In the past few weeks, I’ve been running across articles about emerging problems in the “private credit” markets. In essence, as the economy started exhibiting more strains (inflationary pressures, layoffs, and cratering consumer sentiment), several large businesses that were funded by private credit collapsed and raised the specter of “If you see one cockroach, there are a thousand more you don’t see.” You should definitely search “TCPC” if the topic interests you.
As a small-business lender, we are as far from Wall Street as it gets, but there are similarities worth exploring.
First, some definitions are necessary. For this essay, I equate Private Lending with Unregulated Lending and Private Lenders with Unregulated Lenders. For example, banks are highly regulated, and don’t fall into the Private Lender definition. On the other hand, merchant cash advance companies (“MCAs”), for example, are still largely unregulated and I refer to them as Private Lenders.
Second, let’s all agree that as traditional banks have tightened lending, private lenders have become go to alternatives for small businesses, and some of them do a good job. However, while private credit offers speed and flexibility, and in some cases is the loan-of-last-resort, its “bespoke” nature often masks predatory costs and control mechanisms that can suffocate small businesses.
What is the cost of the relative ease for accessing private debt, a/k/a “hard money?”
- While lenders often disguise the actual cost of private debt, it is significantly more expensive than bank debt, often equating to up to 20% or more APR.
- Origination fees (2%–5%) and the danger of Payment-in-Kind (PIK) features, which allow interest to roll into the principal, leading to a “debt snowball” effect.
- Common restrictions on owner draws (taking a salary), limits on taking other debt, or requiring approval for minor operational decisions.
- Because these lenders are less regulated, they may move faster to seize collateral or force a sale if a single quarterly metric is missed.
- Most regulated lenders will eschew paying off hard-money loans and in many cases would not lend to businesses that took such debt at all.
Most worrisome, what was meant to be a short-term, as a quick fix to a cashflow crunch, creates a “zombie” – meaning borrowers generating just enough cash to pay the interest but never enough to reinvest in growth or pay down the principal.
I urge small business owners to look at alternatives to unregulated loans.
- Both the Small Business Administration (SBA) and USDA have a variety of loans programs, some through banks, some direct, that focus on borrowers that can’t access conventional bank debt. Gulf Coast Small Business Lending, for example, offers SBA 7(a), 504, and lines of credit as well as USDA B&I loans that, in many cases, supplant the need for hard money.
- Equity investment, while typically more expensive than debt and comes with its own set of drawbacks, is in most cases a better solution than many of the private debt offerings.
- Banks (like ours) offer a variety of other loan products such as factoring, asset-based loans, equipment loans, secured and unsecured lines of credit, and purchase-order financing for cash-strapped companies. While the rates are invariably higher than SBA and USDA loans, they are largely devoid of the critical risks found in unregulated loan products.
True for all forms of loans and investments, but especially for the more opaque products, perform due diligence on the lender and have legal counsel study the paperwork.
If you are looking for capital and would like a value-added opinion from our experienced team of professionals, contact us (https://gulfcoastsba.com/our-people/) to discuss whether something in our toolbox of products fits your unique borrowing needs. More information can also be found on our website here: https://gulfcoastsba.com/sba-loans/ or in our Knowledge Center here: https://gulfcoastsba.com/resources/. Day in and day out we are finding a way to say YES!