Commercial Alternative Lending

An impressive amount of attention and money have been foisted upon the relatively nascent alternative finance market. Is it good or bad? Is it predatory or justifiably appropriate? Is it warranted and much needed or capitalism on steroids? Should it be regulated or not? Should borrowers be protected or simply carpe diem ? Those who know me come to expect that I am pretty black and white on most topics, right or wrong. In this case, my opinion is “Yes and No”!

Alternative Financing

The term “alternative financing” as it is being used today in the commercial finance world basically covers the gamut of commercial financial products, from peer-to-peer lending or crowd-funding to short-term small dollar accounts receivable financing for new ventures or distressed borrowers. Basically, alternative financing is anything other than straight-up traditional C&I lending (loans and equipment financing) to credit-worthy businesses. Over the past two decades, technology has caught up with commercial lending to the point that very large databases of credit data and behavioral analytics (“big data”) have merged with B2B e-commerce. The results are purported to be predictive models for business credit decisions.

What do you get when you combine this technology with a wall of stagnant cash seeking yield and a clear need by business borrowers? A new genre in the commercial finance industry. Well, OK, not a new industry exactly, but a new mass production version of an old one. One thing is absolutely clear, though: There are serious investors and big money flowing to the providers of these alternative financing products, both directly and indirectly through securitizations. Yes, securizations are back, my friends. I, for one, think that is a good thing.

Let's talk about the economic environment as it relates to new business startups in the U.S. Over the past three decades, the birth-death rate (new business entrants divided by exits) has steadily declined. The U.S. has always been known for its entrepreneurism and small business employment contributions as it relates to GDP and work force participation. By the way, I am not talking about just Social Media, but the “ACME Tool & Dies” on Main Street, USA.

In the 1970s, new business “entrants” as a percentage of all firms in the U.S. reached the 17% mark. At the same time, the business “exits” as percentage of all firms in the U.S. was around 13%. Obviously, that is a good thing in that we were starting up more businesses than we were losing. A less pronounced positive variance has generally persisted up until the Great Recession, during which time “exits” surged to 12% while “entrants” fell to around 9%. The latest data shows we have improved, but to the point of stasis (“exits” about equal to “entrants”).

During this same period, the ratio of new companies (one to five years in business) to the total of all U.S. companies has fallen consistently. For example, the percentage of businesses that were five years of age compared with the total number of businesses in the U.S. reached a high of 12% in the late 70s, compared with 6% in 2010. That is striking and sobering. Companies younger than five years suffered similarly. Regardless of your political or economic persuasion, this does not bode well for the future, since the survivors of this group are the pool from which we find our future Russell 1000s or bigger. Last, employment creation and destruction trends from small businesses are unimpressive. You are probably asking yourself what all this has to do with the topic. I'm getting there!

One last note, and it is an obvious one. You all know that federal regulatory oversight from myriad agencies has restricted the ability of financial institutions to lend to businesses generally and to non'investment-grade credits more specifically.

Upside Argument

Now to the point of the article. I would like to discuss the positive reasons that the alternative financing products are absolutely the right thing and should continue to expand and evolve. Let's first start with the fact that given the statistics discussed above relative to business entrants and exits, the declining trend in the percentage of young companies, and the negative employment impacts, something needs to be done to reverse these disturbing trends. So, allowing investors (not federally insured bank depositors ) to come into the market of financing young and distressed businesses is highly desirable in reversing the negative trends. The risks and rewards, in my opinion, are properly aligned.

Let's face it, lending to this sector has extremely high default and loss rate characteristics that require investors be adequately rewarded for the risk. The biggest complaint that I have heard about these alternative finance products is the extraordinarily high rate of interest charged. When you add the various loan fees to the equation and solve for interest rate over very short term maturities, you empirically derive what looks to be an extremely high rates of interest. Oh, by the way, these rates do not take into account loan loss provisions that are also quite high.

What would be the lost opportunity cost to a business in need of the capital that alternative finance products provide if the business could not otherwise secure the capital whatsoever? As I said above, in the case of the alternative finance products, both the investors and borrowers interests are absolutely aligned. This was not the case during the Great Recession. Additionally, I do not think that the potential scale for the total amount of financing in the alternative financing sector will ever get close to the scale of the subprime mortgage market.

