SME lending competition may lead to “capital washout”

Rapidly rising competition in the small business lending market could lead to a deterioration in credit quality and a “capital washout”, Isaiah Toback, deputy co-chief investment officer at Castlelake, has warned.

While Toback noted a broadly healthy macroeconomic environment for small businesses, he suggested that increased competition among lenders could present challenges going forward.

“I think the biggest issue has been that too much capital has come to that space too quickly, and we’ve seen a rapid expansion of credit, which typically means a deterioration in quality,” he told Alternative Credit Investor.

Castlelake is a US asset-based finance (ABF) specialist with around $33bn (£24.5bn) in assets under management. Toback said that the firm’s data analysis indicated a deterioration in credit quality in the small business lending space, which could lead to “a capital washout in the future.”

While Toback emphasised that there had not yet been significant losses to lead to the washout, he said it was “just what we expect. And I think if you’re buying that product today, it’s a challenging prospect.”

He continued, “the lenders are growing very quickly, and as they compete with each other, they are willing to go down market, they are willing to lend weaker loans… there’s also competition from the ABF investors who are rapidly trying to grow their exposure to this space.”

He now sees a trend whereby originators are commanding deals with little structural protection, aiming to sell loans at high premiums and not wanting to entertain any type of economic share or incentive alignment.

“Rapid expansion and credit deterioration, combined with competitive dynamics on the ABF side where you’re forced to buy loans with no structural protection has created a double whammy,” he added. “That’s the red-light event.”