- The Compliance principle has been broadened to ensure that proponents are willing and able to comply with the relevant legislation, as well as transaction-specific reporting requirements, on an ongoing basis.
I’ll now seek to provide a better sense of how we see these principles being used in practice by illustrating how they will fit into our transaction assessment process. We haven’t finalised this process and are unlikely to do so until we have hired an Investment Manager to undertake certain aspects of it, but this is how we envisage it working here and now.
First, we will call for proposals. Note, we have not done this yet and I am not doing it today. These proposals may come to us from SME lenders (or originators), that is those who are the lender of record on the loans to be financed. Or they may come from an originator’s existing financier acting on both of their behalves. The information we will ask proponents to provide will comprise enough detail for us to assess the proposal against the guiding principles – that is we will use the principles as first-pass selection criteria. At this stage we think we will ask proponents to make a statement of claims against each principle, but this could be as simple as referring us to the relevant section of a pitch book that they may choose to submit as part of their proposal. At any rate, it will be in proponents’ best interests to put the AOFM in a position of being able to form a view as to how the proposal measures up against each criterion. Ambiguity will not be your friend; nor will grandiose claims that cannot be substantiated with reference to the material provided to us.
As well as providing information that will enable us to assess the proposals against the guiding principles, we will also ask for some empirical data. We haven’t reached a final landing on the definitions at this stage, but we will have by the time we call for proposals. In broad terms, we expect that they will cover things like loan book size, historic arrears and loss rates, the range of interest rates charged and a breakdown of security types. This data will serve two purposes – the first is to help us produce a map, so that we can apply the strategy I outlined earlier. The second is to establish a baseline, to help us conduct a market census if you will, so that market development can be monitored through time.
Our desire to establish a time series means it is obviously important to us to motivate you to submit this information even if my description of our strategy has just put you off making the effort. First, I would make the point that we can’t provide feedback on a proposal we haven’t received. Second, perhaps more tangibly, when we do subsequently find ourselves investing further into the unsecured region of the market we will give some weight to proponents who have already provided the empirical data we have asked for on their loan book. For this reason, to ease the administrative burden on SME lenders operating some distance from the cliff, we are considering a class of proposal we call a ‘Clayton’s proposal.’ Essentially this is a submission made to us by an SME lender that makes no claims against the guiding principles because they presume they are too far away from the part of the market we are currently targeting. It would simply provide us with the census data component so that we can build a picture of the market, and the proponent’s place in it. The term ‘Claytons’ is typically used in the context of an action or enterprise without much meaning or effect, but I assure you that this is far from the case and the information we get will be highly useful to further our understanding of how to help develop the market.
The submission process I have described might be tweaked between now and when we finalise it but I can undertake that we will provide more prescriptive instructions no later than when we call for proposals.
Having applied the guiding principles and our strategy to the proposals, we should be in a position to form a shortlist of transactions. At this stage we will seek the input of our Investment Manager, who will conduct a detailed due diligence process on the originators and a credit analysis on the proposed transactions. We envisage that the Investment Manager will also be asked to undertake a few other roles in the post-trade phase and to assist us with reviewing our investment strategy over time. Having selected suitable transactions that pass muster from a credit risk and due diligence perspective, we will then move forward towards execution.
For those who miss out, we would propose to offer to provide feedback. Given the Fund will be seeded in a staggered manner over time, I would suggest you interpret missing out on the first round as a ‘not yet’ rather than a ‘no’. However, it might be the case that something does prove problematic for us, in which case we’d let you know if you sought our feedback. This is where my frustrated inner central banker would like to make reference to the Saints’ song: “No, your product.”
It's our expectation that we will periodically issue calls for proposals and at this stage, given the revolving nature of warehouse facilities in which we expect to be investing, we think it is likely that subsequent calls for proposals would typically be issued just in advance of additional capital being made available to the Fund (that is on 1 July each year).
You’re probably wondering when we will issue the first call for proposals. It will be a function of the time taken to procure the services of the Investment Manager, a process we will kick off soon via an open tender process. I can’t be too specific about when the call for investment proposals will occur because I don’t want to put the taxpayer at a potential disadvantage in this procurement process by setting an arbitrary deadline. Our mantra is to execute well, not to focus on speed alone.
That is what I wanted to cover today, but I’m happy to take questions with the remaining time.
A summary of the question and answer sessions that followed is available here.
*The original publication of this Speech incorrectly read 'CMBS' and should have read 'ABS'.