How non-bank lenders differentiate themselves and successfully capture market share while navigating risk will determine how they are able to define the current moment. Non-bank lenders are well-positioned to take advantage of the current economic and credit environment and will be better able to help borrowers compared to traditional banks.

The 1996 movie “Tin Cup” is about a washed-up golf pro named Roy McAvoy (played by Kevin Costner) whose rebellious nature and bad attitude cut short his otherwise bright future as a professional golfer. However, his unsurpassed talent and rivalry with his most fierce competitor fuels his drive for one more run at potential glory. In a scene with his long-time friend and parttime caddy Romeo (played by Cheech Marin), McAvory utters the phrase, “When a defining moment comes along, you can do one of two things: Define the moment, or let the moment define you.”

The effects of the COVID-19 pandemic on supply chain disruptions, inflation and labor shortages have been well documented and discussed at great length. On the inflation front, the Federal Reserve’s policy has been persistent and pronounced, as it has made consistent rate increases over the past year. As a direct result, economists expect economic growth to slow and credit conditions to weaken for both consumers and businesses. Meanwhile, banks will likely grow more cautious and restrictive about extending credit as they respond to not only headwinds in the credit markets and elevated inflation, but also recent insecurity with bank liquidity and impending bank regulations brought on by recent bank failures. Against this backdrop, where will borrowers look for continued working capital support as traditional banks tighten?

Non-bank lenders include institutions such as credit unions, private debt funds, family offices and online lenders. Many non-bank lenders also provide the same services that traditional banks offer, such as asset-based lending and factoring, as well as equipment finance. Other non-bank lenders differentiate themselves by focusing on niche products, such as standalone inventory and purchase order funding, while others are industry experts that focus specifically on certain sectors.

The need for these non-bank lenders has grown over the past six months. According to data from the Federal Reserve Bank of St. Louis, consumer credit increased at an annual rate of 5.5% in February 2023, with non-revolving credit increasing at a rate of 6.6%. Meanwhile, many non-bank lenders have reported noticeably stronger performance in originations in recent months.

There is a large subset of non-bank lenders in various industries that have the size, expertise and risk appetite to help fill the void that will soon be left by banks. For these non-bank lenders, this is one of those defining moments to which McAvoy was alluding.

MOMENT OF OPPORTUNITY

At the onset of the pandemic, banks were indirect beneficiaries of government programs, such as the Paycheck Protection Program and more liberal assistance from the Small Business Administration. Existing bank clients appeared healthy and more than capable of weathering the storm created by the pandemic as a result of these programs. Artificially inflated balance sheets, along with a directive of forbearance from regulatory agencies, such as the Office of the Comptroller of the Currency, provided banks the justification they needed to continue to lend and to do so more aggressively than may have been warranted. In essence, the federal government created an artificial safe haven for banks to continue to compete vigorously to keep existing assets and compete for new ones.

The Fed’s efforts were warranted and much needed; however, that safe haven has all but vanished as a result of the glaring economic factors that are steering the U.S. economy into a looming recession. Now, instead of enjoying portfolios filled with healthy balance sheets, banks are beginning to see cash evaporate, leaving portfolios filled with “walking zombie” clients to service with out of formula borrowing bases and tripped covenants at below market pricing. This puts non-bank lenders in an enviable position to help borrowers for several reasons.

First, non-bank lenders are able to move to a decision much faster than banks. This has always been the case, but it is even more important now, especially for borrowers that are dealing with severe liquidity issues and need to act fast to shore up working capital to continue operations. Non-bank lenders can be faster than banks because they are often smaller in terms of headcount, which eliminates the layers of decision makers and bureaucracy found at banks. In addition, nonbank lenders are often made up of sales and credit teams that work more closely together and are more aligned than at large banks, with owners frequently playing an important role in sales and ensuring deals get through much more quickly. Non-bank lenders are also able to make decisions more quickly than banks due to the lack of regulation they face, although some regulatory headwinds are beginning to develop.

Beyond speed, non-bank lenders can maintain more flexible lending criteria and be more creative in terms of structure than banks. Non-bank lenders can set mandates to lend to companies with negative cash flow and earnings as long as there’s a “story” or positive trend in sales and cost cutting measures. Others can be more liberal in lending policies based on the relationship with the client and the continued support from institutional owners, such as sponsors and private equity. Lastly, many non-bank lenders are experts in non-traditional collateral, such as recurring revenue, customer purchase orders, assets of owners and intellectual property, which banks are more loathe to incorporate into a deal structure.

