#60 - The Rise of Private Credit and why Alternative Lenders Should Get Their Ducks in a Row

With structural barriers holding banks back, Africa’s future may depend on whether new players in private credit can organise, adapt, and seize the lending opportunity.

Illustrated by Mary Mogoi - Website

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Introduction

The SME funding gap in Africa is a frequently discussed issue, with estimates putting it at around US$ 330 billion and an additional US$ 100 billion trade finance gap. I believe these figures are underestimated due to the presence of “discouraged borrowers.”

Working at Sote was a very insightful experience because I came across the funding gap as an outsider i.e. not a banker. It gave me a fresh perspective on things, particularly the idea that in a lot of industries, many industry insiders have assumed knowledge based on shared language and terminology.  One of the instances that springs to mind is the idea of collateral and in particular the need for traditional collateral in lending. Most bankers will say that we don’t lend on the basis of collateral, but rather on the validity of the business, its transactions and the cash flows. This is largely true. Nonetheless, the reality is that we saw very many good transactions being ignored due to a lack of collateral and we saw transactions that we would never approve getting done due to the client having perfect collateral.  This inconsistency suggests that “we don’t lend on collateral” is more of a narrative than reality. It’s like an internal psy-ops campaign.

Collateral remains critical to SME lending, and this will continue so long as global regulatory frameworks exist. Thus, alternative lending methods are necessary, as credit demand is likely to outstrip supply. Private credit markets, currently valued at US$ 2.1 trillion and projected to grow to US$ 3.5 trillion by 2028, exemplify this trend.

To tackle this I think it’s better to give an overview of the market for private credit and be prescriptive rather than descriptive., I’ll explore why banks struggle with unsecured lending, opportunities in the lending market, the growth of private credit, how to structure a private credit strategy, and the challenges to consider.

Aum on the Left and A.J on the right

To do this I was joined by a good friend Aum Thacker of TLG Capital who I met whilst at Sote. He’s a finance guy through and through and shows not only technical sophistication but a deep desire to solve problems. It’s very easy to build a relationship with him. I always make fun of him that he was destined to be in asset management given that his name is the acronym for Assets Under Management. I was also joined by A.J Davidson, an experienced capital markets guy who’s founded Six Point Capital to help emerging and frontier market Fintech companies scale their lending businesses. Not only does he know his stuff inside out, he has the battle scars to show for it.

Why Banks Struggle to Lend without Collateral;

To understand why unsecured lending particularly to SMEs is so difficult for banks, one has to go back almost 15 years to the Global Financial Crisis of 2008. Banks had binged on reckless activities particularly the Collateralized Debt Obligation (CDO) boom where they repackaged subprime mortgages and sold them off to “unsuspecting” investors. This led to the global financial system coming to its knees particularly with the collapse of Lehman Brothers. Globally, Central Banks had to step in and bail out the banks with taxpayer money. It became apparent to everyone that banks had to have more skin in the game and how this would be done would be through increasing the amount of capital that banks held in their balance sheets. To understand how this was carried out, one needs to understand how global Central Banking is generally coordinated.

Back in the 1980s, the Basel Committee on Banking Supervision (BCBS) which was established by the G10 countries in 1974 , aimed to create stability in the banking sector. It introduced the concept of Risk Weighted Assets which classified a bank’s assets into different risk categories. For instance, government bonds were low risk and were therefore categorised differently than consumer loans or corporate loans. The different buckets of assets had a specific risk weight so for instance, government bonds had a risk weight of 0% and unsecured personal loans had a risk weight of 100%. The regulations then stated that the risk weights should affect how much capital a bank should keep. The idea was to link the amount of capital a bank held to the amount of risk that it takes.

For sure bankers were smart and found ways to circumvent this. Both Basel I and Basel II prescribed the use of internal ratings models to determine the risk weight and gave significant emphasis to ratings agencies in determining “risk”. This mix of self appraisal and the use of badly incentivised ratings agencies gave rise to the global financial crisis. The response by Basel focused on two key planks when it comes to capital;

1. Stricter oversight on how banks calculate risk weights with floors on specific asset types;

2. Increasing overall capital requirements from 8% to 10.5% with additional buffers recommended. In Kenya, it’s actually 14.5% with only SA and Nigeria hovering around the Basel recommendation.

