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Consider the Alternatives

Companies rejected by banks are finding a friend in alternative lenders.

15Nov

When commercial bank lending rises as steadily as it has the past year, it’s hard to fathom some companies being denied credit. Believe it: there are always companies (and industries) that are just not bankable. Among them: companies that are cash-flow negative, start-ups with intellectual property but no customers, and young industrial companies that need to finance fixed assets before entering the production phase.


The situation for the have-nots could get worse in the next few years, as pieces of the new Basel III bank capital rules may force banks to be more selective with their capital commitments, especially when lending to companies of marginal creditworthiness.


But there are some alternative financing sources that are hungry to deploy money and willing to finance higher-risk projects. Low interest rates are a big reason. “There’s not a lot of yield to be gotten in the public bond markets. Private-capital providers need yield in their portfolios,” says Allen Weaver, senior managing director at Prudential Capital Group, which invests long-term money from insurance companies and pension funds.


A Deeper Look

Last year, two-year-old spirits start-up Deep Eddy Vodka had trouble securing financing when demand outstripped the capacity of its bottling line equipment. Deep Eddy was spending a lot on sales and marketing to build its brand and grow its top line fast, and it was paying less attention to profits, says vice president of finance John Scarborough. As a result, many banks did not consider Deep Eddy’s business model creditworthy, and once they saw the company’s operating losses, they said they needed personal guarantees from Deep Eddy’s principals.


Ultimately, Deep Eddy found Fountain Partners, a provider of lease lines of credit for capital equipment. “Fountain was willing to look at the business model, peel back the onion a bit, and see that there was a fundamentally strong business underneath,” says Scarborough. Deep Eddy landed a $250,000, 36-month lease to buy its new high-capacity bottling line, as well as a sale-leaseback of existing equipment to generate additional working capital.


There is a drawback to alternative financing: a nonbank lender’s cost of capital is higher than a traditional bank’s, since it doesn’t have dirt-cheap deposits to fund loans. Since its cost of capital is higher, the borrower pays a higher rate. “With the funds we are running right now, we are looking for rates of return that are double-digit, and we are very clear about our willingness to take large-scale risks that make that [rate] deserving and fair,” says Tom Carter, founder of Fountain Partners and a former CFO.


Room to Stumble

Another group offering financing to the unwanted is business development corporations (BDCs), publicly held investment companies that must distribute 90% of their profits to shareholders. Such entities lower their cost of capital by leveraging their balance sheets, says Manuel Henriquez, CEO of Hercules Technology Growth Capital, a BDC. Hercules originates senior secured loans, often collateralized with intellectual property, and has a cost of capital of 5% to 7%, compared with 2% to 3% for a bank.


The real advantage of this form of alternative financing is not in the hard costs, though. Henriquez says his clients — companies with $20 million to $100 million in sales, but inconsistent cash profits — can place their deposits and operating accounts into any bank. In addition, the financing agreements are a lot less covenant-driven. And in the event a company gets into trouble, “the loan doesn’t get passed to a workout group whose sole purpose is to get the bank’s money back at whatever cost, because regulators are breathing down its neck,” Henriquez says.


“Because we are not regulated like a bank and have permanent capital on our balance sheet, we can work with a company through difficult times,” he adds. “We expect our companies to stumble, like a little kid on a bike.”


While monthly payments with interest rates higher than a typical bank loan may scare finance executives, nonbank debt lets some companies save expensive equity capital for strategic uses. It doesn’t make sense for a start-up to buy furniture, servers, and routers or fund working capital with equity dollars, Henriquez says: “Better to supplement that with debt that helps the company bridge a two-to-three-year period until it reaches its next milestone and attracts a higher valuation.”


But alternative lenders don’t have an infinite appetite for risk, either. Fountain Partners looked at several deals in the solar industry between 2006 and 2011, Carter says, but never extended credit to one. His reasoning: basic science and execution risk around the companies’ manufacturing plans, and the fact that many of the solar companies didn’t have enough venture money to reach the production phase.


Still, in general, firms like Fountain take a more expansive view of a borrower’s prospects. “We take risk that large-scale financial institutions shy away from,” says Carter.

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