Transcript
Speaker: These days, when a middle market company is looking for a loan, nearly three out of 10 times, it goes not to a bank, but to a non -bank lender. Is that a good thing? Is that a bad thing? Should we be delighted? Should we be worried? Find out on the next episode of The Market That Moves America.
Speaker: Welcome to The Market That Moves America, a podcast from the National Center for the Middle Market, which will educate you about the challenges facing mid -sized companies and help you take advantage of new opportunities.
Speaker: Today's podcast is about where middle market companies go for the capital they need to grow, and about the increasing importance of non -bank financing. How big is the phenomenon? What lies behind it? And is it a good thing? I'm Tom Stewart. I'm the executive director of the National Center for the Middle Market at the Ohio State University Fisher College of Business.
Speaker: were the nation's leading research group looking at middle market companies, mid -sized companies which account for about a third of private investment, private sector employment, private sector GDP, and the lion's share of economic growth. It is indeed the market that moves America. The National Center for the Middle Market is a partnership between Ohio State and CHUB.
Speaker: With me today is Ishel Errol, Professor Ishel Errol, who is the David A. Rissmiller Chair in Finance at the Fisher College of Business and a Research Fellow of the National Center for the Middle Market. Professor Errol, it's good to have you. Thank you, Tom. Very happy to be here. Ishel, start out by talking to us about the research that you did into non -bank lending. What were you looking for and what did you find?
Speaker: Great. Thank you for the opportunity. In this research, we provide the extent and also the characteristics of non -bank lending to middle market firms post -crisis. And I want to pause here and explain what I mean by non -bank lending. When we say non -bank, we mean non -commercial bank lending. So the loan
Speaker: that I have in mind is a direct loan that's extended to the borrower, but the lender is not a commercial bank. So I'm not regulated by the Federal Deposit Insurance Company. I do not worry. I do not worry about the Fed directly overseeing me or the controller. Definitely no. So who am I?
Speaker: if I'm that lender. Mostly, I'm a finance company or a bank -affiliated finance company, and a number of these types of companies have been declining, but they are still out there. Or, more importantly, I'm a hedge fund or a PE or VC firm, an investment manager, and the list goes on. So any financial institution that's not a commercial bank is our non -bank.
Speaker: And the basic thing is they're not regulated the way banks are, either at the state level or at the federal level. Yes. And very often they have very short -term liabilities, like a hedge fund would have. But in some cases, like in the case of an insurance company, they might have longer -term liabilities. So there's a variety of non -bank lenders in our sample.
Speaker: So let me explain more. So what do we do? So we randomly select 750 US publicly traded middle market firms. So they are publicly traded. That's because you can get the data, right? Yes. There are constraints on the research, unfortunately.
Speaker: Typically, for this sample of firms, a bank, a commercial bank would be the lender because they are not very large to rely on public debt markets all the time.
Speaker: So I can't issue bonds on my own, so I need to go to a lender rather than the public market. Yes, some of them can, but a typical, a traditional lender to this type of borrower would be the commercial bank. And one of the things, some of our earlier research showed that
Speaker: Middle market companies value their banking relationships. I mean, everybody's got a bank, right? And so that banking relationship is sort of the core fundamental banking relationship. So going outside the banking relationship is a little unusual, right? Is it a second choice?
Speaker: That's right. And the firm characteristics will determine this choice. So let me tell you a little bit about these firms. So if you're a borrower from a non -bank, you are more likely to be riskier and not profitable. My bank won't do business with me, so I will only... Okay.
Speaker: They can do it. So if you sort firms based on profitability, EBITDA, the firms with negative EBITDA, negative profitability, would be more likely, 34 % more likely to go to a non -bank. But that doesn't mean that they would not go to a bank. And same for profitable firms. They are more likely to go to a bank, but that doesn't mean that they would not go to a non -bank either.
