The Benefits of Lending to SMEs for a Higher Return: A Compelling Alternative to Private Equity in the Face of Rising UK Taxes

Investing in small and medium-sized enterprises (SMEs) has long been a strategy with significant growth potential, offering diverse opportunities outside traditional equities and public shares. With recent discussions in the UK about potential tax increases on dividends and capital gains from public company shares, investing in SMEs through lending presents an increasingly attractive alternative. Not only do these loans yield solid returns, but they also support critical economic sectors and promote job creation. Here, we explore the advantages of lending to SMEs over holding public equity, especially as tax implications may reshape investor priorities in the upcoming UK budget.

1. High Potential Returns from SME Lending

Lending to SMEs can yield substantially higher returns compared to many equity holdings. Unlike traditional stocks in established companies, which often experience gradual price changes, lending to SMEs can deliver returns in the form of fixed-interest payments, offering more predictable income streams. SME loan returns typically range from 6% to 15%, often surpassing the dividend yields of publicly traded companies. While equities can offer significant growth, the payout from SME loans is not dependent on share price appreciation, reducing the pressure for capital appreciation and offering returns on an ongoing basis.

Additionally, unlike public equities, which can suffer from severe price volatility due to macroeconomic factors, SME loan repayments are typically more stable, allowing lenders to generate income regardless of stock market fluctuations.

2. Tax Efficiency in the Current Landscape

With the upcoming UK budget likely to include new taxes on capital gains and dividends, SME lending offers an appealing tax-efficient investment alternative. Lending arrangements, including direct lending and peer-to-peer lending, may be structured in ways that avoid capital gains and dividend taxation. For example, lending income can be offset against certain business-related tax deductions, allowing for more efficient tax handling than with dividends from equities.

The Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS), although mainly designed for equity investments, do offer considerable tax benefits for investors who provide capital to SMEs. Some investors also consider Innovative Finance ISAs (IFISAs), a tax wrapper available on some peer-to-peer lending platforms, which allows tax-free returns on interest from SME loans. This is in contrast to dividends and capital gains, which could face higher tax burdens in the near future if the UK government proceeds with anticipated tax changes.

3. Portfolio Diversification and Reduced Volatility

Public markets are notoriously sensitive to global events and economic cycles, often resulting in high volatility in stock prices. On the other hand, SME lending allows investors to diversify their portfolios beyond the public market, lowering their exposure to large swings in value. SME loans typically have a lower correlation to public equity markets, making them a valuable tool for diversification. This lower correlation to market trends means that SME lending portfolios often exhibit less volatility than traditional equity investments.

In addition, SME lending allows for further diversification within the asset class, as lenders can invest in different sectors such as technology, healthcare, manufacturing, and retail. This wide exposure helps cushion any downturns in individual industries or sectors, further reducing the volatility of the overall portfolio.

4. Direct Impact on Local Economies and Job Creation

Supporting SMEs has far-reaching effects on the broader economy, fostering job creation, innovation, and regional development. SMEs account for over 99% of UK businesses, creating 61% of all employment in the private sector and contributing significantly to GDP. By lending to SMEs, investors have the opportunity to provide businesses with essential funding to scale operations, improve productivity, and introduce new products and services.

This investment can help drive local growth and innovation in areas that may otherwise struggle to attract capital. By supporting SMEs, investors contribute to a sustainable cycle of economic improvement, which benefits society as a whole while offering competitive financial returns.

5. Lower Entry Barriers and Greater Control Over Investment Terms

Compared to public equity investments, lending to SMEs provides a range of investment options with flexible terms. Investors can often negotiate loan structures that align with their financial goals, whether those are higher interest rates, specific repayment schedules, or priority claims on business assets. This flexibility allows for better risk management, as lenders can tailor their investment terms to the unique needs and capabilities of each SME.

Additionally, some forms of SME lending, such as peer-to-peer lending platforms, have low entry barriers, allowing smaller investors to participate. This is particularly advantageous for investors who may not meet the high minimum investment thresholds that come with private equity or venture capital but still want exposure to high-growth, early-stage companies.

6. Emergence of Fintech Platforms and Improved Risk Management

The fintech sector has revolutionized SME lending, offering sophisticated digital platforms that make the process easier and more secure. New tools for credit analysis, risk assessment, and borrower vetting have enhanced transparency in the SME lending space, allowing investors to make well-informed lending decisions. Fintech platforms also facilitate loan diversification, enabling investors to spread their capital across multiple SME loans, mitigating risks tied to individual company defaults.

With improved risk management techniques, investors can balance their portfolios by choosing SMEs with credit profiles suited to their risk tolerance. This enhanced structure makes lending to SMEs more accessible, safer, and more transparent, thus appealing to investors who may have previously preferred more traditional investments.

Conclusion

As the UK government contemplates new taxes on dividends and capital gains, lending to SMEs presents a compelling investment alternative. Not only does SME lending offer the potential for high returns, but it also allows investors to diversify their portfolios, enjoy favourable tax treatment, and make a direct impact on economic growth and job creation.

For investors seeking a stable income stream with the potential for tax-efficient gains, lending to SMEs is an attractive option. The growth of fintech platforms and specialized lending vehicles has further reduced entry barriers, allowing a wider array of investors to participate in this promising asset class. With SME lending, investors can achieve consistent returns while contributing to the backbone of the economy—SMEs—helping both individual investors and the broader economic landscape thrive in the face of rising taxes on traditional equity investments.