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Lending Where Banks Fear to Tread

Nonbank lenders and other sources of private capital will often provide financing to small and midsize companies when banks won’t.

Consider how CapX finances an equipment deal for an expanding manufacturer. It buys the equipment from the vendor and leases it to the company, and receives an up-front fee and the interest on the lease. It gives the lessee the option to purchase the equipment at the contract’s end, but if the lessee returns the equipment, CapX can turn around and sell it to make an additional return, says Pfeffer.

Nonbank lenders get comfortable with riskier borrowers also through confidence in the equity capital supporting the company. “PE- or venture capital-owned companies are our primary focus because they have dedicated capital below us in the capital structure,” says Pfeffer. “They have money at risk and a defined investment period.” Unfortunately, many closely held businesses without a financial sponsor might not be attractive borrowing candidates for some of these lenders.

Expensive but Flexible

Borrowers seeking private capital have to find a way to get comfortable themselves, since borrowing from a specialty financing firm is different from tapping a bank. (See story, “Finding the Quirks in the Loan Agreement.”) For one, it’s more expensive: the interest rate is perhaps double what a bank might charge, and the lenders are largely unregulated. The quality of capital backing these finance companies also varies. While some have dedicated funds raised from institutional investors, others may be tapping the high-yield market, and may be nearly as uncreditworthy as the companies trying to borrow from them.

On the other hand, private capital comes with a lot of flexibility for the borrower. Private debt often is less structured from a covenant standpoint and does not rely on personal guarantees. The specialty lender can also react more quickly to a company’s debt needs, says Latimer. “We lend to companies on the borrowing base — that’s the ‘bible’ of the loan — and we’ll have maybe one covenant, an EBITDA [earnings before interest, taxes, depreciation and amortization] covenant based on the company’s forecast,” he says.

Nonbank lenders also look very closely at collateral, says Latimer. “Some receivables may not be collectible or may be very slow moving and have less value, but we’ll spend extra time on the valuation,” he says. Gibraltar can find 10% or more value than a bank can, he claims.

Swifter reaction time is also a benefit to borrowers, says Latimer, a former executive vice president at Wells Fargo Foothill. A business loan can take a bank more than 90 days to close, because they have to go through “layers and layers” of credit committees, whereas an alternative lender with a five-person credit committee may be able to close in 30 days, he says. “Finance companies can react more quickly because they don’t have capital-limitation issues from the government.”

Favorable Terms

The amount of liquidity in the corporate credit markets (at least as of early September) also creates a more favorable terms-and-conditions dynamic for borrowers, says Scott Essex, a managing director in the private debt practice at Partners Group. The search for yield by institutional investors has caused pricing for corporate debt to fall; Essex said his firm has seen the contractual rate of return on its loans come down. The postrecession return to so-called covenant-lite deals in the investment-grade space is also trickling down to the private markets, giving middle-market borrowers greater flexibility in documentation and structures, Essex says.

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