Pros and Cons of Different Types of Lenders: Which Lender is Best?
By: Juanita Schwartzkopf, Managing Director
Business people wonder what type of lender is best for them – who will lend them the proverbial umbrella in a rain storm, but at a fair price, with the fewest hoops to jump through. There is no “one size fits all”. The personality of the business owner and the management team, the financial performance of the company, and the goals of the owners will all be key factors in determining the type of lender that will be best for the unique situation of each borrower.
Let’s discuss four different lending approaches:
- Traditional Lender
- Asset Based Lender
- Private Equity as Lender
- Private Equity as Investor
A traditional lender could be either a national or a regional bank. National banks often have the ability to lend a higher dollar amount (known as the lending authority) to one borrower or group of borrowers, and have more brick and mortar locations. Regional banks typically focus on the small to mid-size businesses located within the bank’s geographic footprint.
In both cases, the financial institution is highly regulated. Standards applied to and requirements of borrowers of traditional lenders are relatively uniform due to the impact of state and federal regulators. All borrower relationships are rated according to a rating standard, and certain rating classifications require specific actions, such as an annual appraisal.
With traditional lenders your relationship with a specific individual at the bank can be key. The banker can be your advocate within the bank, and specifically with the decision making committees. Borrowers are able to develop strong ties to a specific lender.
The traditional lender looks at recent financial performance (Capacity), the management (Character), and the collateral (Capital). These are the 3 C’s of credit. The business will need to meet the standards of the traditional lender in each of these areas.
An asset based lender is able to focus more on the assets being pledged, and less on recent financial performance, although recent performance will also be considered. This lender relies less on the capacity of the borrower and more on the collateral of the borrower.
The asset based lender is either a division in a traditional lender, a separate entity owned by a large financial institution or a separate entity entirely. The type of entity impacts the regulations the lender must deal with. If the asset based lender is a division of a traditional lender, the regulatory standards will apply. If the lender is a separate entity, the lender will have more flexibility to relax standards.
In any case, the asset based lender focuses on the assets being pledged and is constantly and consistently verifying the existence of those assets. Regular field examinations will be required. These examinations are typically every quarter, and work to verify the assets pledged as collateral – the accounts receivable, inventory and/or equipment of the company. The borrower is responsible for the additional costs of monitoring the collateral and will pay field examination fees to the lender.
The borrower will be required to submit detailed borrowing base certificates on a regular basis. Often the submission schedule is weekly, but the schedule could be monthly or daily. The borrower will need to devote internal resources to the preparation and submission of the borrowing base certificates, and to the required monthly reporting, and the field examinations.
The asset based lender will generally require dominion over cash in the form of a lock box, cash accounts maintained at the lender, or cash accounts maintained at a mutually agreed upon lender with a third party agreement allowing the lender to sweep cash under certain circumstances.
The interest rate and fee structure will typically result in a higher annual lending cost.
Recently a company had experienced two years of substantial losses. Although the company had returned to interim profitability, the traditional lender was concerned because the equity of the company had eroded. From a “capacity” perspective, the traditional lender felt the profitability and the equity position were unacceptable. However, the company’s accounts receivable and inventory could be readily verified and showed a strong collateral position for an asset based lender. Although the company paid a higher interest rate to the asset based lender, and would be paying collateral audit fees, the asset based lender considered the company to be a very good credit risk and was excited to have the opportunity to build a relationship with the company for the long term.
Using private equity as a lender will provide more flexibility in the structure and account management because these lenders are not regulated in the same way banks are regulated. However, higher returns are required by the investors in the private equity firm.
This type of lender will accept more risk, and charge higher rates and fess in exchange for the risk profile. This class of lender may also require less monitoring; for example, field exams may not be required or may be required less frequently.
A borrower should expect that this lender will ask for a structure that allows warrants, or an alternative ability to convert to equity if loan conditions are not met.
Private equity firms can differentiate themselves from each other by their experience in specific industries, their experience with specific collateral types, and their experience with different types of structures.
In another example, a company had been reporting break even performance, but had good prospects for the future. Accounts receivable, inventory and equipment were solid assets, but insufficient to fund the cash needs associated with growth. From the asset based lender’s perspective, the “capacity” and the “capital” were not strong enough to support the entire debt needs. A private equity firm combined an asset based line of credit tied to the accounts receivable and inventory with an equipment loan, and then overlaid an eighteen month fully amortizing term loan to fund the additional cash needs. As the company’s sales grew, the collateral base for the line of credit grew and provided a source of repayment of the term debt. The profitability of the company provided the remaining term debt repayment.
Private equity as an investor is a good opportunity for borrowers who are willing to give upside potential to an investor in exchange for the investor’s willingness to accept more risk. As an investor, there will be an expectation of some combination of input on management roles, the ability to place personnel the investor selects in key roles, and/or board seats.
This investor may be willing to wait longer for a financial recovery. Alternately, this investor could move faster to act on warrants, board seats, etc. if there are performance problems. There may be pressure to “fix and sell” to maximize the investor’s return.
One example of using private equity as an investor would be in agriculture, when a borrower needs to acquire land to support its operations, but will need a longer loan commitment than a traditional lender would find acceptable, and does not have sufficient accounts receivable and inventory to support the land purchase. In this case the private equity investor saw land as a good long term asset to hold either as collateral, or if necessary, an asset to convert to cash via sale.
In another example, the private equity investor was interested in funding merger and acquisition activity other lenders would not have considered. In exchange for this funding, the equity investor received two board seats, and was able to serve on the committee that selected the CFO.
Which lender is best for a company?
There is no one size fits all for borrowers and lenders. Within each of these lender categories you will find lending partners that move closer to the lower and higher risk entities they compete with. Lending works in cycles, with looser credit and tighter credit alternating over time. The same circumstances private equity as a lender will accept at one point in time, an asset based lender will be comfortable with at another point.
It is important for a borrower to objectively review its own Capacity, Character and Capital from the perspective of an outsider. And then use that analysis to determine the best group of lenders to pursue. Often that means looking at several lenders in at least two categories to determine the options available – and the risk and reward for both the lender and the borrower – as expressed in the final structure of the lending relationship.
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