Downside Argument

Here are the potential negatives as I see them. I have been in the equipment leasing and finance business for over 20 years. Much of that time was focused on the vendor finance sector of the equipment leasing and finance market, which basically involves lending to small and medium businesses. Transaction sizes are predominately between $10,000 and $250,000, considered “small ticket” in leasing parlance. Yields in this market tend to range from high single-digit to mid teens. Naturally, technology and low touch processes are a prerequisite. As you would expect, the default and loss rates in this business sector were higher than say lending to investment grade enterprises. Invariably, we had defaults that required us to seek legal relief in a variety of jurisdictions and locales across the U.S., from urban to very rural.

When seeking relief in the event of a lessee default, getting service for summary judgement and equipment repossession could really be a frustrating endeavor. Occasionally, you had those judges who would disregard “hell and high water” provisions in the contracts out of fairness as they defined it. Believe it or not, creditors can and do lose but it is a rarity in the scheme of things. Why do I bring this up? Simply this: If it can happen to traditional equipment leases and loans, it will happen even more frequently with the “alternative finance” products. Think about it. Alternative finance rates range from the 20% to 150% imputed all in yields. As this market proliferates, courts will see a higher number of these cases and at these kinds of interest rates, judges will be even more inclined to find in favor of the borrowers ' in the name of fairness. As this occurs more often, precedence could start to take hold. I am not an attorney but a practitioner. The fear here is that precedence setting in the alternative finance market can potentially be used against traditional small-ticket lessors. This could be disastrous given our more modest spreads.

The next concern and potentially more damaging, is the potential for the intercession by regulatory agencies, self-serving politicians and attorneys general. There has been and will be an increasing number of hard luck stories of borrowers being damaged by alternative finance lenders exercising their default remedies. Some media outlets will make hay on these events. Then, some attention-grabbing politician or state attorney general will take up the cause in the name of fairness.

The above self-serving persons instigate the Consumer Financial Protection Bureau (CFPB) to get involved. One would think that the CFPB would have nothing to do with commercial finance. While that is “rational,” it is at that point not about rational. The CFPB will use the fact that many of the credit decision models that the alternative finance industry uses rely heavily on the personal credit of the business owners. The credit applications usually ask for name, address, social security number of the borrower. Further, the loan agreements will usually require a personal guarantee. Therein lies the hook that the CFPB will likely use in justifying its regulatory involvement.

So, let's assume the parade a horribles above (i.e., CFPB involvement) does in fact become reality. You may think that I am over-reacting, Game over! The traditional small business lending and leasing will undoubtably be ensnared. Most of the independent lenders, lessors and finance companies will not be able to afford the regulatory costs nor be able to pass it on in the form of even higher interest rates. This leaves only the banks to fill the void. But wait, they can't fill the void, because of the regulatory and compliance rules limiting their involvement in “risky” lending. Some may think, well the CFPB would know that this would hurt business development, employment and economic growth. Wrong. These agencies will tell you point-blank that those types of concerns are not in their charter or policy. They are just the enforcement arm of broadly written law. Remember at the beginning of the article I talked about the trends of new businesses and young businesses? The negative trend will just continue until we are just like the old European economies.

Conclusion

I do not mean to paint an overly bleak picture. However, the alternative finance institutions and legal profession serving the same could be proactive in ameliorating the probability for these negatives becoming reality. One way is for the financial institutions in the alternative finance market to develop some models that do not require personal credit information or personal guarantees. Hey, I didn't say this would be easy! As for how the legal profession can help, I leave that up to you to brainstorm.

Robert J. (Bob) Rinaldi is CEO of King Commercial Finance, LLC, a national equipment finance company headquartered in St. Louis, MO. Formerly, Rinaldi was senior vice president of CSI Leasing, president of National City Commercial Capital (NC4) Canada, and executive vice president of NC4 in the U.S. He is Chairman Elect of the Equipment Leasing & Finance Association. Reach him at [email protected] or www.linkedin.com/in/bobrinaldi.

