An overview of the emergence of new debt facilities.
Written by James Sinclair at Trade Finance Global.
It is important to understand the root of finance and look back almost 8.600 years ago where it was reputed that people in Turkey used to use copper as money. Leather and paper money were created by those in China and this later progressed to concepts of related products, such as insurance, securities and products traded on the commodities markets; mostly invented by the Mediterranean civilizations. The securities market was then modified in northern Europe. In 1792, the New York Stock Exchange was created by an agreement between 24 businessmen. This takes us into more modern day finance.
The current state of play?
The landscape of the debt market and way that lenders work has changed dramatically in the last five years. This was driven largely by the financial crisis of 2008 and the main effect has been that traditional banks have significantly reduced lending to small businesses. Due to increased regulation and tougher credit processes, financing can take several months to approve. Thus stifling the growth of businesses.
Regulation has meant that risk-aversion has set in within many financial institutions who have cut off lending to many SMEs. Alternative lenders (not being subject to the same regulation) began offering finance in a market where liquidity was high but credit was cheap. This has been perpetuated by the tightened of credit restrictions imposed by many banks, which has remained in force even though the government has extended their Funding for Lending Scheme (FLS).
The FLS was launched on 13 July 2012 with the aim to incentivise mainstream financial institutions to increase their lending to the UK real economy. We have now come to the end of the extension to the FLS, which went from 24 April 2013 to the end of January 2015.
Have rejections increased?
Widespread data on loan applications has not shown a huge increase in rejections, but we see that applications have been effected due to the low confidence amongst SMEs to approach mainstream banking institutions.
Cost of capital
The cost of the capital that is borrowed through alternative lenders is often higher than borrowing via more traditional avenues. However, many business owners have no alternative option; especially with increasing time scales associated with borrowing in the current market. Alternative financiers also offer flexibility, less restrictive credit terms to companies with a poorer credit history and their speed of processing is faster, which is a necessity when new deals present themselves.
What new lending types are there?
There are many forms of lending that have been created or advanced, such as growth loans, asset-based lending, mixed debt and equity kicker products, peer-to-peer lending, vendor accounts, and invoice financing that we are seeing an increase in.
The investor profile in these new forms of finance has changed dramatically. At the start, most cash advances were backed by individual investors. However, as performance has improved and familiarity increased, a broader range of investors including individuals investing through investment vehicles or managed accounts and institutional investors such as pension funds have entered the market. With a wider range of debt platforms being developed, there are a greater number of risk appetites that are catered for, as the system of profiling of debt in relation to loans has become more sophisticated.
The approval process for a traditional lender in relation to a business loan concentrated mainly on the personal credit score and these stricter requirements are becoming more difficult to meet. More flexible alternative lenders realize that personal credit history does not necessarily reflect the management of the business and its potential. Newer lenders focus more on cash flow, and so are able to approve credit challenged individuals in order to stabilize and grow their businesses.
Debt compared to Equity
Looking at debt and equity in today’s market is a question for the individual company. This must always be viewed against the backdrop of heightened regulation in the banking sector and mainstream lenders not being able to cater to seasonality.
Banks usually require a fixed monthly payment and generally ignore the seasonality and inevitable cash flow fluctuations of a business. This lack of ‘partnership’ has a strain on working capital and creates a difficult situation for the operators of a business. Therefore sometimes equity is the best route as it ‘de-risks’ the process and the element of downside for the secured parties in any debt transaction.
Where are we?
There has been a perceived loosening of lending standards of banks, but alternative lenders have already taken a substantial piece of the small-business lending pie. It is not clear whether this is a permanent change to the business landscape or a temporary fix.
Need to budget your financing costs? Want to understand details of cashflows and balance sheet entries for your loan?