Speaker: But having negative EBITDA explains a lot in terms of non -bank lending. And there is some regulation that would put constraints on banks here. For example, OCC, one of the main regulators of banks, would require that you would flag loans going to non -profitable firms
Speaker: as substandard. And that might require more loan loss reserves, meaning that they don't tell you not to make this loan, but it might be more expensive for a bank to make such a loan. And there are some other requirements across agency, leverage lending requirements. So how big is this phenomenon? I mean, you looked at 750 companies,
Speaker: Is non -bank lending growing? Growing a lot? Growing fast? How big is it? I'm very glad you asked this question because this is the most important finding in this research. That over the time period that we analyzed, which is 2010 to 2015, we see that one -third of
Speaker: All direct lending, private direct lending to middle market firms is coming from a non -bank lender. Is that one third of the money or one third of the loans? One third of the loans. In terms of size adjusted numbers, it's about 16%. But in the last year, which is 2015, it increased to 28%, even size adjusted.
Speaker: It is huge. So three out of ten dollars. In 2015, three out of ten dollars loaned to middle market companies came from a non -bank lender. Yes, and mostly from finance companies. And how could you compare that? I mean, what would that have looked like 20 years ago? I don't know. Unfortunately, I don't know. But we presume a lot smaller. A lot smaller.
Speaker: There has been always lending by finance companies, but I think the new players are hedge funds, PE firms, and one reason could be the fact that there is lots of capital in the private lending market.
Speaker: Capital sitting on shelves trillions of dollars. I think they say of capital sort of Sitting on a shelf being waiting Desperate begging to be put to work. Yes, that's I think the most important reason and also Advancements in information technologies is another reason, you know, these firms can screen very well. They can use I'm sure state -of -the -art data analytics
Speaker: to look at many borrowers and pick a very small person to jump on. And also presumably on the other side, the demand side, middle market CFOs and leaders themselves have a better opportunity to scan for non -bank lending.
Speaker: Yes, definitely. And one characteristic of non -bank lending is the fact that it is more innovative, I think, compared to a bank lending. Is that a good thing or a bad thing? Let me explain a little bit further. So typically, what banks would do is that when they write a loan contract, they also include financial covenants, which would protect them going forward. I mean, the banks.
Speaker: In a typical non -bank lending, financial covenants are not that common. So these covenants are things that I as the borrower promise. I promise that I will deliver X amount of revenue or I promise that I will do these three or four things that assure you the lender that I'm
Speaker: still working hard for you. Yes. And if those numbers fall below a certain threshold, then the loan is renegotiated. And that's generally how banks monitor the borrowers. For a non -bank, I think this is not possible. I mean, that's not their expertise, if you think about hedge funds and PE firms.
Speaker: So that's why they are 34 % less likely to write financial covenants, but they align incentives in different ways. They include warrants, for example. They would allow them to get some equity share and share the upside with the borrower. So if I don't meet those warrants or those things, those targets, I'm going to give you stock. Yes.
Speaker: Okay, got it. The banks don't want to stop. Yes, they cannot. They cannot get it. So these are different loans on average. And that's why we say we see a huge market segmentation in terms of lending by non -banks. So one of the things that I was looking at the research, there were a couple of things that I was struck by. One is,
Speaker: these more innovative loans, somewhat riskier borrower profile. Let's call them risky, not sketchy, although probably some of them are sketchy, right? But I also was struck by your discovery that
Speaker: The growth in non -bank lending was partly related to the retreat of banks from certain markets and certain areas that were some places where I just, if I were looking for a bank, I couldn't find one anymore, or they'd left rural Georgia or wherever it was. Talk to me about that.
Speaker: We don't provide direct evidence on this, but people have been discussing about the fact that, I mean, this increase in the number of non -bank lending happened post -crisis because banks were capital constrained and there was more regulation. I gave some examples.
Speaker: But also, for a typical bank loan, it would be hard to write financial covenants or monitor the loan if the borrower is not profitable. I think these non -bank lenders are finding a good niche market for themselves. So they land to, it's very important to understand what happens to these borrowers actually. So for example, PE firms, they generally land to
Speaker: smaller riskier firms but with lots of growth potential and around the investments and some of them and many of them become profitable later and might turn back to the banks or for hedge funds for example a typical portfolio is riskier borrowers but at later stages of their lives so they had a few years of bad revenue
Speaker: And that's why perhaps they got dropped from the bank's portfolios and the non -banks helped them. Again, these are not very small private firms. They are publicly traded firms. But many of them can have bad times. Right. Actually, that's an interesting question. You were looking at 750 publicly traded companies, middle market companies, which tend to be older, larger, better established.