These changes gave rise to what’s known as Basel III. What’s critical to understand is the interplay between collateral, risk weights and capital. Most banks calculate their own risk weights using an internal approach. At its core, this internal approach has three key parameters. For each loan or asset, banks need to calculate the probability of default, the loss they expect to incur if the default materialises and the exposure at default which is simply the loan outstanding when the customer defaults. A higher probability of default and a higher loss given default should lead to a higher risk weight. However, if a loan is secured by collateral either cash or property, then the loss given default is lower because the bank can use the property to cover some of its losses. In this instance, if you have security, then your risk weight is lower. An SME loan that is secured by 150% property could have a 0 or 10% risk weight whereas an unsecured SME loan would have a 100% risk weight. In the latter case, the bank needs to hold higher collateral. An example may suffice;

For example, If a bank wants to lend $100 million, it might allocate $80 million to low-risk corporate loans (risk weight of 20%), requiring $16 million in capital reserves. For SME loans, it might allocate only $20 million (risk weight of 100%), which requires $20 million in capital. Despite the smaller SME portfolio, it uses more capital, making SME lending less attractive.

This partly explains why banks in Africa have focused on lending to the government through investments in bonds and T-bills and have shied away from private sector lending. The data actually proves this to be true.

Source: World Bank Data

The graphs show domestic credit to the private sector as a percentage of GDP. This data is sourced from the World Bank and shows how much bank lending is going to the private sector as a percentage of GDP. It’s clear that all graphs are essentially flat. Nonetheless the graphs show an interesting story upon closer inspection. 

1. In the US and South Africa, one can see growth between 1993 and 2008 and a steep decline thereafter. What’s interesting is that even after the GFC, this number doesn’t pick up in South Africa and continues to decline.

2. In the OECD countries and the US, there’s a small spike largely driven by cheap money and a steep decline post Covid. 

3. The graph on the right shows the African picture. In SSA, there’s similar growth prior to the GFC with flat-lining thereafter particularly in Nigeria, Egypt and SSA as a whole. 

4. Kenya shows growth between 2008 and 2015 with a decline thereafter maybe due to the two bank failures that happened in 2015.

Simply, banks have stopped lending to the private sector globally. In Africa, the marginal asset in the banking sector has disproportionately been invested in government bonds leading to a crowding out of the private sector. It’s clear that Basel 3 has had an impact.

The way this actually works in practice is through KPIs. Credit sanctioners in banks, working under the credit risk department and segmented by business divisions (e.g., SME or business banking), have KPIs focused on minimising impairments. Impairments occur when a loan goes bad and must be recognized as such, with capital set aside. Unsecured loans require a 100% provision if they default, while secured loans may need only around 20%. Since credit sanctioners aim to minimise impairments and secure their bonuses, they prefer loans with collateral to reduce risk on their KPIs, making unsecured loans less desirable.

This is a structural issue and won’t change so long as capital regulations remain the same. Bank leaders have complained about it here, here and here.

Opportunities in the Market

As banks prefer lending to governments or large corporations, a significant credit gap remains within the SME and consumer segments. Evidence of this is the rise of digital lenders and microfinance firms targeting specific niches, such as trade and asset finance. Often, funding gaps are misunderstood, but genuine opportunities exist in the following areas:

1. Credit Card Programs - structured to reflect risk, targeting both consumers and small businesses.

2. Trade Finance - credit for SMEs engaging in cross-border trade.

3. Embedded Lending - integrated credit in platforms such as marketplaces or digital wallets.

4. Inventory Finance - loans secured by SME inventory.

5. Asset Finance - particularly for productive assets like mobile phones, critical for gig workers and digital creators.

The Growth of Private Credit ;

The private credit industry has grown significantly, focusing on non-bank lending directly to middle-market or high-yield borrowers without traditional bank involvement. This growth occurred as banks pulled back from lending to medium-sized enterprises, giving rise to private equity entities like Ares and Apollo expanding into debt investments. The main types of private credit include:

1. Direct Lending - Loans directly to mid-sized companies.

2. Mezzanine Financing - Hybrid debt-equity with higher interest rates.

3. Distressed Debt - Buying discounted debt from struggling companies.

4. Venture Debt - Loans to startups, supplementing venture capital.

5. Asset-Based Lending (ABL) - Loans secured by assets like inventory or receivables.

6. Special Situations Financing - Financing for unique corporate events.

7. Real Estate Debt - Loans for real estate projects.

8. Securitized Credit (CLOs) - Pooling loans into securities sold to investors.

9. Structured Finance - Complex, multi-layered debt arrangements.

Source: alts.co

Where is the Money Coming From

According to Aum, the source of private credit is largely pensions “ …you can see that a lot of this has come from pension capital. So I think in general, you've seen that pension investments and private credit hit an eight year high. A year or so ago. The 200 largest retirement plans in the US had deployed about $100 billion in private credit in 2022… And so these guys have been key underwriters.” It works for regulators because, “Now, what is the advantage of doing this? Well, one, this is not depositor money. These are qualified institutional investors that should be able to know better and make the decisions. They have long term pools of liability, pension or insurance or whatever that matches with a long term investment horizon.”

