Alternative financing options go mainstream
The right lending option properly paired with the right business story can help businesses seize opportunities in the US.
Today’s credit markets have been widely characterised as yield-hungry and borrower-friendly. In the first quarter of 2013, leveraged loan volume climbed to a post credit crunch high of $185.2bn, making it an ideal time to refinance existing debt. However, traditional sources of capital such as banks, which must comply with more stringent regulation, prefer lending to higher quality companies and frequently turn away riskier, smaller middle-market borrowers even though they offer the potential for greater profits.
What’s the story?
Many of the middle-market companies are commonly referred to as “storied credits” by capital providers, recognising each business has its own story. Unlike the traditional credit approach, a story-based solution considers a myriad of factors unique to a particular business including its story (how it got to where it is and where it is going) among others. The challenge is ensuring the story of the business is carefully matched with the right finance option and lending partner.
Fortunately, the current state of the credit markets is fueling creation of new financing options for middle-market businesses and what were once considered alternative capital sources are becoming more mainstream.
The two most common forms of debt financing available to middle-market companies are asset-based loans and cash-flow loans.
Asset-based loans (ABLs) benefit the borrower as their collateral can attract needed liquidity at a relatively low cost. Borrowing is determined by the amount of underlying collateral securing the loan and lenders discount these collateral amounts using advance rates to determine the final borrowing availability. These loans are generally more conducive to borrowers with weaker cash flow but strong asset quality, as lenders generally can feel more comfortable with their collateral security.
Cash-flow loans are predominantly issued to companies with a proven ability to generate strong cash flow. Interest rates on cash-flow loans are typically higher than an ABL, but borrowers still find rates on these loans generally attractive.
Non-bank financing alternatives
Companies with negative net income, in the early stages of a turnaround, or that have more of a story behind their financial situation, will often turn to non-bank institutions for financing. These lenders are more willing to lend more aggressively against the liquidation value of the assets despite a lack of historical profitability. Due to the greater risk alternative financing sources charge borrowers higher rates.
Popular financing vehicles
Business development corporations (BDCs) represent what is perhaps the trendiest alternative financing option for middle-market businesses today. In this yield-hungry environment they have proliferated as an alternative capital source. BDCs must meet certain statutory requirements that can affect their transaction profile, for example total BDC debt cannot exceed its equity. However, these publicly traded companies have the flexibility to make both debt and equity investments giving BDCs the ability to offer one-stop capital shopping. In addition, BDCs have an obligation to provide “significant managerial assistance” to portfolio companies. While there can be some risk of loss of control, this assistance and guidance can be very helpful to growing the enterprise.
Small Business Investment Corporations (SBICs) are generally private partnerships authorised by the Small Business Administration (SBA) to make loans to qualifying US small businesses. A business must have net worth less than $18m and, on average, less than $6m after net income for the last two years.
Both BDCs and SBICs have much greater flexibility in lending money to companies. Their rates tend to be in the low double digits but are justified by providing needed financing when others do not.
Hedge funds and specialty finance companies
Hedge funds and specialty finance companies are the least regulated of the alternative debt capital producers. Hedge funds loans are priced according to their perceived risk. While not the lowest cost source of financing, hedge funds can take a more holistic approach to the financing needs of a business. Many specialty finance companies are experts in financing secured by a specific class of assets and rarely venture out of their comfort zone. If you fit their profile, finance companies can often act quickly to fund a loan.
For more information, contact:
Carl Marks (a member of CohnReznick LLP’s Capital Markets Advisory Consortium)
T +1 212 909 8459