With slowly rising interest rates, many middle-market businesses are reevaluating their borrowing options. Before closing the deal, it’s important to fully understand the differences between traditional and alternative funding sources. Here’s a look at each.
While the market is still strong, many businesses are considering selling before valuations dip. For prospective buyers, nontraditional funding sources, such as individual investors, private equity, and various fintech companies, may offer quicker funding access than traditional banks. These sources also may have looser compliance restrictions.
However, the absence of certain federal and state guidelines also means any agreements with such sources may be less straightforward than traditional lending agreements, and they’ll probably involve higher interest rates. The biggest concerns, however, may be the possibility of relinquishing some ownership and the significant pressure to meet performance targets.
Non-traditional lenders may include warrants in their lending agreements that convert debt into ownership shares and private equity is likely to come with higher performance expectations than commercial banks. Fund investors typically look for double-digit returns on their money, while a traditional bank will have a much lower pricing structure. Any of these features could cost a business far more than if they’d simply gone with a traditional lender.
As regulated entities, banks will offer lower interest rates that reflect more restrictive lending guidelines and lower loan portfolio risk. While risk-taking has increased in the past few years, banks have been more selective than in prior economic booms because of higher capital requirements that were imposed following the financial crisis. They’re also more careful about their loan recipients and increasingly demand a lower loan-to-value ratio (LTV) on the transaction. Stricter LTV guidelines compared to nontraditional lenders, for example, may cause commercial and residential property deals to stall if the original buyer can’t secure financing.
Even if approved at an acceptable interest rate, borrowers may face other obstacles. While they’re likely to offer relatively low interest rates, over the years banks have increased their fee structures. With interest rates projected to rise even further, businesses may find these additional costs harder to manage. And highly leveraged companies will face the new tax law’s 30-percent limit on business interest deduction, further limiting return on capital.
Manufacturing and distribution entities might feel the greatest impact from the current lending environment. Rising interest rates and higher bank fees coupled with this year’s uptick in inflation will affect their ability to add personnel, carry out acquisitions, or explore potential new revenue streams.
Strengthening the Balance Sheet
Still, traditional lenders have certain advantages that transcend cost considerations. Bank relationships may encompass areas such as cash management, accounts payable, investments and other activities. This results in a stronger institutional connection and willingness to work with a business compared with nontraditional sources, whose involvement is purely transactional.
For businesses seeking to borrow from a traditional source, the first priority is to strengthen the balance sheet. Even in a tight lending environment, banks will fight over business, and generally offer more favorable terms to a company with a solid balance sheet.
Businesses can also enhance creditworthiness by limiting distributions to a reasonable number driven by prudent tax management. They should also clean up outstanding debt and reinvest money back into the company, if possible. And close attention should be given to payables, receivables, and cash flow.
Where possible, businesses should take advantage of the new tax law’s incentives to invest in capital expenditures. They might consider investing in machinery and other equipment likely to support expanded operations, and when available should recognize the expense on their tax returns in the year the purchases are made.
Consider All Options
A business’s optimum financing source ultimately depends on a range of factors—credit worthiness, access to capital, and overall risk profile, among others.
There are advantages and disadvantages to both traditional and nontraditional lending options, and those need to be carefully evaluated against the borrower’s particular circumstances and outlook. Prospective borrowers also should review any proposed agreement with a professional to be assured they’ve entered into the best financing arrangement to realize their financial goals.