WLN Articles

Year Ahead Special Feature: The New Realities in Small Business Finance

After the collapse of the leveraged economy in 2008 and the resulting slump in GDP since then, American small business owners are still wondering what will happen next. While uncertainty and disagreement abound with regard to which public policies are best and what is happening to our tepid recovery, lenders, brokers and borrowers of small ticket commercial equipment transactions are looking for the new rules of small business lending today. Here are some comments on this subject from a credit point of view.

1. Credit scores have lost some predictive power.
Traditionally the majority of non-SBA small business transactions in our industry have been decisioned by credit scoring systems with minimal manual input from a credit officer. Consumer and commercial score products were often combined through a formula to produce a blended score. During the height of the liquidity glut of the last decade, many lessors and lenders competed by dramatically increasing their allowable exposure limits for scored approvals. While my firm, Allegiant Partners, did not offer such an “app-only” scored approval product, we did use credit scores as one measure of risk.

In our experience, no off-the shelf score products based on pre-2008 pooled data were satisfactory in predicting delinquencies and losses during our severe and structural downturn. Fair Isaac may insist that their commercial and consumer scores still “rank order risk” during a recession but that is not much help when so many entities and consumers with good credit scores suddenly file Chapter 11 or 7. In fact there is some evidence that higher FICO scores may have correlated with worse delinquencies and defaults in some segments during this cycle. As optimistic risk takers, many owners of small businesses leveraged up on easy real estate mortgages by the peak in 2006 (and maintained high credit scores by initially paying on time). Those with lower FICO scores had fewer opportunities to become this leveraged.

Although a couple of new score products have recently been released, most of the off-the-shelf scores available now have not incorporated pooled delinquency and loss data from the current downturn. A case can be made that they will have to be completely recalibrated using post-2008 data and additional risk factors in order to provide acceptable levels of predictive power going forward. Hopefully economic conditions will improve significantly by the time these scores arrive— but then that may skew their predictive power to the conservative side and thereby increase lenders’ opportunity cost.

2. Balance sheets are more important.
Cash is king and low leverage is queen. The great de-leveraging has begun and is continuing in fits and starts. Tangible equity and working capital are now as important as ever. Small businesses are being challenged by the depth and duration of this downturn. A longer time in business and an experienced management team are essential to succeed. At Allegiant we look at these attributes before we pull credit data. We review complete bank statements showing all accounts. We ask business owners to explain their cash flow and capitalization and to address the biggest risks in their businesses. In underwriting full credit packages we continue to find hidden weaknesses as well as strengths that cannot be detected with an “app-only” process. We continue to find indications of fraud as well.

3. Fraud is rising.
Bad times make people desperate. Whether it is misrepresentation, the fraudulent conveyance of assets, an altered credit application, forged signatures, double financing or theft, since 2007 we’ve seen a lot more of it. We’ve had strong high-quality borrowers suddenly turn into crooks when times got tough. Sometimes they do this with the aid of their attorney. If opposing counsel runs interference against our efforts to collect and enforce our agreement, the costs can mount up quickly. This makes borrowing more costly and problematic for everyone. So these days we are taking extra care to avoid fraud. We investigate thoroughly. If the transaction doesn’t make sense, we won’t approve it.

4. Rates are realistic.
Some small business borrowers still think they are living in 2006 when lenders competed for the worst deals. With lower revenues and too much leverage some borrowers believe they should qualify for very low rates. But there is simply not the same amount of credit available today. That said, we have lowered our rates at Allegiant because we’re approving stronger “B” credit deals.

5. Small business owners are hesitant.
Many surviving businesses have gained market share and would like to acquire new equipment. But the health of the economy is making some hesitate. They are unsure whether they should acquire more equipment if current economic conditions are deteriorating. This may be smart or this may be a lost opportunity. We have asked brokers to obtain an adequate upfront fee to cover our due diligence costs for complicated applications that may be approved but never funded.

6. Banks will be banks.
We have seen some banks gradually resume lending to small businesses—at least temporarily. We hope their decisions are rational (not excessively tight or excessively loose) but we expect their participation to be uneven. Some will continue to avoid lending altogether for certain industries, types of equipment and geographic regions. Some will impose covenants that are too restrictive. This provides opportunities for Allegiant and our customers. Regardless of the approach that banks are taking, at Allegiant our booked volume is up this year. We are succeeding in meeting the emerging demand for “B” credit commercial equipment financing in a positive and consistent manner.

7. Pool & portfolios are for sale.
Allegiant has acquired several distressed and performing pools and portfolios since 2008. There are banks, lenders, brokers and vendors, which for various reasons, need to sell some transactions. By moving quickly to evaluate, negotiate, document and close such purchases, we have taken advantage of good opportunities to grow our business.

8. Summary
There are definitely new realities at work in small business equipment finance today. There are new requirements for getting deals done. Over time these will evolve. We can’t predict how and when the economy eventually grows out of its current malaise. But seasoned leasing professionals know that there is business to be done now. Opportunity comes to the prepared.