Non-bank Financing for Middle Market Firms
While many forms of financial activity have bounced back from the 2008-09 financial crisis, bank lending to middle market companies remains constrained. A 2012 National Center for the Middle Market (NCMM) survey found that 54 percent of middle market companies said one of their key challenges was gaining access to financing. And as banks face tightening regulations, from Dodd-Frank to Basel III, prospects for opening the lending spigots seem limited.
As a result middle market companies need to pay close attention to the availability of financing available from non-bank sources. There are, in fact, a substantial number of institutions that provide funds to middle market companies.
In an effort to provide a broader understanding of the important role non-bank financing plays at middle market firms, Professors Sergey Chernenko and Isil Erel of Ohio State University, Fellows of the NCMM, have been examining the financing patterns of 1400 publicly traded non-financial companies with sales between $10 million and $1 billion in any year during the period 2005 through 2010. They constructed a random sample composed of 25 percent of these firms, and divided them into four groups based on annual revenues . Chernenko and Erel then examined each firm's SEC filings -- including forms 10-K, 8-K, and other documents -- to glean data on the level and sources of the firm's financing.
Non-bank Financing: Frequent and Substantial
This analysis found that non-bank financing is both widespread and significant for middle market firms.
- More than a third of the firms relied on institutions other than banks for financing. Some 34.2 percent of the firm-year observations listed non-bank lenders.
- Non-bank financing was a substantial portion of the financing for firms that used it: The ratio of non-bank borrowing-to-debt was 50.44 percent.
- The variations across firm size was significant. The mean ratio of non-bank and non-public-market borrowing to debt for the smallest firms was 61.28 percent, while the mean was 38.79 percent for the group of largest firms. In short, the larger the firm, the more it relied on banks and public markets rather than other sources of financing. But for firms of any size that used non-banking financing, it was a substantial component of their financial structure.
- Finance companies and insurance companies were the most important sources of non-bank financing, whether measured by total sums provided or by frequency of use. But there are a number of other specialized financing companies serving the middle market, as well as private equity and venture capital funds. And hedge funds are an increasingly prominent source of middle market financing in certain circumstances.
Understanding the Sources of Non-bank Financing
Beyond the findings of this research, it is important to understand the various sources of non-bank financing. There are a number of sizable commercial finance companies whose principle business is financing small and medium-sized businesses. In addition, while insurance company investment portfolios emphasize publicly traded stocks and bonds, insurance companies have long been active participants in the private placement market. And a number of insurers have direct lending programs that are not unlike the commercial lending departments of banks.
Loans from finance companies, insurance companies, and other lenders are on offer in some cases precisely because the would-be borrowers are not eligible for bank financing. In other cases, these lenders are competing with banks. And in still other cases, finance companies and other specialized lenders are subsidiaries of banks.
The principles guiding non-bank financing differ depending on the nature of the lender. Some institutions offer financing after assessing a company's revenues and cash flow, but in other cases financing is secured by assets, ranging from vehicles and capital equipment to real estate. Some financing mechanisms are traditionally associated with certain industries: factoring, for example, is important in retailing and in the garment industry, while leasing and asset-based lending are used in a wide range of industries, as long as capital equipment is involved. Moreover, a number of manufacturers offer vendor financing to facilitate the sale of their products. And it should be noted that although the venture capital industry is often associated with high tech, venture capital funding has been provided to companies in a range of industries. The same is true of private equity money.
In addition to these private sector sources, there are a range of government initiatives to finance businesses. The U.S. Small Business Administration has a number of programs designed to provide, or guarantee, financing for smaller companies. A number of state and local governments also have general financing programs, as well as incentive financing programs designed to encourage companies to locate or expand within their jurisdiction.
And there is now a nascent "crowdsourcing"marketplace in which a few businesses have been able to raise funds from a number of lenders via the internet.
Tapping Non-bank Sources
The critical lesson for Middle Market companies in need of financing is that banks are not the only game in town.
1. Know your alternatives.
Even if your company has or can get bank financing, any middle market financial executive should become familiar with the range of financing alternatives available to his or her company. What sources are available to a company like yours? What steps could you take to expand the range of potential sources?
2. Compare the costs.
Many non-bank sources finance themselves by borrowing from banks and marking up their cost of funds to their borrowers. They charge more than banks charge their best customers, but many middle market companies are not eligible for a bank's prime rate. Thus, finance companies rates may be no higher than what banks might charge - if they were, in fact, willing to lend to the company.
3. But it's not just about interest rates.
There are a host of conditions associated with various sources of non-bank financing. Asset based financing, for example, can be cost effective because the loans are secured by specific assets: but, miss some payments, and equipment that is critical to the operations of your company may be repossessed. Other sources of funding impose restrictions on a firm's financial ratios and activities. Understand the array of terms and conditions associated with potential financing.
4. Look beyond the next financing.
Many non-bank lenders take a transactional approach: They'll do a deal with you if the terms are attractive at that point in time. But middle market companies often need access to regular financing in order to grow, so it can be important to look beyond the immediate transaction and explore ways in which you can establish an ongoing financing relationship with an institution. A sale and leaseback of your headquarters building may be an attractive source of funds - but you can only do it once. Just as a line of credit may be better than a loan, establishing a relationship with a lender may be a better strategy than getting the cheapest financing available at the moment.
 The four groups had sales of $10-$50 million, 50-$150 million, $150-$500 million, and $500 million to a $1 billion; these categories correspond roughly to the 25th 50th, and 75th percentiles of the distribution.