Madison Street Capital Alternative Lending White Paper

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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:
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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
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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
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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
http://www.madisonstreetcapital.com or give us a call at 312-529-7000.
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