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Madison Street Capital Investment Bank alternative lending white paper

Madison Street Capital Alternative Lending White Paper

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Madison Street Capital Investment Bank alternative lending white paper

  1. 1. idd Alternative Lending Sources for Lower to Middle Market Companies December 2013 In the current commercial lending environment, a sizable number of firms in the lower segment of the middle market ($5 million to $100 million in annual revenue) have been unable to meet their capital needs to fund growth. Even as recessionary pressures ease and the broader economy continues to move into recovery, commercial banks have deemed these firms "unbankable" for any number of reasons. For one, recession-induced depreciation taken to reduce tax exposure can skew the trailing financial data that commercial loan officers consider in evaluating lending proposals. For another, assets shed during the recession can push balance sheets below lending thresholds, as can sluggish revenue growth and weak (or even negative) EBITDA. At the same time, many lenders continue to avoid entire sectors (construction management, certain service providers, tech startups, etc.), or deny loan requests based on insufficient past performance. According to the Small Business Administration, total dollar volume for all small business loans fell each year from 2008 through 2012 ($711 billion in 2008 vs. $588 billion in 2012). And the loans that were made were smaller in value; loans of $100,000 or less grew by nearly $500 million, while loan volume higher than that amount declined.1 But commercial banks are hardly the only lending game in town for small and mid-sized businesses. Lenders willing to evaluate and take on risks that commercial banks won't touch include:       Specialty finance companies that serve a broad spectrum of borrowers in the B and C "subprime" credit classifications, as well as startups and other firms that do not fill the traditional profile of a commercial bank lending prospect. Credit hedge funds that pool investors' cash and re-invest it in a portfolio of self-originated loans with objective of outperforming the market. Business development companies, or BDCs, that assist earlier stage growth companies, often through mezzanine or unitranche financing arrangements. BDCs share some traits with venture capital firms and are regulated by Section 54 of the Investment Company Act of 1940. Mezzanine lenders, which typically pair a debt instrument with some form of equity component. The equity component provides upside potential to the lender, while the debt instrument offers downside risk protection. Certain private equity funds, who unlike traditional PE Firms, seek out lower-middle-market targets where they can deploy capital in the form of preferred investment structures that have debt-like characteristics. Special situation funds geared toward mergers, spinoffs, new product introductions, litigation resolutions, changes in senior management, or similar circumstances that find a firm undervalued relative to its long-term potential. In nearly every case, the cost of capital secured through an alternative funding source will be higher – and in many cases, significantly higher – than it would otherwise be in dealing with a commercial bank. In addition to sharply higher interest rates (ranging from the low teens to the low 20s or more), borrowers often face highly restrictive loan covenants, equity sweeteners such as direct shares or warrants, 1 "Small Business Lending in the United States 2012," U.S. Small Business Administration Office of Advocacy, released July 10, 2013 1
  2. 2. monitoring fees, transaction fees of 1% to 3% of loan value, stiff collateral requirements, preferred cash flow distribution arrangements, original issue discounts (OIDs), and steep penalties for early repayment. More often than not, the lender will demand personal guaranties before approval. The underwriting process takes longer and it can be expected that there will be very stringent credit monitoring procedures put in place once the loan is approved. Should business owners default, they stand to lose their businesses as well as other collateral pledged to secure the loan. Fully understanding these provisions and the risks they pose is an essential component in completing this process. Why would a business owner proceed in this scenario? The answer can vary, obviously, but it boils down to the fact that high risk yields high reward, and the advantages of dealing with an alternative lender can offset the increased costs. For example, the requirements placed on a business by an alternative lending arrangement can force management to re-examine all aspects of operations, reducing costs while eliminating risks. Also, alternative lenders routinely employ highly experienced management professionals with expertise in narrowly focused industry verticals; borrowers can tap into this expertise to refine their marketing strategies, operations, personnel, and other key aspects of their overall corporate alignment. In deciding to pull the trigger on an alternative lending arrangement, business owners must balance the cost of capital against the cost of doing nothing. The opportunity to consolidate market share by acquiring a key competitor may never recur. Similarly, the chance to expand sales and revenue through product introduction, expanded marketing, vertical integration, or even the opportunity to clean-up the balance sheet must be seized when it arises. Countless middle-market firms fail because they fail to recognize and act on a key opportunity. Analysts agree that the current combination of low interest rates and low inflation will allow the Federal Reserve to maintain its bond-buying stimulus program, which has helped lower unemployment even as short-term interest rates have remained near zero. The Consumer Price Index rose just 1.2% for the 12 months ended in September 2013, well below the Fed's target of 2% annual inflation and less than half its 2.5% threshold for tightening monetary policy. By the same token, this means that commercial banks will be in no hurry to resume lending to small and mid-sized businesses at volume levels observed prior to 2008 – and certainly not on the same terms (see chart below on recent lending approval rates). Source: Biz2Credit October 2013 Small Business Lending Index 2
  3. 3. Conclusion Just to be clear: Alternative lending is expensive. But in the ongoing business credit environment, in which traditional financing from commercial banks remains unavailable, small and mid-sized business owners will benefit by seeing alternative lending as a short-term solution. In many cases, the infusion of capital needed to achieve a strategic goal or some other important element of a business plan is precisely what's needed to achieve (or regain) solid financial footing -- and allow the business to refinance its obligations with a traditional lender, under more favorable terms, in the future. As the recovery strengthens and business conditions continue to improve, the amount of capital available to lower-middle-market firms grows larger. Some commercial banks, including smaller regional banks, are continuing to ease their credit qualification standards, while large institutional investors continue to favor direct lending platforms (such as BDCs and credit hedge funds) based on the higher levels of returns they generate. Even so, the potential minefield of alternative lending can be lethal to the uninitiated and inexperienced. Throughout this process, the resources of a valued partner in identifying, negotiating, and executing the optimal alternative financing arrangement cannot be undervalued. About the author Karl D'Cunha, CA is a Senior Managing Director at Madison Street Capital. The range of services include: M&A Advisory, Capital Raising, Fixed Income Trading, and Valuation Advisory services. Mr. D’Cunha has a broad financial services background including over 16 years in capital markets working with some the largest banks, hedge funds, private equity firms and other financial institutions in the world. About Madison Street Capital Madison Street Capital is an international investment banking firm that provides M&A advisory, financial advisory, financing services, valuation services, and operational improvement and restructuring services to public and private businesses. Madison Street Capital has focused expertise in partnering with middle-market firms to successfully navigate complex transactions and successfully assist clients in optimizing the potential of their organizations. Madison Street Capital’s experienced professionals serve clients across the globe from offices in North America, Asia, and Africa. For additional information, please visit our website at or give us a call at 312-529-7000. 3