An impressive amount of attention and money have been foisted upon the relatively nascent alternative finance market. Is it good or bad? Is it predatory or justifiably appropriate? Is it warranted and much needed or capitalism on steroids? Should it be regulated or not? Should borrowers be protected or simply carpe diem ? Those who know me come to expect that I am pretty black and white on most topics, right or wrong. In this case, my opinion is “Yes and No”!

Alternative Financing

The term “alternative financing” as it is being used today in the commercial finance world basically covers the gamut of commercial financial products, from peer-to-peer lending or crowd-funding to short-term small dollar accounts receivable financing for new ventures or distressed borrowers. Basically, alternative financing is anything other than straight-up traditional C&I lending (loans and equipment financing) to credit-worthy businesses. Over the past two decades, technology has caught up with commercial lending to the point that very large databases of credit data and behavioral analytics (“big data”) have merged with B2B e-commerce. The results are purported to be predictive models for business credit decisions.

What do you get when you combine this technology with a wall of stagnant cash seeking yield and a clear need by business borrowers? A new genre in the commercial finance industry. Well, OK, not a new industry exactly, but a new mass production version of an old one. One thing is absolutely clear, though: There are serious investors and big money flowing to the providers of these alternative financing products, both directly and indirectly through securitizations. Yes, securizations are back, my friends. I, for one, think that is a good thing.

Let's talk about the economic environment as it relates to new business startups in the U.S. Over the past three decades, the birth-death rate (new business entrants divided by exits) has steadily declined. The U.S. has always been known for its entrepreneurism and small business employment contributions as it relates to GDP and work force participation. By the way, I am not talking about just Social Media, but the “ACME Tool & Dies” on Main Street, USA.

In the 1970s, new business “entrants” as a percentage of all firms in the U.S. reached the 17% mark. At the same time, the business “exits” as percentage of all firms in the U.S. was around 13%. Obviously, that is a good thing in that we were starting up more businesses than we were losing. A less pronounced positive variance has generally persisted up until the Great Recession, during which time “exits” surged to 12% while “entrants” fell to around 9%. The latest data shows we have improved, but to the point of stasis (“exits” about equal to “entrants”).

During this same period, the ratio of new companies (one to five years in business) to the total of all U.S. companies has fallen consistently. For example, the percentage of businesses that were five years of age compared with the total number of businesses in the U.S. reached a high of 12% in the late 70s, compared with 6% in 2010. That is striking and sobering. Companies younger than five years suffered similarly. Regardless of your political or economic persuasion, this does not bode well for the future, since the survivors of this group are the pool from which we find our future Russell 1000s or bigger. Last, employment creation and destruction trends from small businesses are unimpressive. You are probably asking yourself what all this has to do with the topic. I'm getting there!

One last note, and it is an obvious one. You all know that federal regulatory oversight from myriad agencies has restricted the ability of financial institutions to lend to businesses generally and to non'investment-grade credits more specifically.

Upside Argument

Now to the point of the article. I would like to discuss the positive reasons that the alternative financing products are absolutely the right thing and should continue to expand and evolve. Let's first start with the fact that given the statistics discussed above relative to business entrants and exits, the declining trend in the percentage of young companies, and the negative employment impacts, something needs to be done to reverse these disturbing trends. So, allowing investors (not federally insured bank depositors ) to come into the market of financing young and distressed businesses is highly desirable in reversing the negative trends. The risks and rewards, in my opinion, are properly aligned.

Let's face it, lending to this sector has extremely high default and loss rate characteristics that require investors be adequately rewarded for the risk. The biggest complaint that I have heard about these alternative finance products is the extraordinarily high rate of interest charged. When you add the various loan fees to the equation and solve for interest rate over very short term maturities, you empirically derive what looks to be an extremely high rates of interest. Oh, by the way, these rates do not take into account loan loss provisions that are also quite high.

What would be the lost opportunity cost to a business in need of the capital that alternative finance products provide if the business could not otherwise secure the capital whatsoever? As I said above, in the case of the alternative finance products, both the investors and borrowers interests are absolutely aligned. This was not the case during the Great Recession. Additionally, I do not think that the potential scale for the total amount of financing in the alternative financing sector will ever get close to the scale of the subprime mortgage market.

