There have always been lenders that play in the places where regulated financial institutions fear to tread. When leveraged buyouts took off prior to the financial crisis, structured vehicles provided the capital, not banks. Now that lending to corporations is back in vogue, nonbank capital providers are again underwriting loans that banks can’t or won’t. Specifically, they are providing capital to middle-market and small companies that banks’ credit committees flag as too risky.
“We have found that banks are simply not providing capital or only providing it at the most senior levels of the capital structure, and don’t have the structuring flexibility or desire to provide more services beyond capital,” says Peter Seidenberg, CFO of MVC Capital, a business development firm that makes private-equity and debt investments.
Below the bulge-bracket banks like JPMorgan Chase and Wells Fargo and second-tier players like PNC and SunTrust, “the ability to lend on a collateralized basis falls off a cliff,” says Darren Latimer, chief executive of Gibraltar Business Capital, a business development company. “There are a lot of local and small banks that don’t do it well, come in and out of the space and don’t hire the right professionals.”
Although banks have grown their commercial and industrial loan books aggressively in the past year and have eased loan terms to large companies, they are still conservative with their capital in other areas. Jeff Pfeffer, managing partner of CapX, a specialty finance company, says a private-equity manager recently called him about financing some acquisitions. “He said banks are favoring certain structures and are not as open or aggressive lending to certain industries,” says Pfeffer.
Regulatory capital rules are also weighing on banks, making it particularly difficult to finance unrated or highly leveraged credits, or businesses with hiccups in their financial performance.
Capital for “Positive Things”
Private capital providers are lending especially to companies those with less than $100 million in revenue that don’t have access to the public debt markets. Such firms are often overlooked by traditional lenders and investment banks.
Gibraltar’s Latimer, for example, says he is looking for companies that need capital for “positive things,” such as investments in inventory and technology, as opposed to “bad uses,” like paying judgments and liens or payroll taxes. CapX’s Pfeffer says his business development company focuses on growth- and liquidity-driven capital needs, “where are there are one or two irregularities [with the company], something that gives banks pause.” Those “irregularities” could be a severely constrained balance sheet or recent earnings losses or cash-flow troubles.
Senior and subordinated debt, mezzanine loans, equipment and buyout financing, asset-based loans — there are a host of ways these alternative lenders supply companies with capital. They also often invest in equity alongside a debt financing. They can lend to less-than-ideal credits for a number of reasons, not least because these transactions often have downside protection from being secured by the borrower’s assets or receivables. They also earn high risk-adjusted rates of returns for investors, in part because they charge higher interest rates than banks and have unique business models.
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.”
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.
In mezzanine lending, for example, the competition from banks and other providers is so fierce that borrowers don’t have to give lenders ownership strips or equity warrants, as they did during and after the financial crisis. Having pruned the deadwood, Essex explains, banks are adding assets again and returning to “stretch lending,” where they have no asset coverage but lend based on the business’s cash flows.
Indeed, the middle market has become so competitive overall that there are some deals that firms like CapX just won’t touch. Companies with $100 million or more of EBITDA have a lot of negotiating power now, says Pfeffer. “We have only a handful of [borrowers of that size] because with everyone chasing deals, the structure becomes nonexistent and the pricing is unattractive.”
The liquidity available to corporate credits also means that often a company may not have to choose between a bank and a finance company. On many balance sheets they can co-exist. “There are companies where senior lenders are comfortable to a point and unwilling to take on further leverage, but will allow for additional capital to come into the structure in the form of subordinated debt,” Essex says.
One Point in a Cycle
CFOs also have to look at debt financing from a company-lifecycle point of view. Borrowing private capital doesn’t commit a firm for the long term. Commercial finance providers can provide companies “that extra turn of capital” early in their existence, says Latimer. “If a community bank gives Joe’s Manufacturing $1 million, we may give them $1.3 million,” he says. “That extra $300,000 may mean four extra machines on the shop floor, filling customer orders more quickly and a move to profitability. For that the borrower will pay a higher rate, which is without a doubt a downside, but it will have more capital, and it will use that capital for two or three years. If the plan works, then they can go to a bank.”
Relationships with nonbank lenders, many of whom invest equity as well, can also be long term. Seidenberg says MVC invested $16 million of debt and equity in one company, then sold its equity stake for a $50 million gain. But based on its strong relationship with management, MVC provided the company with a second-lien loan after its exit.
“Due to our role as hands-on advisers, we find ourselves working with management teams time and time again,” says Seidenberg. For some companies, that close relationship with an advisory element may be just what’s needed — and an element they are not likely to get from a big bank.