According to MerriamWebster, the Wild West “was a period characterized by roughness and lawlessness.” If ever a definition applied, this would clearly explain the current lower end of the middle market lending arena, namely small asset-based lenders and single ticket factors. We know there are more than a few but fewer than hundreds of firms providing these services.. According to the Exit Planning Exchange, the lower middle market (LMM) “is a distinct market segment with unique characteristics, but it is not that well understood.” This lack of understanding means that companies in this segment don’t get the level of attention and help they need, especially from major lenders or financing sources. That’s a problem for them but also for the greater community because these companies play an important role in their local economies and beyond.

Defining the Lower Middle Market

Coining this segment of lending as the “Wild West” seems fitting given the number of privately owned, unregulated firms lending to this lower end borrower. Trying to define exactly what constitutes the lower middle market can be as difficult as getting ducks in a row, herding cats and getting millennials to put down their phones. So let us use three separate benchmarks to set the stage.

Sales: Data published using the North American Industry Classification System Association (NAICS) identifies roughly 531,000 companies in the $5 million to $50 million sales range. Although this range isn’t set in stone, this revenue range is a good starting point for identifying the lower middle market.

Employees: The most common data set for the total number of businesses in the U.S. comes from the U.S. Census. This data distinguishes companies by number of employees. Using this data, we see that there are about half a million companies with 20 to 100 employees, which represents roughly 2% of the 30 million companies in the U.S.

Survival: The data on company numbers gets even more interesting when you look at data on corporate survival rates from the U.S. Bureau of Labor Statistics, whichshow50% of businesses do not make it past five years, and that only 20% make it to 20 years.

Of further note, companies in the lower middle market are typically past the start-up stage. They are scaling and growing, but they do not achieve (or often seek) the hyper growth of a public company. They truly are in the middle, which in no way diminishes the accomplishment.

As noted above, it’s not easy to get into the lower middle market. And once you get there, survival is not assured. The LMM is when you create a company and that company needs financing. With no historical track record, banks and other institutional lenders are loathed to lend. So how does, and how can a lower middle market, early stage company get financing.

The Wild West

Enter the Wild West of financing sources. Small ABLs and small ticket factors can fill the void in the lower middle market. How?

By being unregulated by banking and other regulatory industry watchdogs. Let’s assume an ABL or factor in this segment is not owned by a bank. This allows them to be highly flexible in their underwriting and their ability to assume risk without the fear and or oversight of regulators. Under the notion that “it is my money, I’ll lend how I want,” they can — and often do — take on risk beyond what a more conventional and institutional lender would consider prudent. They do this, in large part, by identifying and providing leverage on specific collateral deemed to be worth more than the loan (or factor) advance. For example, the ABL will underwrite the credit worthiness of the accounts receivable, the orderly liquidation value of the inventory, the appraised value of the machinery and equipment and if need be, the forced sale value of any company or personally owned real estate. Assuming the sum of all these assets is less than the loan request, a non-regulated lender can — and often will — make this loan. Terms like high interest rates, short maturity and control of the company cash may seem onerous, but since such lending is usually cheaper than raising equity, it begins to make sense. Take the money now, grow for another year or two, then move into more traditional and institutional lending sources. Often this is viewed and explained as “renting equity” for the year or two.

Lower middle market loans tend to have more leverage, which means banks and institutional lenders will shy away from them. For these institutions, the risk reward matrix is to take a lower risk and get a lower return. Conversely, higher leverage means higher risk, which also means higher return. Direct non-bank lenders have flourished in this space in the past handful of years. They have found a niche where others have not been bold enough to go. With the growing size and sophistication of these funding sources, as well as the heightened competition, many lenders have taken the guard rails off and weakened terms in order to book business. One way these leverage sources can distinguish themselves is in the lack of financial covenants inherent in many of these transactions. No covenant or covenant light deals have come back into favor as aggressively as they were in the late 1990s — everything old is new again.

A Factor’s Place

On the factor advance side, any bona fide invoice to an account debtor can be a source of quick cash to a borrower. Many larger customers of smaller companies may take 30, 60 or even 90 days to pay an invoice, which is cash that small borrowers desperately need to fund the next order and keep the lights on.
Enter a factor, which is often less concerned about the financial condition of the borrower as it is with the creditworthiness of the borrower’s account debtor. Factors advance cash against invoices and they wait to get paid, all the time earning interest and fees for themselves. The presumptive risk is that if the account debtor does not pay as planned, the borrower has sold the invoice and it is no longer their problem. That may or may not be the end of the transaction depending if the sale is recourse or non recourse, but as small non-regulated lending sources, factors can make the decision as to how much risk and at what return they are willing to take for that risk.

Collateral Prevails

A reasonable question to ask is why would an ABL or factor take on this level of risk on a largely unproven segment of the market? First and foremost, if they are right about their collateral, it is a relatively riskless transaction, and given the lack of traditional, regulated and institutional lenders serving these borrowers, the return rates can be quite attractive, from 10-15% (ABL) to 30% (factors) and anywhere in between. The key is understanding the collateral and employing some, not all, of the 5 “C’s” of credit; in this Wild West lending scenario, collateral will always prevail, character being a very close second.

• Collateral: An asset that can back or act as security for the loan
• Character: Reflected by the applicant’s credit history
• Conditions: The purpose of the loan, the amount involved and prevailing interest rates
• Capacity: The applicant’s debt-to-income ratio
• Capital: The amount of money an applicant has

What may bring order to this “period characterized by roughness and lawlessness” to an end? That’s hard to say. There is an abundance of capital in search of returns, and borrowers in search of capital to grow their businesses. With a Prime rate as of this writing of 3.25%, double digit returns look very attractive. Further, many borrower’s creditworthiness may be on the decline due to COVID-19’s effects on first quarter and first half of the year results which are expected to be weak. With an almost anything goes mentality of today’s non-regulated lenders, coupled with the sheer amount of private money out there looking to be put into use, this period may continue for the foreseeable future.