“Because that’s where the money is,” Willie Sutton famously said when asked why he robbed banks. And until recently, small and mid-sized enterprises (SMEs) would more or less agree that banks were their main option when searching for business financing. But today, many companies are looking well beyond conventional bank lending and equity markets for business financing answers. Companies’ options are growing, and their preferences are changing significantly, as both debt and equity markets enter uncharted territory and alternative financial service providers come of age.
The Debt Side of Business Finance
The big story in debt financing right now is the corporate bond market, where interest rates are at all-time lows and volumes at all-time highs. However, it is large companies that have greatest access to bond markets, at lowest cost. Specifically, U.S.-marketed corporate investment-grade bonds were selling at record volumes in August 2016,1 with yields generally in the low single digits as the third quarter of 2016 came to a close.2 In Europe, even central banks are now buying corporate debt.3 Big companies also tend to enjoy easier access and lower rates when borrowing from banks, though short-term rates may be rising.4 And usually, they have more liquid assets on hand to self-fund growth.
SMEs face different business financing prospects. “The use of public corporate bond markets mainly remains the privilege of large companies,” according the Organization for Economic Co-operation and Development (OECD).5 Meanwhile, U.S. banks have been less inclined to lend to SMEs, given the low interest rate environment, post-financial crisis regulatory constraints and lower risk appetites,6 though some see signs in late 2016 that this may be changing.7
Stepping into the business finance gap between large company and SME debt, alternative financial service providers have grown in variety and scale in recent years. These include business development companies, online financial technology (fintech) lenders and crowdlending. Asset managers8 and institutional investors9 are also seen coming more strongly into the middle-market lending space. All of which add to the range of more established options that, depending on the borrower’s size, can include asset-based lenders/finance companies, factoring companies, mezzanine funds, U.S. Small Business Administration loans, corporate credit cards and venture debt.10,11
Among growing business finance options, the rise of business development companies gives SMEs the opportunity to work with specialty finance companies that are regulated but charge higher interest rates (10-15 percent) than conventional banks, while providing more managerial input.12
In the fintech sector, online alternative lenders (known as marketplace lenders) can provide faster, easier access to capital than banks. A survey by seven U.S. Federal Reserve Banks found that 20 percent of small businesses turned to them in 2015.13 However, companies surveyed expressed low satisfaction (15 percent satisfied) due to high interest rates and unfavorable repayment terms. Marketplace lending is also going through a period of business setbacks and heightened regulatory scrutiny following explosive growth.14 In another fintech category, crowdlending websites provide peer-to-peer business loans. While they can also be fast, they too can have higher interest rates than banks.15
The Equity Side of the Business Finance Equation
Some debt patterns for big, mid-sized and small companies are mirrored in equity markets. Like the bond market, the U.S. stock market is in record territory but initial public offerings (IPOs) are largely reserved for big companies – and then so are secondary public offerings (SPOs). At the same time, U.S. IPOs have been declining in number.16 Some companies – for example, trend-setting Silicon Valley enterprises in the sharing economy sector – have been choosing to remain private, rather than face the quarterly reporting scrutiny and other obligations of public companies.17
Halfway through 2016, private equity activity was declining at an elevated pace – in part because borrowing costs remained so low for many companies that otherwise might be targeted.18 Venture capital activity rose slightly in the second quarter of 2016, following two quarters of declines. Both types of firms provide the benefit of no-interest capital and management guidance, but they can be hard to persuade to invest and there is the potential for disagreement with management over the direction of the company.
Notably, some of the business finance options above combine equity and debt. For example, debt from mezzanine funds gives the lender the right to convert to equity interest in the event of a default.
Since SMEs typically are higher risk and more opaque than well-established companies, they have higher bars to clear in business finance. But they also have alternatives, creating the opportunity to devise a diversified business financing strategy to fund their activities and growth without disruption.