High-interest rate debt, whether senior or subordinated, gets a lot of bad press. At the same time, high-interest rate debt remains misunderstood (especially when there is a quick need for capital). Most business owners think about the cost debt in relative terms and in a static environment.
The problem is that the cost of capital for debt often varies significantly. Important factors include:
This can cause confusion. Business owners rarely understand the underlying costs of alternative lenders’ businesses. Many of these firms must consider that their clients want to return to a bank and will not be long-term clients. This is one of many reasons that non-bank lenders charge higher rates (in addition to their higher capital costs).
Business owners should educate themselves on non-bank capital alternatives. Most businesses face adversity at some point. Understanding what options are available can be the difference between success and failure.
Non-Bank and Alternative Lending
Anything seems expensive compared to bank (or bank-owned) asset-based lending (“ABL”). Or a factoring division. To state the obvious, banks lend at a low cost because they borrow at a low cost from federal funds or customer deposits.
Banks maintain several revenue line items, such as treasury and payments and processing, in addition to their interest income. Most non-bank lenders deal with higher costs of capital and only have one form of generating income: making profitable loans. Non-bank and alternative lending arrangments don’t often lead to long-term client relationships. They must seek higher returns to make a profit.
Most Business Owners Miss Other Opportunities
Most business owners spend their entire career dealing with one bank. This makes them ill-prepared to navigate the world of alternative lending. For purposes of this article, all non-bank lenders are “alternative.”
That most business owners limit themselves to one bank drives many misconceptions and negative connotations in the marketplace. No business owner thinks of what to do in an emergency situation except to ask their bank to help!
Sometimes, banks help, but not always. Banks face intense regulatory pressure and have to reserve against troubled credits. Many companies end up being asked to leave banks even if no payment default has occurred.
This is where the rubber meets the road. A business owner might be able to go to another bank, or they might have to transition to an asset-based lender. This could trigger a need for extra capital. This capital — termed “airball” or “stretch capital” — is the difference between what a business’ assets support and what it needs to get financed out of a bank. People misunderstand this capital because it is completely subordinated to a bank (and usually not long-term).
Returns for this capital can range from mid-teens to high-twenties and sometimes higher.
This type of pricing causes major heartburn with business owners. After all, most business owners might go decades without ever having an issue. When one arises, though, they’re left like a deer in headlights. Most professional business service providers – accountants, lawyers, etc. – develop strong relationships with a limited number banks (sometimes just one). They don’t often keep a list of firms who specialize in subordinated debt or troubled credits. They should.
All a business owner needs is one wrench thrown in their business, bad season, vendor issue or lawsuit to create a cash crunch.
Business Owners Have More Options than Ever Before
Never before have there been more options for business owners seeking capital. A slew of internet based companies cropped up for companies who need less than $250k. Non-bank ABLs service companies forced to leave banks. Subordinated capital providers can finance any shortfall. Rates and structures may vary. This depends on if a company raises senior or subordinated debt (and whether equity might be part of the equation).
Traditional mezzanine capital is the most patient form of mezzanine capital. Typically, it comes with warrants. Most non-private equity-backed companies cannot obtain this type of capital.
Instead, firms that provide second lien capital (just like it sounds – a second lien behind the senior lender – provide an amortizing term loan subordinated to a bank). This is less patient capital and contains no equity, but is considered high interest rate debt.
High Interest Rate Debt – When to Use It
The term “high interest” is relative and often misconstrued. Companies that have access to institutional capital or public markets pay a very different price than companies who don’t. There is a disconnect between what business owners think debt should cost vs. what it actually costs when you need non-bank capital.
The smaller the company, the fewer options to raise capital. It doesn’t matter if you’re talking about debt or equity: there are fewer products available to them. It is not uncommon to see certain lenders obtain pricing in the mid-teens for providing more availability and flexibility than a traditional bank.
When it comes to subordinated capital, business owners can see structures ranging from:
Many of these alternatives, especially junior debt alternatives, are not always easy to evaluate. This is because they are very rarely apples-to-apples. That said, business owners have many options in today’s marketplace. The need and decision to incur high interest rate debt products does not come often. But, when it does, it typically comes quickly! The fact remains that, in most situations, debt is cheaper than equity.