According to the Merriam-Webster dictionary, the definition of “The Wild West” – is that it was “a period characterized by roughness and lawlessness.” If ever a definition applied, this would clearly explain the current lower end of the middle market lending arena, namely small Asset Based Lenders (ABL) and single ticket factors. For argument’s sake, let us agree there are countless firms providing this service. We say countless since we know it is more than a few but less than hundreds, hence the vague notation of, countless. According to the Exit Planning Exchange website*, “the Lower Middle Market (LMM) is a distinct market segment with unique characteristics. But it is not that well understood, and this lack of understanding means that companies in this segment often do not get the level of attention and help they need, especially from major lenders or financing sources. That is a problem for them, but also for the greater community, because these companies play an important role in their local economies and beyond.”
Coining this current period of lending as the “Wild West” seems fitting given the number of privately owned, unregulated firms lending to this lower end borrower. Trying to define exactly what constitutes the Lower Middle Market can be as difficult as getting ducks in a row, herding cats and getting millennials to put down their phones. So, let us use three separate benchmarks to set the stage.
- Sales: Data published using the North American Industry Classification System Association (NAICS) identifies roughly 531,000 companies in the $5-50 million sales range.* Although this range is not set in stone, this revenue range is a good starting point for identifying the lower middle market.
- Employees: The most common data set for the total number of businesses in the US comes from the US Census. This data distinguishes companies by the number of their employees. Using this data, we see that there are about half a million companies with 20-100 employees, which represents roughly 2% of the 30 million companies in the US.*
- Survival: The data on company numbers gets even more interesting when you look at data on corporate survival rates from the US Bureau of Labor Statistics. It shows that consistently 50% of businesses do not make it past five years. And that only 20% make it to 20 years.*
Of further note, companies in the lower middle market are typically past the start-up stage. They are scaling and growing, but they do not achieve (or often seek) the hyper-growth of a public company. They truly are in the middle, which in no way diminishes the accomplishment.
As noted above, it is not easy to get into the lower middle market. And once you get there, survival is not assured. The LMM is when you create a company and that company needs financing, with no historical track record, banks and other institutional lenders are loathed to lend to it. So how does, and how can, a lower middle market, early-stage company, secure financing?
Enter the notion of the “Wild West” financing sources. Small ABL’s and small ticket factors can fill this void. How? Well first by not being regulated by the banking and other regulatory industry watchdogs. Let us assume the ABL or factor is not owned by a bank, which allows them to be highly flexible in their underwriting and their ability to assume risk without the fear and or oversight of regulators. Under the notion that “it’s my money, I’ll lend how I want” they can and often do, take on risk beyond what a more conventional and institutional lender would consider prudent. They do this, in large part, by identifying and providing leverage on specific collateral deemed to be worth more than the loan (or factor) advance. For example, the ABL will underwrite the creditworthiness of the accounts receivable, the orderly liquidation value of the inventory, the appraised value of the machinery and equipment, and, if need be, the forced sale value of any company or personally owned real estate. Assuming the sum of all these assets is greater than the loan request, a non-regulated lender can and often will make this loan. The terms may seem onerous, high-interest rates, short maturity, controlling the company cash, but when viewed in the lens of that it is typically cheaper than raising equity, it begins to make sense. Take the money now, grow for another year or two, then move into more traditional and institutional lending sources. Often this is viewed and explained as “renting equity” for the year or two.
On the factor advance side, any bona fide invoice to an account debtor can be a source of quick cash to the borrower. Many larger customers of smaller companies may take thirty, sixty or even ninety days to pay an invoice. Cash that the small borrower desperately needs to fund the next order and keep the lights on. Enter a factor, which is often less concerned about the financial condition of the borrower as they are about the creditworthiness of the borrower’s account debtor. The factor would advance cash against the invoice, and they would then wait to get paid, all the time earning interest and fees for themselves. The presumptive risk is that if the account debtor does not pay as planned, the borrower has sold the invoice, and it is no longer their problem. That may or may not be the end of the transaction depending on if the sale is recourse or non-recourse, but as a small non-regulated lending source, the factor can make the decision for their own account as to how much risk and at what return they are willing to take for assuming that risk.
A reasonable question to ask is why would an ABL or factor take on this level of risk on a largely unproven segment of the market. Well, first and foremost, if they are right about their collateral, it is a relatively riskless transaction, and given the lack of traditional, regulated and institutional lenders serving these borrowers, the return rates can be quite attractive. Anywhere from low teens (ABL) to low thirty percent (factors) and anywhere in between. The key is understanding the collateral and employing some, not all, of the 5 “C’s” of credit… in this “Wild West” lending scenario, collateral will always prevail with character being a very close second.
- Collateral – an asset that can back or act as security for the loan
- Character – reflected by the applicant’s credit history
- Conditions – the purpose of the loan, the amount involved, and prevailing interest rates
- Capacity – the applicant’s debt-to-income ratio
- Capital – the amount of money an applicant has
What may bring order to this “period characterized by roughness and lawlessness,” to an end?
Well, hard to say. There is an abundance of capital in search of returns, and borrowers in search of capital in search of growing their business. With a Prime rate as of this writing of 3.25%, double-digit returns look very attractive. Further, many borrowers’ creditworthiness may be on the decline due to COVID-19 first quarter and first half of the year results, which are expected to be weak, and with an almost anything goes mentality of today’s (non regulated) lending, coupled with the sheer amount of private money out there looking to be put into use, this period may continue for the foreseeable future.