Institutional investors are told that diversifying their portfolios is the best way to manage the risks inherent in global financial markets, but when taking the next step to allocate their assets, many are not given the adequate tools to do so.
By sticking to listed equity markets and only buying into liquid corporate and government bonds, investors risk narrowing their opportunity set significantly. Only the largest companies are able to issue shares on the London, New York or European stock exchanges, due to the amount of regulatory due diligence and cost to get them there. Similarly, for companies to issue bonds to international investors via public markets takes time and money that most just do not have.
And while global stock markets are believed to track the health of a country’s economy, they are often not a true representation at all. In 2018, the London Stock Exchange1 said more than two thirds of the revenues earned by the companies listed on its FTSE100 came from overseas. Instead, some 99.9% of the 5.7 million companies operating in the UK are small to medium-sized, according to government figures. This means they give a more accurate picture of the country’s economy – and offer an investor a broader piece of the action. Additionally, as these companies are not held up as a representation of the UK’s economic daily or weekly economic strength, they are not at the mercy of the volatility that frequently moves global stock markets.
By picking companies to lend to on a case-by-case basis, investors are also able to cut out a lot of the noise from global bond markets and establish a fair rate for both sides of the deal. This means funding medium sized enterprise provides investors with predictable, stable and long-term cash-flows, away from erratic global shifts. And aside from shielding investor portfolios from volatility, SME2s also offer a much wider range of companies than listed equity and bond markets. SMEs account for at least 99.5% of the businesses in every main industry sector in the UK and are often in those where no major corporation operates.
These companies offer other diversification opportunities, too. Rather than being headquartered in London, SMEs are spread out across the whole UK. Some 10% of UK SMEs operate in the north west of the UK, 8.7% in the south west and almost 15% across the midlands. This geographical spread is not just important for the diversification of a portfolio – investing outside of the capital gives a boost to the real UK economy, too.
These 5.7 million companies that are dotted all around the country from Lands End to John O’Groats employ many more people in the UK than those listed on the London Stock Exchange, which derive so much of their revenues from overseas. Some 60% of the working UK population are employed by SMEs, which are responsible for 52% of the country’s annual turnover. By lending to these companies, investors can support the local, real economy all around the UK.
When considering diversification, along with all these other qualities the actual size of these companies is important, too. Many of the multi‐billion‐pound global giants issuing bonds to capital markets are looking to finance acquisitions, mergers or other corporate actions. They have often grown as far as they can organically, which is usually not the case with companies further down the scale. SMEs often borrow to fund expansion by upgrading machinery or hiring more staff, allowing investors to be part of a growth story that is pivotal to their future.
Of course, there is risk attached to investing at this end of the market – just like there is at the top. At BNP Paribas Asset Management, we are increasingly using big data to help us mitigate this risk and pick the right companies to fund and build their sustainable future. There is plenty of publicly available information about SMEs at Companies House or in carefully selected private databases, which allows us to take a systematic approach to consolidating and aggregating data. Once thoroughly cleansed and analysed, we put this data through our credit risk modelling processes and assess the likelihood of defaults. Our parent bank also offers us the infrastructure to streamline our lending process.
There are millions of companies that need investor capital to grow across the UK and millions in investor capital to help them, while producing a diversified return.
1 London Stock Exchange, “International companies joining the London markets” as of May 2019
2 Small and Medium Enterprises
Unless otherwise stated, all facts and figures come from the Department for Business, Energy & Industrial Strategy 2018 statistical release: Business population estimates for the UK and region