Scott Picken of global real estate investment platform Wealth Migrate discusses how banks and alternative lenders can work together to offer financing to small and midsized businesses.
Many economists consider the financial crisis of 2007–2008 the worst debacle since the great depression. A lot of the recent crisis banks offering traditional loans to small and midsized businesses, and even those offering mortgage loans, became very skittish as risk-tolerance for lending was on the decline.
However, even with the resultant harsh financial impact on small businesses, some experts still believed the lending market would recover once the economy regained its footing. Regrettably, this has not been the case. bank lending for small businesses is still showing a 20 percent decline1 since the latest recession.
According to business insider2 , only half of small businesses with $100,000 to $1 million in annual revenue received some of their financing from large banks in late 2015.
Given the current lending obstacles, coupled with the fact that more than 543,000 businesses launch each month (many of which need capital), it is clear to see how these dynamics have created a huge funding gap for startups looking to access the money needed to roll out innovative products and services.
While banks have been getting a bad rap across a variety of industries and startups for tightening their purse strings, many of these institutions have some very legitimate concerns impacting their ability to free up capital.
To prevent future economic meltdowns like the financial crisis of 2008, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Dodd-Frank greatly increased capital reserve requirements, while limiting how banks could invest. this caused banks to become even more cautious, tighten their standards and become less risk-tolerant.
DEMAND FOR STRONGER RETURN ON INVESTMENT
As nearly half of all small companies fail3 in their first four years, investing in small and midsized businesses by granting them loans can be a high-risk and low-reward proposition that scares banks away. Small and midsized businesses often have smaller, less pro table loans with higher default rates, and banks typically prefer funding large business loans that have a better chance of yielding stronger profit margins.
GOOD CREDIT IS KEY
To mitigate risks, banks require not only a strong personal credit score but also a strong business credit score. But many startups have not yet established a business credit history, and this makes it harder for banks to invite these types of businesses into the traditional loan environment.
Small businesses are not the only group to feel the grip of tightening lending requirements. Borrowers looking to fund commercial and new construction projects in the real estate arena are also finding it harder to obtain low interest rates with moderate leverage. In the heyday of lending, before the financial crash, banks such as Corus bank (which went out of business due to such loans) commonly lent at ratios of 70 to 75 percent loan-to-value for condo developments, with little to no pre-sales.
Today, the market shows the pendulum swinging the other way. The High Volatility Commercial Real Estate, or HVRCE, regulations,4within the Basel III capital requirements, mandate that borrowers of acquisition, development and construction loans meet a 15 percent equity requirement. the leverage on such loans also cannot exceed 80 percent of the project’s estimated completed value.
If a loan does not meet these requirements, it is subject to a 150 percent risk weight requirement — an increase from the previous 100 percent requirement — which greatly increases the price of the loan.
With HVRCE and Dodd-Frank requirements, banks have tightened lending within the real estate arena. Few bank lenders are offering nonrecourse construction lending. the banks that have reentered this market, such as bank of the Ozarks, have reduced leverage to 45 to 50 percent loan-to-cost.
THE RISE OF THE ALTERNATIVE LENDER
Many real estate syndicators have begun to turn to alternative lenders and crowd-funding/ financial technology platforms for their capital needs. In fact, crowdfunding has allowed these syndicators, as well as many other types of businesses, to access capital more quickly, while also allowing them to leverage the ever-popular equity crowdfunding model.
Equity crowdfunding gained notoriety in May 2016, when Title III of the Jobs Act was approved, allowing millions of everyday Americans to invest in businesses that could lead to potential wealth generation. With this equity incentive in the marketplace, millions of dollars have now become more accessible to businesses for driving innovation, job creation and boosting the economy. “I found equity crowdfunding to be very beneficial for my capital needs, especially for my latest real estate venture,” said Roger James Hamilton5, the founder of Vision Villa Resort, who launched his project on the global real estate marketplace Wealth Migrate.
“Just this year when I needed to raise $3 million for Entrepreneur Resorts,6 an initiative that empowers business owners to achieve their dreams of living and working in exotic, paradise-style locations, while connecting to like-minded mentors and investors from around the world, I did not look to traditional sources, but I looked to crowdfunding,” he said. “I knew that I could tap into my very large social network, as well as the customers that I already serve, to help co-fund my expansion project while allowing them to enjoy owning a little piece of paradise by issuing shares for their investment dollars.”
