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The Rise of Non-Bank Lending For Middle Market Companies

The Pros & Cons of Non-Bank Lenders Every Business Should Know

Non-bank lenders have increased significantly in the last twenty years both in volume and in amount of capital available for them to deploy. As commercial banks have tightened their credit procedures, more and more middle market companies are finding that non-bank lenders offer greater flexibility and expansive loan structuring options. Non-bank lenders include asset-based lenders, mezzanine funds, venture debt lenders, SBICs, family offices, and other private debt funds. Here is what to consider when evaluating loan options across the market.

Why the rise in Non-Bank Lending

NON-BANK LENDERS and Their Effect On The Middle Market

Advantages of non-bank lending

Disadvantages of non-bank lending

Common TYPES OF Non-Bank LENDERS

negotiation when applying for a non-bank loan

Checklist: Is a Non-Bank Right for your Company?

Why the Rise of Non-Bank Lending?

Non-bank lenders have existed for decades but were typically considered a last resort option for companies on the brink of failure. However, in the decade following the financial crisis, middle market CFOs, business owners, and financial sponsors have been turning to non-bank lenders as a viable solution for growth capital, recapitalizations, acquisition financing, and other capital needs. This shift begs the question – what caused the change?

After the financial crisis abated, traditional banks faced increased regulatory scrutiny that resulted in tighter lending criteria. Credit committees declined more borrowers and reduced lending limits. Gone were the days when a long standing relationship could tip the scales for companies who were just outside the bank criteria. Many middle market companies who still had strong performance were left asking where to turn. Over the past decade, the vacuum created in the market was quickly filled by a proliferation of non-bank lending. With an ability to provide credit in structures and amounts a traditional bank cannot, these lenders experienced strong demand from well-performing firms willing to pay higher interest rates to ensure access to capital.

This demand was met by a strong supply of investment capital from institutional investors like pension funds and insurance companies. To help the economy recover faster, the Federal Reserve introduced low interest rate policy, which reduced the yield on traditional fixed income assets like treasuries and resulted in billions of dollars migrating to higher yield investments like direct lending.

In just the past two decades, “globally, private credit, which includes distressed debt and venture financing, has ballooned from $42.4 billion in 2000 to $776.9 billion in 2018. By one estimate, the total is likely to top $1 trillion in 2020.” – Bloomberg (Butler)

Non-Bank Lenders and Their Effect on the Middle Market

This rapid influx of capital and investment alongside bullish expectations has increased debt structures and credit options for the middle market. However, non-bank lenders do not have the human resources nor the marketing budgets to find borrowers in the same way large banks can. This leaves the bulk of the work on middle market CFOs who have less resources to navigate the rapidly growing opportunities available for financing.

Corporate borrowers are forced to actively research and seek out private credit via lengthy RFP processes with little information on how each of the non-bank lenders put their capital to work. Additionally, some of these non-bank lending options are backed by fixed income funds, insurance companies, sophisticated family offices, etc., which makes the search process more overwhelming. Worse still is the lack of comparable information available to borrowers. How are borrowers supposed to know if they have uncovered the best deal in the market with so many options available?

Until Cerebro Capital launched its loan marketplace in late 2017, there was no single platform to access middle market loan options across lender types. Today, Cerebro Capital has aggregated underwriting criteria from over 650 lenders, with 50% of those lenders in the non-bank lending market. Now, corporate borrowers can easily access and leverage competitive pressure from multiple lender pools and debt tranches in one platform.

Non-Bank Lending Market Research

Key findings from our quarterly survey of top non-bank lenders in our network.

Advantages of Non-Bank Lending

Not Regulated by FDIC
Larger Loan Sizes
More Flexible Structures
Less Onerous Covenants

Higher Certainty of Close & Expedited Process

By nature, non-bank lenders are smaller organizations with less bureaucracy. Relationship managers sit much closer to the credit committee decisions. Information is more quickly disseminated to borrowers and they have fewer regulatory burdens to overcome when approving loans. All of these reasons lead to more certainty of getting to funding if a non-bank lender has provided you with a commitment letter. Due diligence processes will still be required, of course, but borrowers will have clearer views of closing timelines with non-bank lenders.

Long Term Flexibility

If a company misses targets and trips covenants under a regulated bank’s loan agreement, the bank will oftentimes call the loan, liquidate the collateral, or force it into refinancing. With fewer regulatory requirements, non-bank lenders have the ability to create bespoke loan structures that include longer interest-only periods, custom amortization schedules, and lighter and more varied covenants. In exchange for higher interest rates, non-banks can reduce their cash payments with a portion of interest in PIK. They can also adjust the amortization schedule and maturity to align with the company’s expected performance.