Speaker: I know you don't want to go beyond your data, but go ahead, extrapolate if you will. What do you think this talk says about non -public middle market companies and the prevalence of non -bank lending there? Do you think it's even greater? Do you guess? I would assume so.
Speaker: because they would be the more credit rationed borrowers, if I can put it that way. One problem might be, though, is the data, right? I'm assuming these lenders process lots of data. And for publicly traded firms, data is much more easier to get.
Speaker: But you never know. If they can get the data, I'm sure they would be willing to learn to screen and learn to these types of borrowers. So put on your CFO hat, you're now the borrower.
Speaker: You have various choices. You need capital to grow. You want to get debt capital. You've decided for whatever reason you don't want equity, and you haven't got, you know, 30 gazillion dollars in your—in your hip pocket. So you've got—retained earnings aren't going to give you what you need.
Speaker: I have a choice. There's a bank. There's a hedge fund. There are a number of non -bank options. What should my process be as the borrower to make the smartest choice among those options?
Speaker: If I'm the CFO, I would go for a more flexible and a cheaper loan, right? That's the obvious decision, I guess. But loan terms matter a lot. That's why I said flexible as well, because there might be times in your cycle where you cannot
Speaker: really write or accept tight financial covenants, right? One thing about these non -bank loans is that non -bank lenders charge on average about 200 basis points more. And this can increase to 400, 500 basis points for PE firms and hedge funds.
Speaker: So I'm paying more if I'm at CFO. If I want to go to a non -bank, I might get a more innovative, flexible loan. Or a loan. The bank might not be willing to do it, but it's going to cost me more. That flexibility or availability is going to cost me more. And it's likely, you said earlier, it's also likely to be a shorter term loan.
Speaker: Yes, they are more likely to be fixed rate and shorter term. And it's understandable. It's more like a one -night stand than a marriage, more like a date than a marriage. I mean, on average, it's about four years. I mean, it's not that short.
Speaker: But it's understandable because research shows that if you are lending to a riskier firms, you are more likely to write a shorter term contract. Makes sense. So to discipline the borrower. Also because you can't see that far out into the future, right? To discipline yourself too, right? Yes. But one thing that I want to emphasize is that because they charge non -banks, charge larger interest rates, we were very worried whether
Speaker: they end up landing to two risky borrowers and many of these get bankrupt and this can be an issue for the economy as well. Sort of like subprime loans and bonds, right? Definitely. So that's why we did look at their future performance. I mean the borrower's future performance.
Speaker: I want to pass here and say that it has been good times, right? We haven't gone through a down cycle yet since a thousand times. And the economy has been sweet, and I like to say the economic weather has been sort of like Bermuda. Not too hot, not too cold, and mostly sunny.
Speaker: Definitely. And keeping that in mind, controlling for all loan and borrowable characteristics, all this matching between non -banks and banks, we find that non -bank borrowables are not significantly more likely to get bankrupt. So despite the difference in interest rates.
Speaker: So unconditionally, there is a 7 % difference. But if you control for the lone characteristics and barbed characteristics, this difference drops to 2 .6%. And it's not statistically significant. I mean, statistically, it's not different from 0.
Speaker: But and also, actually, when we look at the future performance in terms of operating performance, they seem to be doing well. So if you look at this picture, what it shows in simple terms is that they screen well, they pick the right borrowers that are having perhaps that are more likely to have negative eBITDA in the growth cycle, investing in research for PE firms or for, as I said, hedge funds or other lenders, highly -levered riskier firms.
Speaker: not very profitable, but they end up doing well afterwards. And even if we were to go into a recession, I think, the difference interest rates is not justified by the probability of default or loss given default using the last recession data.
