The US has more banks than any other country on the planet, at more than 4,000. But it might not always feel that way to SMEs looking for credit. Every three months the Federal Reserve takes the pulse of the top loan officers at the nation’s most important banks. The story they tell has become wearingly familiar. Once again in October, banks tightened lending standards for US businesses of all sizes, based on the survey of US’s 100 largest institutions.
The trend toward stricter conditions for commercial and industrial loans has become even more pronounced since the failures of Silicon Valley Bank and Signature Bank in the US in March. These failures highlighted the potential for liquidity problems at regional banks amid increased competition for deposits in a higher rate environment.
‘We have seen a notable decline in credit from banks following the failure of Silicon Valley Bank’
Many banks have also been struggling to offload cheaper loans issued to companies prior to the 2022 series of hikes by the Federal Reserve. In response, loan officers have become even more timid. ‘We have seen a notable decline in credit from banks following the failure of Silicon Valley Bank,’ says Steven Wasserman, a senior lecturer in finance at Bentley University in Massachusetts and a consultant to small companies.
This adds to a longer term retreat of banks in supporting SMEs; since the 2008 financial crisis stricter controls on bank risk-taking have led to a progressive decline in the willingness to lend.
Variety of options
For CFOs of more modest sized companies, there are a variety of options, says Wasserman. ‘We are talking about everything from customer financing – asking for down payments on large orders – and secured financing – selling receivables for immediate cash – all the way to convertible debt,’ he explains.
For more substantial enterprises, the gap has increasingly been filled by private credit lenders. These funds, which draw on capital from wealthy individuals, pension schemes or sovereign wealth funds, have roughly doubled in size over the past five years – with US$1.6 trillion in assets under management, according to Preqin.
So, what does this shift mean for finance directors and CFOs? And are there drawbacks to this form of borrowing?
‘Since private credit funds are generally backed by sophisticated investors, they can be far more flexible’
First, it is generally good news for companies that more borrowing options have become available. ‘As an executive, the bigger the menu the better,’ says Dr Andrew Hilton, former director of the Centre for the Study of Financial Innovation. ‘US companies have been complaining that they are getting less support from banks every year. If you didn’t have private credit providers stepping in, the situation would be tougher.’
Private credit funds – such as Ares Management or Antares Capital – have the capacity to provide financing to companies whose credit metrics would make them too risky for a traditional bank loan. This can include more innovative early-stage companies that have yet to turn a profit all the way to more established firms in distress. ‘Tighter regulation since the global financial crisis has made it harder for banks to service such creditors,’ says Dr Hilton. ‘Since private credit funds are generally backed by sophisticated investors, they can be far more flexible.’
Second, private credit funds can provide greater certainty on terms than syndicated loans – more substantial loans that are split between several creditors. Until the moment a deal closes, the price of syndicated loans can be impacted by swings in financial markets. Private funds, by contrast, can lock down terms in advance. Such terms can also be tailored more closely to fit the needs of a firm, including allowing a fast-growing company to defer interest payments. ‘This can be extremely valuable to companies with volatile cashflows,’ says Dr Hilton.
‘When you order something more exotic on the menu, the price tends to be higher’
Third, such alternative lenders can be nimble, processing loans at speed compared to seeking credit via individual bank loans, syndicated loans and especially the bond market.
Higher costs, more restrictions
Of course, there are downsides and risks. ‘When you order something more exotic on the menu, the price tends to be higher,’ says Dr Hilton. ‘Private credit is generally no exception.’ Reporting by Bloomberg suggests that direct lenders often charge between 200 and 300 basis points more than a syndicated loan for a similar company. For additional context from an investor perspective, private loans yield close to 12.5% at present, according to UBS, compared with around 9% for US dollar high-yield credit.
Beyond higher costs, finance chiefs may need to accept more restrictions on their freedom to raise additional funds through stricter covenants. Breaching such limits can result in penalties.
Finally, while private credit funds can be flexible partners, this form of borrowing has a relatively limited track record, only reaching significant scale after the global financial crisis. That raises the threat that these newer lenders could withdraw credit abruptly during a crisis, just when companies need it most.
This risk was highlighted by a recent study, ‘Non-Bank Lending During Crises’, from the Bank for International Settlements. The authors argued that traditional banks are ‘relationship lenders’, giving them a commercial incentive to see companies through the tough times – while some private lenders are transaction-based and so more likely to turn off the taps. A paper in the ABA Banking Journal, run by the American Bankers Association, echoes this point.
The bottom line is that the surge in private credit has both pros and cons. But it does provide an additional choice for finance chiefs, especially those aiming for a diversified range of lenders. At present, private credit is most prominent in the US – which accounts for just over US$900bn of the US$1.6 trillion of assets under management, based on Preqin data.
Access to private credit is also expanding in Europe, where such funds now have US$400bn in assets. Assuming banks continue to take a more cautious approach to lending, it seems likely that this option on the menu will be tempting more finance chiefs around the world in coming years.