Downside Argument

Here are the potential negatives as I see them. I have been in the equipment leasing and finance business for over 20 years. Much of that time was focused on the vendor finance sector of the equipment leasing and finance market, which basically involves lending to small and medium businesses. Transaction sizes are predominately between $10,000 and $250,000, considered “small ticket” in leasing parlance. Yields in this market tend to range from high single-digit to mid teens. Naturally, technology and low touch processes are a prerequisite. As you would expect, the default and loss rates in this business sector were higher than say lending to investment grade enterprises. Invariably, we had defaults that required us to seek legal relief in a variety of jurisdictions and locales across the U.S., from urban to very rural.

When seeking relief in the event of a lessee default, getting service for summary judgement and equipment repossession could really be a frustrating endeavor. Occasionally, you had those judges who would disregard “hell and high water” provisions in the contracts out of fairness as they defined it. Believe it or not, creditors can and do lose but it is a rarity in the scheme of things. Why do I bring this up? Simply this: If it can happen to traditional equipment leases and loans, it will happen even more frequently with the “alternative finance” products. Think about it. Alternative finance rates range from the 20% to 150% imputed all in yields. As this market proliferates, courts will see a higher number of these cases and at these kinds of interest rates, judges will be even more inclined to find in favor of the borrowers ' in the name of fairness. As this occurs more often, precedence could start to take hold. I am not an attorney but a practitioner. The fear here is that precedence setting in the alternative finance market can potentially be used against traditional small-ticket lessors. This could be disastrous given our more modest spreads.

The next concern and potentially more damaging, is the potential for the intercession by regulatory agencies, self-serving politicians and attorneys general. There has been and will be an increasing number of hard luck stories of borrowers being damaged by alternative finance lenders exercising their default remedies. Some media outlets will make hay on these events. Then, some attention-grabbing politician or state attorney general will take up the cause in the name of fairness.

The above self-serving persons instigate the Consumer Financial Protection Bureau (CFPB) to get involved. One would think that the CFPB would have nothing to do with commercial finance. While that is “rational,” it is at that point not about rational. The CFPB will use the fact that many of the credit decision models that the alternative finance industry uses rely heavily on the personal credit of the business owners. The credit applications usually ask for name, address, social security number of the borrower. Further, the loan agreements will usually require a personal guarantee. Therein lies the hook that the CFPB will likely use in justifying its regulatory involvement.

So, let's assume the parade a horribles above (i.e., CFPB involvement) does in fact become reality. You may think that I am over-reacting, Game over! The traditional small business lending and leasing will undoubtably be ensnared. Most of the independent lenders, lessors and finance companies will not be able to afford the regulatory costs nor be able to pass it on in the form of even higher interest rates. This leaves only the banks to fill the void. But wait, they can't fill the void, because of the regulatory and compliance rules limiting their involvement in “risky” lending. Some may think, well the CFPB would know that this would hurt business development, employment and economic growth. Wrong. These agencies will tell you point-blank that those types of concerns are not in their charter or policy. They are just the enforcement arm of broadly written law. Remember at the beginning of the article I talked about the trends of new businesses and young businesses? The negative trend will just continue until we are just like the old European economies.

Conclusion

I do not mean to paint an overly bleak picture. However, the alternative finance institutions and legal profession serving the same could be proactive in ameliorating the probability for these negatives becoming reality. One way is for the financial institutions in the alternative finance market to develop some models that do not require personal credit information or personal guarantees. Hey, I didn't say this would be easy! As for how the legal profession can help, I leave that up to you to brainstorm.

Robert J. (Bob) Rinaldi is CEO of King Commercial Finance, LLC, a national equipment finance company headquartered in St. Louis, MO. Formerly, Rinaldi was senior vice president of CSI Leasing, president of National City Commercial Capital (NC4) Canada, and executive vice president of NC4 in the U.S. He is Chairman Elect of the Equipment Leasing & Finance Association. Reach him at [email protected] or www.linkedin.com/in/bobrinaldi.