Lending isn’t what it used to be. Despite record-low interest rates and gradual improvement of the economy, the lending environment is surprisingly difficult — especially for small businesses. As a recent report by the NSBA explained, “Just 65 percent of small businesses report they are able to obtain adequate financing, down from 73 percent just six months ago.”
The inability to acquire traditional financing has caused many small businesses to look to alternative means for capital, a trend we have noticed on Axial. As CEO Peter Lehrman explained in our press release yesterday, “The sustained lack of traditional commercial debt financing is driving lower middle market companies to the Axial network to explore non-traditional lending and financing options from senior debt down to unitranche, sale leaseback and even cash flow loan.”
But what has caused the tightening of the lending market? Partially the performance and perceptions of small businesses; partially the requirements of banks and traditional lenders; and partially new regulations implemented by policy makers.
Small Businesses May Not Be Lendable
One of the biggest challenges facing the lending environment is that small businesses are not as eligible for loans as they used to be.
While recent activity has suggested a modest recovery of the economy, many small businesses are still well below their 2007/2008 levels. “Reduced small business growth translates into subdued loan demand,” remarked the Federal Reserve of Cleveland in a recent report. “Fewer small businesses are interested in borrowing than in years past.”
Some small business owners are avoiding loans altogether because they believe they don’t qualify. The Fed remarked, “Some of the subdued demand for loans may stem from business owners’ perceptions that credit is not readily available.”
Those interested in, and capable of, getting loans are finding that their loans are smaller because of their lack of collateralizable assets. Since real estate prices have remained low, many business owners are only eligible for modest amounts of capital.
With smaller revenues and lower demands, it is only natural that the number of small business lenders has shrunk. But without loans, business growth has been stymied – creating a chicken and egg problem.
Banks Have Raised Their Standards
Banks and traditional lenders have not made the situation any easier for small businesses. After the ‘Great Recession,’ traditional lenders became extremely careful with their loans and their lines of credit.
Advanced stipulations have grown worse with time and fueled the perception that small business loans are unattainable. Though there was a slight easing in some sectors last year, the Survey of Credit Underwriting Practices by the Office of the Comptroller of the Currency learned that banks tightened small business lending standards in 2008, 2009, 2010, and 2011.
Bennett Goodman of GSO explained in an Institutional Investor article, “In the old days a bank might have been more willing to commit its balance sheet for long-standing clients…Because of the regulatory environment, it’s harder from them to do that economically.” New laws like Dodd-Frank, Consumer Protection Act, and the Volcker Rule have funneled many traditional lenders into making their profits from very specific paths, most of which focus on larger businesses.
Banks, in an effort to stay relevant and prevent being rolled up in a merger, began focusing on coping with the new regulations and their effect on a bank’s bottom line. Since small business loans are “banker-time intensive, are more difficult to automate, have higher costs to underwrite and service, and are more difficult to securitize,” according to the Fed, they are less appealing and less profitable. On the other side, loans to large companies have grown in recent years.
The stricter standards have cut off traditional loans for many businesses. Fewer small businesses have the cash flow, credit scores, or collateral that lenders seek. As the Federal Reserve of Cleveland explained in a recent report, “Lenders see small businesses as less attractive and more risky borrowers than they used to be.” In numbers, that means that “despite an increase of nearly 100,000 small businesses over the period, the number of [small business] loans dropped by 344,000 over the 2007 to 2012 period.”
But, without loans, many small businesses are now simply playing a game of endurance against the mostly stagnant economy.
Combining the new regulations with a growing aversion to risk has caused “banks [to retreat] to traditional roles as advisers to corporations, underwriting bonds for only the most highly rated companies and riskless deals,” Goodman reasoned.
What to Expect Going Forward
If the game of small business lending has indeed changed for good — thanks to regulatory shifts, small bank mergers, and new paths to bank profits — what are small businesses to do about their credit needs? Many are suggesting the forms of alternative lending.
Alternative lending — like mezzanine financing, peer-to-peer lending, crowdfunding, SBIC-backed funds, sale/leasebacks, or even large institutions acting through shadow banking — has picked up momentum in recent years. In the last six months alone, nearly 800 non-equity financing deals originated on the Axial network by members. This transaction activity represents 200% percent year over year growth on the network — and a growing impatience of capital seekers regarding the tight traditional lending channels.
But will the alternative trend endure? If the economy continues to recover and the Fed diligently tracks the rise in interest rates, there is a chance that traditional lenders will retake their position as the primary capital providers in the United States, and alternative lenders may be relegated back to their ‘alternative’ classification.