As our economy struggles to achieve job growth momentum, one of the forces holding back emerging growth companies is the relative lack of bank credit. For a company trying to get out of No Man’s Land, the “Capital Gap” is a key problem: they need to raise capital to fund growth and develop the company’s infrastructure. Bank credit has been traditionally part of the middle
market funding picture. In the old days i.e. before the financial crisis of 2008, an entrepreneur’s relationship with the banker could be personal and intimate.
Old World: Focus On Relationship With Your Banker
Back then some of the most often cited best practices for an entrepreneurial CEO in dealing with their banker were:
- Know your cash flow needs and where you are on debt covenants. Understand your funding requirements: whether working capital, equipment financing or another type of credit facility.
- Communicate these requirements based on your understanding of your credit officer’s mindset and his or her place in the bank hierarchy. For example, does your banker have some wiggle room because she has a low loss ratio? Or is she under pressure because her loss ratio is high? \
- Do everything you can to convince your banker that the money they lend you will be in prudent hands.
- During good times, cultivate relationships with bankers seeking your business so that when you hit a dip you can resort to a backlog of potential lenders.
- Avoid negative surprises: provide realistic projections and give your banker a balanced view of your business, letting him know about your challenges. Educate your banker on the risks of your business and what you are doing to mitigate them.
- Prepare for every interaction with your banker and be ready to talk to him on short notice.
Notice a key assumption in the above: the company CEO or CFO can have an in-depth relationship with their banker.
New World: Black Box Lending
A raft of government regulation has led many banks to make “black-box” decisions on credit applications for middle market companies: decisions based on algorithms and metrics that bankers themselves may not understand. Banks are being encouraged to use the same 14-16 credit categories, with the borrower’s size being the largest weighted consideration. This has forced banks to move up market. At many banks the current focus is borrowers who need a minimum of $5 million in credit exposure. Why? Banks say they can’t make money below $5M in exposure. Capital requirements, the cost to monitor a loan or line of credit make lending in smaller amounts uneconomical. To the extent they are lending at all to companies with smaller companies, credit decisions tend to be 100% model-driven—with little or no chance for the banker to consider company-specific factors such as their relationship with the CEO or CFO. The result is that credit availability to small businesses has been cut up to 50%.
For many smaller banks, the hurdles to lend to middle market companies are even higher.
Private Equity: An Alternative
Regulation and cost structure have driven banks out of the market to lend to many emerging growth companies. This has opened the door for private equity firms to play a larger role in funding emerging growth companies—more often as control investors; sometimes as minority investors. Private equity isn’t right for all companies. But the decline in commercial lending to the middle market is leading many growing companies to take a second look at this alternative for closing the Capital Gap.
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