Willingness to Assist in Growth Opportunities

Non-bank lenders often execute an equity sweetener alongside the debt transaction. In principle, most companies are initially opposed to any equity participation since the purpose of debt is often to avoid or reduce the dilution associated with a capital raise. However, any kind of equity participation has a very powerful advantage because it aligns the lender’s economic interests with the owners’ interest in growing the business. This means that when the company sees opportunities to grow valuation that may require additional capital or more flexible existing debt structure, non-bank lenders will be much more willing to relax covenants, reduce cash interest payments, or increase their loan amount. Commercial banks would never be willing to make such concessions because they do not directly benefit from an increase in company value.

Treasury Management Not Required

Surprisingly, conventional banks don’t earn large profit margins off their loan services. Instead, they make the majority of their earnings from treasury management services. When selecting a new bank lender, they will almost always want you to switch your treasury management to their bank in order to achieve their profitability hurdles. Switching treasury management services can be a time consuming process and is almost always dreaded by the finance team. Non-banks, conversely, do not offer treasury management services and therefore will allow you to maintain treasury services with your incumbent lender.

Disadvantages of Non-Bank Lending

Higher Interest Rates

Non-bank lenders experience higher credit losses than a traditional bank; therefore, they charge higher cash-on-cash interest rates and may include payment in kind (PIK) interest to further enhance total returns.

Frequent Requirement of Equity Sweeteners

Oftentimes, non-bank lenders will only participate in the deal if equity sweeteners are available. While this can be a positive indication of finding a long term lending partner, companies should still consider the downside of equity dilution.

NOTE: Asset-based non-bank lenders are an exception to this rule.

Higher Prepayment Penalties

With many non-bank lenders allocating capital from vehicles with finite investment lives and capacity limits, they likewise need to ensure their capital is allocated in a manner that can align with the duration of their investment structures. To satisfy this need, non-bank lenders often include prepayment penalties which increase the switching costs for borrowers looking to refinance as soon as possible.

Minimum Loan Sizes

While leaner organizational structures can reduce the time required to execute a transaction, it also reduces the bandwidth of the lender. As such, many lenders have instituted screening criteria that include a minimum deal size to ensure efforts expended result in an efficient deployment of capital relative to resource intensity. These minimums are often between $2MM – $5MM loan size.

Common Types of Non-Bank Lenders

Asset-Based Lenders (ABL)

Purpose: Working capital and liquidity for fixed assets

Types of Loans:

Loan Size: $2MM to $100MM+

Equity Sweetener: Rare

Covenants: Covenant lite

Mezzanine Funds

Purpose: Expansion, growth capital, refinancing

Typical Collateral: Second lien tangible and intangible assets

Loan Size: $5MM to $100MM+

Equity Sweetener: Required

Covenants: Cash flow leverage, Debt service coverage, etc.

Venture Debt Lenders

Purpose: Expansion, growth capital for technology focused service businesses

Typical Collateral: All asset lien, A/R, IP, other fixed assets

Interest-Only period: available

Loan Size: $1MM to $50MM – usually tied to a multiple of MRR or ARR

Equity Sweetener: Frequently required

Covenants: Minimum Revenue, EBITDA Liquidity, or fully covenant lite

Negotiation When Applying for a Non-Bank Loan

The best way to ensure you receive optimal terms in the market is to leverage a broad network of commercial bank & non-bank lenders. Rates and terms vary more than you think. Optimize terms by leveraging your existing lender relationships with a broader scope of options.

Reduce cash interest
Slash commitment fees
Extend interest-only periods
Limit prepayment penalties
Limit warrant participation
Increase the size of the loan

Checklist: Is a Non-Bank Lender Right for Your Company?

You might be a good fit for non-bank lending partner if your company meets at least 3 of these characteristics:

Looking for a large loan than a commercial bank will offer
Needs a flexible loan structure
Is seeking between $2MM - $100MM in debt capital
Can afford to pay slightly higher interest rates
Requires less onerous covenants
Would like to reduce equity dilution
Is projecting more than $3MM in EBITDA this year
Has a weak balance sheet or assets below 10% of the requested loan amount
Has more than 50% of employees in the U.S.
Has experienced high double digit or triple digit growth and is projected to continue
Is backed by private equity or institutional investors

References:

Bakewell, Sally, and Christopher Cannon. “Investors Are Piling Into Loans That Banks Have Avoided Since the Crash.” Bloomberg.com, Bloomberg, 2018, www.bloomberg.com/graphics/2018-private-credit-yields/.

Butler, Kelsey. “How Private Credit Soared to Fuel Private Equity Boom.” Bloomberg.com, Bloomberg, 2019, www.bloomberg.com/news/articles/2019-09-22/how-private-credit-soared-to-fuel-private-equity-boom-quicktake.

Brooke, David. “Covenant-Loose the New Norm in the Private Debt Market.” Reuters, Thomson Reuters, 15 Aug. 2019, www.reuters.com/article/cov-loose/covenant-loose-the-new-norm-in-the-private-debt-market-idUSL2N25B0ES.

Rise of Non-Bank Lending