Speaker: So they seem to be, in short, they seem to be taking the right— In other words, the non -bank lenders look like they themselves are in pretty good shape. Yes. So that means, as a borrower, I don't have to worry that my—as long as I've done a reasonable amount of due diligence as a borrower, I would not have to worry that my non -bank lender is itself going to go belly up. Yes, it will disappear. But you never know, right? Like, as I said, we haven't gone through the non -cycle yet.
Speaker: Let me flip the question. We are entering into, if not a downturn, at least slower growth, and things are stormier in their trade wars, and there's all kinds of uncertainty. There's an issue of, from a borrower's perspective, these guys might be the capital that's available for me. I might benefit from their innovativeness. I might not have a bank available to me.
Speaker: But as you were saying, it tends to be a shorter -term relationship. And I'm still going to want to build that long -term relationship with the bank too, right? I mean, I'm going to want to have something like that because, well, I remember a couple of years ago when Hurricane was it.
Speaker: Irma in Florida and Harvey in Texas, I think it was Irma in Florida. A bank that I was talking to talked to me about a lot of their middle market company clients calling them up saying, how's my credit? If this storm hits, can you help me? And that's the sort of relationship that a bank is more likely to offer than a hedge fund.
Speaker: I agree. And what we call commitments or lines of credits with banks help a lot in down cycles. And that's something I can call on at my discretion when I need it. Yes, it's an option and you can use it whenever you want to draw down under the commitment. So these loans that I'm talking about from non -banks, they are mostly term loans. They don't provide commitments like banks would do.
Speaker: So that's why we still need banks. But they can get capital constraint during the down cycles and land to even better credit quality firms. Because we have some research showing that when the capital gets tight, the firms that are
Speaker: highly rated with less credit risk, end up staying in the market and borrowing from banks, and riskier firms drop out of the lending market.
Speaker: If non -banks survive in a down cycle, they can help risk your middle market firms. So what I think we're seeing in this research is that post crisis, post Dodd -Frank and other regulatory changes, post some of the disappearance or attenuation of community banks and local banks, some of that.
Speaker: post the emergence of all kinds of internet connections and crowdsourcing and other things like this, and in this time of rich, in this capital unconstrained time, capital rich time, there's a structural change in the ways that middle market companies are financing their business. Definitely.
Speaker: more private capital, some of that's debt, some of that's equity. And in the debt market, what we're saying is a big change in the emergence of a whole sector, more innovative, less regulated, maybe a little riskier, a little costlier in the debt market, and that's not going away.
Speaker: Yeah, but it's interesting. It means that I, as a middle market company, if I were, I have a little bit more complicated landscape to navigate, and I guess a bunch of choices about short -term, long -term relationship now, money now, money later, what I want to do and what I want to be if and when I grow up.
Speaker: Availability of credit is always good, so having options from which you can choose will always help.
Speaker: I mean, as long as you are not overpaying, I think having these options will help. As I said, they charge more, but they give the credit. I think middle market firms will decide whether they can benefit from this. So where can I find or where can listeners find your paper? Because it's a really cool paper. Oh, thank you. It's on my website, on Fisher's website. And I'm sure you will be happy to share the paper as well.
Speaker: Well, I will. And that's, you can find that as fissure .osu .edu. And then Israel Errol, I -S -I -L -E -R -E -L, Professor Errol is the author of this and you can search for her and you can find this paper. And as I said, and thank you so much for your insights here. This is a whole,
Speaker: new landscape of financing for middle market companies, new features, new opportunities, new flexibility, maybe some new pitfalls, but certainly stuff that people ought to be looking at and considering and thinking about as they try to build their companies into the future. So, Professor Errol, thank you so much for your time.
Speaker: Thank you. It's my pleasure. And thank you all for listening to The Market That Moves America. Never miss a new episode. You can subscribe to the podcast on iTunes, Stitcher, Google Play, or wherever fine podcasts are found. Or you can subscribe and learn more about the National Center for the Middle Market at our website, which is middlemarketcenter .org.
