April 2016 - Banks have long been the primary source of financing to small businesses – but over the past 7 to 8 years, financing to this sector has shrunk by over $100 billion. Why the big drop-off, and what does it signal for the future? One major factor is consolidation in the banking sector. A lot of the financing that has dried up came from community banks; and with fewer community banks, there is less financing to go around. In addition, many of the bigger banks are now trying to move upmarket to larger borrowers, so small and medium-sized businesses have gotten the short end of the stick, and a fair amount of capital has been pulled out of the system. Fintech and new platforms are trying to fill that gap, but there’s been a net reduction in small business financing.
In the leveraged credit world, the market is reasonably liquid. The bigger the company, the more broadly syndicated the loan, the more there’s an active trading market. On the other hand, middle market leveraged credit tends to be done in club deals; there’s some liquidity but the bid ask tends to be fairly high.
One of the interesting things that’s happening now in the market is people are trying to find new ways to use technology to create liquidity for small business financings. Platforms are being created that are giving investors of varying types the ability to participate in small business loans that are much smaller than the market had the opportunity to engage in before. Technology is helping create liquidity and velocity of capital, and opening up some of these assets to a different investor base.
However, there’s a very real need to look closely at the new platforms popping up. As more platforms evaluate using securitization as a funding option, more investors are going to want to explore the model – but many of the platforms have been developed within the last five or six years and haven’t been proven in a down cycle.
As we look ahead, here are three key issues to watch for in the small and medium-sized financing market over the next year. First, there are still a number of weak spots in the economy, with numerous sectors that are challenged, including segments of retail, and oil and gas. Overall, I believe the risk of recession has risen, which would have a profound effect on small and medium-sized businesses. Second, like many others across the industry, I am concerned about the new regulations taking effect in the ABS market and the impact they will have in a market already facing tight liquidity. Third, the ability for small and medium-sized businesses to obtain funding is cracking open in new ways, leveraging technology, global liquidity pools and new origination sourcing models. It’s exciting that these new fintech platforms have popped up to try to fill the gap. It remains unclear whether many of them will have the platform profitability and capital/capital availability to keep going during rough times, incubate their businesses and develop a proven track record.
It’s a complex but fascinating time for the ABS market. With every new paradigm change, from marketplace lending to the next big thing, we are bound to see new waves of opportunities for investors, issuers, borrowers and lenders. Investors are excited about the changes that are occurring in the market, but they will need to be vigilant regarding the potential risks, especially with less proven sectors and issuers.