In recent months we have seen the greatest ever UK Government borrowing requirement, outside of the two world wars. Partly connected with this is an estimated £100 billion of unsustainable debt built up in UK private companies. We are used to thinking about central, investment and retail banks providing all this funding - together with public markets and private equity. Should we stop to think about where all this funding actually originates from? Does it matter? What we learned from the global financial crisis is that yes, it does matter!
Major global capital flows come from long term holders of funds which are usually huge pension or insurance funds. To give you an idea of the scale, the OECD estimates that global pension funds currently carry assets of around $33 trillion. When investing, they have timelines over when they want their money back and strict criteria over which assets and risk profiles, they want exposure to.
The global aspect of this is important. For example, 50 percent of the funding of UK listed stocks comes from UK funds and the rest from around the world, with half of that coming from North America. Fundholders therefore have global choices about where to deploy their money.
Private equity (PE) money predominantly comes from the same sources, albeit the smaller end of these funds, which has been specifically allocated for such investment. Pension funds largely want to know that their money is coming back sooner than PE can offer and also want a lower risk profile than PE provides.
Banks’ funding comes in part from savings accounts, but also from central bank instruments. How much banks can lend (capital ratios) versus the risk weighting of who they lend to has a marked impact on their ability and appetite to lend. This is tightly regulated and indeed has been at the centre of regulators’ attention since the global financial crisis.
Non-bank and fintech lenders don’t have this same access to central bank funding. They have to rely on wholesale lending and securitisation markets. This is causing friction at the moment in the UK, with volatility in wholesale spreads restricting their liquidity. The non-bank and fintech lenders are feeling squeezed out of the market by their larger, traditional competitors.
Of course we mustn’t forget the funding needs of the largest individual funder of them all at the moment – the UK Government! It is borrowing around £390 billion this year and tax revenues over the next 3 years are going to be hundreds of billions of pounds less than that expected back in March. The UK Government issues bonds to fund its own borrowing. These are currently sucked up either by the Bank of England Quantitative Easing programme (QE), or the above funds who in difficult times seek the relative security that comes from Government debt.
The major global funds want visibility of a safe home for their money. This is good news for governments and very large companies, but bad news for smaller privately-owned businesses. I’ve previously noted that the UK corporate landscape is highly fragmented and that this is a challenge to our resilience in a crisis.
The cross-border nature of capital flows is also a fundamental question that needs addressing as we move towards the end of our Brexit transition period. We are used to London being a global financial centre and for all sorts of reasons, we need it to stay that way!
Large funds are also increasingly looking towards stronger environmental, social and governance (ESG) credentials in everything that they invest in – not just with a renewed moral compass, but because of the economic drivers that will follow government commitments around the world towards net zero carbon. Secondly it is also because of a growing realisation that ‘G’ for governance means better run companies and therefore a better risk/return outcome. Our lesson here is that no matter how far down the funds-flow chain you are, from a fund manager to a fund raiser, this expectation is coming your way. If you don’t have a strong and credible ESG agenda in your business, then you’re likely to need one soon!
The PE sector is very healthily funded at the moment, with an estimated £190 billion of dry powder waiting to be deployed across Europe. However, don’t expect this to be an easy answer to the unsustainable debt question, as they’re not going to bail anyone out by paying down legacy debt problems. PE invests in successful, growing companies. So, you either need to be largely unaffected by COVID-19, have low levels of existing debt or you need to go through a debt restructuring.
Bank lending is tight. Operational stretch and those capital ratios mentioned above mean that banks are barely open to much more than some sensible additional lending to high quality existing customers. Debt leverage available for new private equity deals in the UK is also limited. I see many mid-market deal processes which will need high levels of equity to fund them, or expensive structured debt from credit funds, or a return to more normal banking appetite in the autumn.
The non-bank and fintech lenders would love to be stepping in now to support the economy. They see this as a possible step forward in their business into the mainstream, at a time when borrowers are becoming more comfortable with new sources of lending and with digital customer interaction more broadly. However as I have noted above, they don’t have much funding with which to do so. The Government has so far resisted calls for them to achieve funding directly from the central bank and this displays a caution from the Government in moving the regulatory status quo. How long can this last? The future of financial services will contain as much disruption and change as any other sector, perhaps more.
And what about government? The standing of the UK Government and economy is such that this huge burst of additional borrowing barely seems to be raising an eyebrow, but this hasn’t fully played out yet. In the next few years it is likely that our economy will be smaller at a time when the spending requirement will be higher.
High borrowing can stall economic development. QE is intended to stop this, but of course there is no such thing as a free lunch. Economic commentators sometimes refer to the risk of ‘Japanification’. This could arise where government support is not sufficiently focused around maintaining or enhancing our productivity. In this scenario, high levels of borrowing supported by longer term use of QE fails to stimulate the economy and we’re left with low interest rates, low inflation and anaemic growth. Wilful government overspending brings relief in the short term but is a drug that we must come off if we are to return to a healthy and balanced economy!
Thought for the day ‘Start each day with a positive mindset and a grateful heart’
About the author: Richard Peberdy leads KPMG’s National Markets Deal Advisory business. An Economics graduate, he has spent the last 25 years helping our clients develop their strategic business models and then fund and execute their corporate development ambitions.