Why is it attractive to Lenders

Again, according to Aum “Again, in the US, you need to prove that there are different and separate alternative asset classes than the infrastructure funds and private equity funds out there. And so what they're saying are the advantages, well, it's quicker turnaround time. You get to win better corporate clients. I get to write direct loans, and therefore I'm more secure. I'm not the holder of my other bondholders who can maybe structurally subordinate me, and I can also maybe have these equity warrants / equity-like upsides and kickers” Moreover, there is the fact that unlike banking, there is an actual match between your funding and your assets with private credit firms raising longer-term capital that matches the duration of their loans.

Why is it attractive to borrowers;

From my experience, banks often underestimate the value of convenience and certainty to businesses, which are often willing to pay higher rates for these benefits. At Sote, we had a client whose loan application faced endless delays and non-responses from the bank. The credit team avoided giving a clear rejection, resorting to stalling tactics instead. This left the client seeking the certainty that private credit offers, even at a higher cost. Ultimately, the client obtained offshore private credit. In summary, businesses value clear and timely decision-making.

1. Flexible terms - No standardised cookie-cutter terms;

2. Speed;

3. Flexible collateral requirements including accepting assets such as receivables as collateral;

4. A deeper partnership particularly where workouts need to be executed;

The African Private Credit Context;

Whereas we’ve set out the global private credit context. It’s important to understand the African context. Globally pensions dwarf other sources of capital and are worth US$ 55 trillion according to data from the Thinking Ahead Institute. In Africa, pensions are worth US$ 1.1 trillion according to data from AFIS with a concentration in South Africa, Nigeria, Namibia and Egypt. They’re a very valuable source of liabilities as alluded to by Aum; “I think firstly, the conception that pension funds don't have that much money I think is maybe wrong. When you look at Nigeria, it's 20 or 30 trillion Naira. I've been in Djibouti just now. I met a state depositor that plays in the $200 million range, right?… But even so, for a country of 1 million people that’s a lot. You have to remember that all these countries in Africa, that 50% of employment is the state. So these guys are raising liabilities, they're providing insurance, they're giving pensions. Okay, maybe they're in local currency, maybe they're not in dollars, but they're still raising money”.

The challenge with the Capital Markets in Africa is that African governments have created a captive source of capital for funding deficits. The capital markets regulations in most countries stop pension managers from investing in alternative assets such as Private Equity, Private Credit and Venture Capital. This creates a situation where local asset managers are stuck with bonds whose yields don’t beat inflation. Whereas most commentators think that local pensions are comfortable with getting 15% risk free from the govt, Aum takes a different view; “I don't think it's as simple as pension funds are getting 15% for free, and so they're not deploying, because if you compare it to inflation in all of these markets, it's still negative. Real firms and long term allocators are focused and they're aware and they're smart people. They know what their real returns are, and they know their real returns are negative… and by the way, all the pension funds we pitched to in Nigeria, they were the ones also going to SEC being like, allow me to invest in different products, because at the moment, there's not much I can do. The question as a regulator, and the regulator is a function of government… and the question is, if the government's getting $10 billion of inflows guaranteed to buy their bonds every single year, is it in their interest to open up capital markets and say goodbye to all of the money?”

There have been successes in allowing pensions to invest in alternative assets. FMCB and TLG launched a Naira fund targeted at alternative investments and other players like Stanbic IBTC have also launched funds. All the same, the point is that the move towards local pension capital supporting local businesses through private debt will take time.

Global Capital on the other hand can be split into both DFI based capital and commercial capital. The latter is deeper but more selective whereas the former is focused primarily around themes such as ESG and Sustainability. Aum gives some insight into this “What is the investor appetite and what do we want to do? Well, we want dollars, we want liquidity, we want supernormal returns. You go to a hedge fund in New York and they say we're making 15% on Amazon warehouse risk. And this is levered and it's investment rated. So long as basically most African countries are junk rated or they're not investment grade. It's going to be really difficult to convince commercial investors to put money in and not expect like 20% or 30% or just something ridiculous.”

The solution according to Aum is to create well structured facilities that enable private credit investors to take comfort in the receivables and the structure of the loan. For instance, TLG has structured facilities for Nollywood movie producers who are selling into either Amazon or Netflix with the idea that they are taking Amazon risk which is more palatable. Moreover, players like TLG, Blue Peak, Vantage and Ninety One take a more proactive approach in monitoring the performance of their clients relying heavily on having either feet on the ground or credit monitoring solutions like Cascade Debt. The big question is how can African Fintech Entrepreneurs build sustainable lending businesses targeting the massive credit gap in the market?

How to structure a Private Credit Strategy