Small-balance credit—a subset of alternative credit gaining traction in the United States as fintech makes modest consumer and business loans more investable—could be a yield generator for institutional investors.
In addition, this type of credit could be a solid diversification tool, says Colin Kilgour, principal at Kilgour Williams Capital in Toronto. His firm runs the KIWI Private Credit Fund, which invests in small-balance prime consumer loans, small-business loans and short-term residential development loans primarily in the U.S.
“This is an area that is largely untapped by Canadian institutional investors, which can generate yield, which is uncorrelated to anything else they’re doing right now [and] which has been around long enough that it is generating some demonstrable, reliable results,” he says.
Small-balance credit typically encompasses loans under US$250,000. Kilgour says the asset class has performed quite well through the pandemic. In the U.S., he explains, borrowers on the top arm of the so-called K-shaped recovery are in better shape financially than they were pre-crisis, while borrowers on the bottom arm have benefited from government supports, for businesses in particular, that have enabled them to continue to service their debt obligations.
A carefully curated small-balance credit portfolio can advance new loans with the effects of the pandemic in mind, he says, giving preference to individuals working in the public sector and healthcare where employment remains robust, and to businesses such as grocery stores, online retailers, information technology services companies, gas stations and auto repair shops that have enjoyed consistent or even growing demand.
“If you lend with a COVID lens, you can make good loans,” he says. “We have seen the resilience of U.S. consumers and small businesses through the pandemic, [and] while there have undoubtedly been some bumps along the road over the year, the performance has been really strong.”
While most assets in alternative credit remain focused on multi-million-dollar loans, Kilgour says the very size of those loans makes it difficult to acquire enough of them to achieve portfolio diversification. In contrast, a small-balance credit portfolio may contain thousands of loans, making it possible to diversify by geography, industry and individual names. One key to success, he says, is aiming for a relatively conservative return and emphasizing principal protection to guard against loss.
“The biggest risk is probably [that investing in small-balance credit] requires you to work with a fintech platform and you need to choose your partners well,” Kilgour says. “We look at [the ones] that have been in business for some time, that are well capitalized and that have management strength comparable to or superior to what a bank would have.”
In addition, he says, “We bifurcate the business risk of the lending platform from the credit risk of the underlying loans, [which] insulates us from the credit risk of a fintech. . . . We buy the loans [and] we put them on our own balance sheet. That’s a credit risk that we’re comfortable with and it’s a credit risk that we know how to adjudicate.”
Beyond risk, liquidity can be a concern for small-balance credit investors: “If you wanted to sell, you could sell loans in a secondary market, but it would be at a discount.”
KiWi Private Credit Fund’s strategy is to buy and hold and, since both consumer and business loans tend to be amortizing loans, a steady stream of principal and interest payments can provide predictable cash flow to generate income or reinvest.
In Canada, some institutions and very large family offices have been exploring small-balance credit, but pension plans haven’t dipped their toes in this asset class yet, Kilgour notes. Some of the hesitation may be because of a perception that it’s hard to deploy a large volume of capital in small-balance credit — but that’s not necessarily the case. He says LendingClub, for example, has been originating just over US$100 million a month in loans during the pandemic, but reached close to US$800 million a month at its peak.
For institutional investors, he adds, “From a non-taxable investor perspective, an asset class that can reliably yield seven to eight per cent with this kind of credit profile ought to be a slam dunk.”