The fintech revolution has produced more than 400 daily debit lenders, which makes it seem like money does grow on trees.
To avoid having clients obtain quick fixes of up to $500,000 online within minutes, asset-based and commercial lenders are going to have to implement new structures and strategies to provide more cash availability and to better protect and monitor collateral. For most secured lenders the problem is not losing deals to fintech companies, but, rather, having clients breach loan agreements by incurring additional debt without consent and not understanding the cash flow effect of daily amortization.
In response, second lien lenders are developing creative solutions to help ABLs and commercial lenders provide up to 100% availability and preclude clients from taking short-term daily debit products to solve short-term capital needs.
Daily debit loans, whether structured as purchases of receivables (MCA) or small business loans (SBL), have exploded from a niche product designed for the restaurant industry to a multi-billion dollar global industry, which now has access to the securitization market. The real target market for online lenders should be companies generating less than $1 million that need $30,000 in capital. Technology, data analytics and algorithms enable industry leaders, such as Rapid and OnDeck, to make funding decisions within minutes. For those fintech lenders, daily repayment requirements ensure acceptable loss rates. This easily obtained capital has become the lifeblood for many small businesses.
Online Lending Moving Upmarket
The problem is, online lending has already started to move up market to larger companies. As a result, the tension between traditional senior lenders trying to stay within formula and borrowers demanding access to quick cash is increasing. Small ABLs serving the $5 million and under market have become more vigilant and have been forced to take on more risk by providing temporary over-advances to control the situation. Or they may increase advance limits. Going out of formula creates more risk and internal pressure for secured asset-based lenders. This sub-$500,000 capital needs market is a very hard niche to finance when factoring in cost of capital, bad debt and overhead, among other things.
Currently, the senior lender can choose to go out of formula or risk the borrower taking a daily debit loan. Neither alternative is ideal. The former requires a senior lender to dip into the reserve or go way past it, and the latter requires letting borrowers take capital that was never meant to solve a cash cycle. Daily debit loans are not easy or practical to turn off, and most borrowers would never think to sign an intercreditor agreement, let alone ask for any type of consent.
Most fintech firms lack a skilled professional on the front lines who can analyze a situation and make a business decision. The name of the game for these lenders is massive originations, algorithms and automation, all of which work to support the SBL industry’s sub-$50,000 senior loans to non-bankable companies, but are less effective venturing up market to companies with non-linear capital needs.
Based on significant experience and research, new products are being developed that can resolve the over-advance issue without sending the borrower to a SBL fintech for a quick fix.
One new product is a fund formed specifically to finance over-advances up to $500,000 and enable the senior lender to manage everything from soup-to-nuts. The senior lender would administer and manage an over-advance, but a third-party fund would finance the loan. Having the senior lender manage this process is a game-changing way to provide more capital and better control a risky situation. This method offers a more flexible amortization schedule based on the needs of the respective businesses rather than a bank statement analysis or algorithm. Too often the interest rate becomes the focus rather than the real issue affecting the cost of the loan — daily amortization. By resolving the amortization paradigm, companies are more effectively able to put the over-advance capital to work and stand a better chance of returning to formula.
Most borrowers clearly do not know this is an option because the product is not marketed directly. A client typically goes to its senior lender first to ask for over-advance before pursuing other alternatives, including SBL firms. The senior lender now has a viable alternative to provide additional capital instead of either going out of formula or saying “no.” This product offers clients a viable alternative to get much needed capital rather than forcing it to go online and search for quick cash that might not be tailored to its actual cash needs.
The borrower, in these cases, may be unaware that there is a third party fund financing the over-advance. The economics for the over-advance would be expensive, but the amortization would be significantly less aggressive (monthly versus daily) and the senior lender would administer the loan. The key is crafting a partnership with the senior lenders as they are best equipped to provide additional availability and monitor collateral. The partnership enables the lender to provide a quick over-advance when the need arises with scalability across a portfolio of companies.
The FILO (First In Last Out) structure is not new, but applying it to lower middle-market lending structures certainly is. Debt funds like Super G have come up with a bespoke mechanism that enables asset-based and other secured lenders to fund an over-advance on their own loan paper and then enter into a relationship with Super G (or other capital sources) whereby it would purchase or finance the over-advance on the senior lender’s paper so the senior lender is within formula. The combination of using a participation agreement that can easily be replicated across many deals and allowing the senior lender to administer, manage and remit funds to the participant enables a scalable solution.
Partnership Between Lenders
The participation agreement is a standard form between the senior lender and the over-advance capital provider and allows a lender to expand an over-advance financing program across many clients. The ordinary course risk to the over-advance capital provider is stand-still risk and therein lies the technical and practical beauty of this partnership.
With a daily debit loan, when something goes wrong, there is no real mechanism to get a modification. All of these firms would have that loan classified as bad debt at best and, at worst, would raid the borrower’s bank account, as some of the these firms actually employ a “confession of judgement” – a written agreement signed by the borrower that accepts the liability and amount of damages that were agreed on, enabling the lender to circumvent normal court proceedings.
The partnership aspect is the key to the success of these arrangements as the capital provider entrusts management and administration of the over-advance to the senior lender and is paid by the senior lender. Each deal is unique, but there is a tacit understanding of the risk and a relationship in place to deal with the likely occurrence of having to modify a decrease in availability or planned amortization as part of working out of the over-advance.
The over-advance capital product can offset a tidal wave of fintech firms, who are not concerned if their borrowers have existing loans. Their primary underwriting methodology is a bank statement analysis to determine how much to lend. This methodology (plus a look at the FICO score) has proven to be effective when it comes to mom-and-pop businesses borrowing $50,000, but does not work well when it comes to bigger businesses with cash cycles that do not fit an indiscriminate daily payback.
The commercial finance industry is entering a new era of borrower sophistication and technology, giving borrowers more options to obtain small amounts of capital in a matter of hours. We are in the first inning of a long ball game as the fintech industry is only going to grow.
Fintech loans were never designed for subordinated working capital issues due to the indiscriminate nature of the repayment with no flexibility to provide a structured solution. The move upmarket and to subordinated financings is a result of too much competition and market saturation from several hundred daily debit providers. This industry has the potential to act as a double edge sword for ABL and commercial lending clients because an indiscriminate daily debit loan cannot possibly take into account the cash need or cycle of most businesses.
To combat the rise of daily repayment loans, asset-based lenders would be wise to partner with over-advance capital providers that understand the senior lenders are the ones best positioned to provide, manage and monitor an over-advance.