Since non-bank lenders are in this so-called enviable position to provide access to capital to companies cut off from banks, they will also be able to capture more yield. This is a direct result of the value non-bank lenders are able to provide and the additional risk they take on. However, while borrowers see the value and need for access to capital provided by non-bank lenders, it will take time to manage expectations when it comes to price. Non-bank lenders need to be careful and strategic as they price opportunities to avoid creating ill will in order to establish a strong and meaningful relationship with new clients. Aggressive and misguided pricing can merely exacerbate the challenges these borrowers are already facing.

THE RISKS

Getting back to McAvoy’s quote in “Tin Cup”, we’ve identified the moment. We’ve also discussed how non-bank lenders can execute and define the moment. However, what are some of the risks non-bank lenders need to identify in order keep the moment from defining them?

Let’s start by addressing the process of moving a lending relationship from an existing bank to a non-bank lender. As mentioned earlier, many banks have been overly aggressive, which has been reflected in loose lending structures and aggressive pricing. Transitioning a borrower that is out of formula or in an “over-advance” creates a challenge for a new lender no matter how aggressive they may be. In addition, it will take a fair amount of time to negotiate with existing banks to get them to agree to term out a portion of their existing exposures and become subordinate to the new lender. This process will also be dependent on specific circumstances unique to each client relationship. As they say, “time kills deals.” The more time it takes to negotiate and work through this process between two lenders, the more likely a company starved for cash won’t survive. To keep things moving, non-bank lenders may make concessions and compromise sound credit decisions to take on a new client in hopes that everything will simply work out.

Moving clients over from banks is just one of the risks facing non-bank lenders, even in this potentially fruitful environment. Non-bank lenders are not immune to continued inflationary pressure and the systemic effects of rising interest rates. Plus, that sound growing louder from the other end of the tunnel is the sound of an impending recession. While the degree and longevity of this incoming recession is debatable, there is no question that it will be unavoidable and have far-reaching effects. For non-bank lenders taking on new relationships, they must take into account how these overall macroeconomic factors will affect borrowers.

Additionally, as more opportunities present themselves to non-bank lenders, there may be a natural progression toward overly aggressive structure and pricing. To avoid this, non-bank lenders need to keep in mind what they do best and “stick to their knitting.” New opportunities for non-bank lenders today may have operational challenges with significant leverage and other balance sheet baggage. Non-bank lenders who have been starving for deals will need to abstain from taking on risks they don’t have the expertise to manage and offering prices they can’t absorb if there are future losses all for the sake of booking a new client.

Lastly, the regulatory environment is morphing and changing on a daily basis. No longer are banks the only players facing regulatory headwinds. Non-bank lenders are facing new and very punitive regulatory risks. Like it or not, this wave of regulation is only the beginning. These regulations may be inconsistent from state to state and virtually impossible and extremely costly to comply with, so non-bank lenders need to be aware of all requirements in the territories they operate and make prudent and strategic decisions on whom they lend to and where they do business.

THE QUESTION REMAINING

Non-bank lenders will be the direct benefactors of what’s already becoming a tightened bank credit environment. It’s an unavoidable result of the pandemic and the necessary actions taken by the federal government. While non-bank lenders are well-positioned to take advantage of this much awaited opportunity, these same non-bank lenders need to focus on credit decisions that make sense and be mindful of the risks that will tag along.

In closing, another scene in “Tin Cup” comes to mind. When McAvoy is challenged by his rival to see who can hit the ball further with a 7-iron, there is no doubt that McAvoy will win if they both hit the 7-iron on a driving range for distance. However, when his rival creatively changes the game by hitting his 7-iron down a paved road where the ball will bounce longer than on grass, McAvoy finds himself on the losing end of the bet, losing his car in the process. Like McAvoy, there is no doubt that non-bank lenders will be better suited to the task ahead: providing the critical working capital solutions many borrowers will desperately need to be able to define the moment. The question is, will non-bank lenders be sensible and mindful of the risks, or will they let the moment define them?

ABOUT THE AUTHOR: Bryan Ballowe is a co-founder and managing partner of TradeCap Partners. Ballowe has been in the purchase order funding industry for more than 25 years, providing funding solutions to U.S. and Canadian based importers, exporters, distributors and manufacturers. He can be reached at [email protected].