Hamilton’s campaign was very successful. Just weeks after he launched the pre-initial public offering phase of his campaign, he raised $2.8 million. He eventually reached his full $3 million goal.
This project on the Wealth Migrate platform is a clear example of the power of technology. The platform now has investors from 40 different countries, and this enables entrepreneurs like Hamilton to access investors globally.
While real estate is an area where alternative lenders have been making a huge splash, they have been very active in nearly all lending areas. In addition to actively marketing to potential customers, they have fewer restrictions and regulations to impede deal flow, leading them to fund many loans that are not within traditional banks’ underwriting criteria.
In 2015 alternative lenders originated 68 percent more loans than the year before, according to the Mortgage Bankers Association. American Banker reported a 700 percent growth in the marketplace lending industry in just four years. And a 2013 survey7 by the Federal Reserve Bank of New York found that one in five credit-seeking small businesses applied to an online lender, with many of the survey respondents citing the ease of the application process and the speed of funding as the top reasons for their leap into the online sphere.
WHAT’S NEXT FOR BANKS?
Once dubbed by many bankers as a nonthreat that would provide credit only to the most high-risk borrowers, marketplace lending and other financial services tools like crowdfunding are going mainstream. Attend any banking conference, and it is clear from the agenda that banks and traditional financial services companies are taking notice of fintech. Many of the biggest banks
and several midsized ones have launched incubators and venture capital funds to invest in early stage fintech companies that could someday be competitors.
There has even been an increase in strategic partnerships between banks and crowdfunding platforms. These partnerships are allowing platforms to provide more robust service offerings by using traditional lending solutions coupled with crowdfunding to help fund businesses through each stage of growth.
For example, Fresno First Bank’s partnership with crowdfunding platform Breakaway Funding8 enables the bank to offer what the two companies call “hybrid crowdfunding.” It combines equity crowdfunding with traditional bank lending on their Community Capital Marketplace platform. The platform matches investors with businesses requiring capital and helps position those companies for funding by traditional community banks.
‘FOCUS GROUPS’ BENEFITS
The ability of crowd investors to vote with their dollars and share their feedback on products and services provides great market data and insight for banks and venture capital firms. Companies that gain positive marketplace engagements from this focus group type of environment can meet with banks to be considered for additional capital.
Businesses that use reputable crowdfunding platforms must go through due diligence procedures and undergo thorough background checks. This is beneficial for a banking partner who can now tap into a new client that has already been vetted and met certain financial criteria.
Since many high-performance companies will need to leverage a variety of sources for raising capital, banks are able to play a role in the financing ecosystem. A company may use a combination of capital-raising sources to meet its full funding goal. For example, it may utilize a mix of crowdfunding, venture capital funding and bank loans. This allows banks to share some of the risks with other funding sources, and it makes loans and deals more attractive.
The bottom line for all lending organizations is to find ways to work together in this new digital era of finance, especially now that Securities and Exchange Commission regulations have opened the doors of funding and investing on a much larger scale through the Jobs Act. It would not be beneficial for banks and alternative lenders to view one another as threats.
A healthy competitive climate is created when venture capitalists, banks and crowdfunding platforms work together to educate the marketplace on the pros and cons of all types of financing and to allow decision makers to choose the funding method that best suits their business needs. This healthy competition will ultimately benefit consumers and support small businesses in driving innovation and economic growth for years to come.
1 Warren Lee, 7 Reasons Banks Not Lending to Small Businesses, Lending Mag (Nov. 13, 2015) http://bit.ly/2xtplY0.
2 One area of US alt lending is recovering, Bus. Insider (Feb. 23, 2017), http://read.bi/2fWWPHS.
3 U.S. Bureau of Labor Statistics, Business Employment Dynamics, http://bit.ly/2oTGGKg.
4 Am. Bankers Ass’n, High Volatility Commercial Real Estate, http://bit.ly/2yAACL0.
7 Fed. Reserve Bank of N.Y., Fall 2013 Small Business Credit Survey, http://nyfed.org/2fMuGoh.
8 Bill Streeter, Crowdfunding cooperation helps bank build “bankability,” Banking Exch., Sept. 27, 2016, http://bit.ly/2xtVluO.
This article initially appeared in THOMSON REUTERSTM, volume 23, issue 11, October 16, 2017