The Economy

When Banks Won’t Touch Your Company

Alternative financing firms take on credit risks that financial institutions don’t want.
Vincent RyanOctober 10, 2012

When commercial bank lending rises on a sustained basis as it has the past year, it’s hard to fathom some companies being denied credit. Believe it: there are always companies (and industries) that are just not bankable. They are neither A nor B credits, in industry parlance. Among them: firms that are cash-flow negative, start-ups with intellectual property but no customers, and young industrial companies that need to finance fixed assets before entering production phase.

The situation for the have-nots could get worse in the next few years: pieces of the new Basel III bank capital rules may force banks to be more selective with their capital commitments, especially to companies of marginal creditworthiness.

But there are some alternative financing sources that are hungry to deploy money and willing to finance higher-risk projects. Low interest rates are a big reason. “There’s not a lot of yield to be gotten in the public bond markets. Private capital providers need yield in their portfolios,” says Allen Weaver, senior managing director at Prudential Capital Group, which invests long-term money from insurance companies and pension funds.

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Take Deep Eddy Vodka. When demand was outstripping the capacity of its bottling line equipment last year, the two-year-old spirits start-up called on many banks but found its business model didn’t line up with their idea of creditworthiness. Deep Eddy spends a lot on sales and marketing to build its brand and grow its topline fast, paying less attention to profits for now, says John Scarborough, the company’s vice president of finance. Once bankers saw the business’s operating losses, they said they needed personal guarantees from Deep Eddy’s principals.

After searching, Deep Eddy found Fountain Partners, a provider of lease lines of credit for capital equipment. “Fountain was willing to look at the business model, peel back the onion a bit, and see that there was a fundamentally strong business underneath,” says Scarborough. Deep Eddy landed a $250,000, 36-month lease to buy its new high-capacity bottling line, as well as a sale-leaseback of existing equipment to generate additional working capital.

There is a knock on alternative financing, though. A nonbank financier’s cost of capital is higher than a traditional bank, since it doesn’t have dirt-cheap deposits to fund loans. Since its cost of capital is higher, the borrower pays a higher rate.

“With the funds we are running right now, we are looking for rates of return that are double-digit, and we are very clear about our willingness to take large-scale risks that make that [rate] deserving and fair,” says Tom Carter, founder of Fountain Partners and a former CFO.

Also taking those credit risks are business development corporations (BDCs), which are publicly held investment companies that must distribute 90% of their profits to shareholders. By leveraging their balance sheets, BDCs can get their cost of capital down, says Manuel Henriquez, CEO of BDC Hercules Technology Growth Capital. Hercules originates senior secured loans, often collateralized with intellectual property, and has a cost of capital of 5% to 7%, compared with 2% to 3% for a bank.

The real advantage of alternative financing is not in the hard costs, though. Henriquez says his clients — companies with $20 million to $100 million in sales, but inconsistent cash profits — can place their deposits and operating accounts into any bank. In addition, the financing agreements are a lot less covenant-driven. And in the event a company gets into trouble, “the loan doesn’t get passed to a workout group whose sole purpose is to get the bank’s money back at whatever cost, because regulators are breathing down its neck,” Henriquez says.

“Because we are not regulated like a bank and have permanent capital on our balance sheet, we can work with a company through difficult times,” he adds. “We expect our companies to stumble, like a little kid on a bike.”

Not that borrowers shouldn’t pay attention to the cost of alternative financing. In lease deals, notes Scarborough, sometimes the actual interest rate is buried in a bunch of numbers. In borrowing from Fountain Partners, Scarborough generated an implied interest rate by creating a cash-flow model that took into account the deposit, the monthly payment, and the buyout.

While monthly payments with interest rates higher than a typical bank loan may scare finance executives, nonbank debt lets some companies save expensive equity capital for strategic uses. It doesn’t make sense for a start-up to buy furniture, servers, and routers or fund working capital with equity dollars, Henriquez says: “Better to supplement that with debt that helps the company bridge a two-to-three-year period until it reaches its next milestone and attracts a higher valuation.”

“In consumer packaged goods, value is created by the brand,” says Scarborough. “We have a finite amount of capital and the highest-return, best use of capital is to invest in marketing programs and a world-class sales team, not equipment.”

But alternative financing firms don’t have an infinite appetite for risk, either. Fountain Partners looked at several deals in the solar industry between 2006 and 2011, Carter says, but never extended credit to one. His reasoning: basic science and execution risk around the companies’ manufacturing plans, and the fact that many of the solar companies didn’t have enough venture money to reach production phase.

Still, in general, firms like Fountain take a more expansive view of a borrower’s prospects. “We take risk that large-scale financial institutions shy away from,” says Carter.