Credit Competition

Banks, on the other hand, are limited by their charter, lending terms, and need to maintain a reserve. “They can’t go and lend some little software company a ton of money with no collateral—they’ll get beat up by their regulators,” says Patrick Donohue, vice president of Northland Securities, Inc., a securities firm in Minneapolis.

That freedom allows non-bank lenders to write loans that banks don’t want—to highly leveraged companies, for instance. But it can also help them as they issue money to companies that banks do want as customers, either because their loans are on the riskier side of what banks will accept, or because their looser underwriting guidelines allow them to provide quicker closings, write bigger loans, accept more leveraged companies as borrowers, and request less documentation and oversight.

The market has changed in other ways. Larger companies once went to banks when they needed loans. “Now they go directly to the market by offering corporate bonds,” Mueller says. “The size of company that’s able to do that has been dropping.” When banks lose those large, stable customers, Mueller says, they’re forced to go after smaller, riskier loans—a move that puts them in direct competition with nontraditional lenders.

Nontraditional lenders also picked up smaller commercial customers during the real estate boom, when some banks leaned toward writing more mortgages and away from additional business financing. “A lot of community banks have been able to grow significantly by doing real estate lending,” says Karen Turnquist, president of Prinsource Capital Companies, LLC, a commercial finance and asset-based lender in Minneapolis. With mortgage rates higher, though, “there’s much less,” she says. “Banks are going to have to focus on offering revolving lines of credit and equipment loans”—and they’re finding that nontraditional lenders have developed a foothold in those markets.

The relatively new practice of securitizing loans has also opened banks to competition. Instead of holding them for the long term, banks typically sell loans, often in mortgage pools that are offered to bond market investors. “Institutions that used to hold loans on their balance sheets are more interested in having them as fee generators,” says Sean Goodrich, director of alternative investment strategy research at Minneapolis-based investment consulting firm Jeffrey Slocum & Associates, Inc.

By securitizing loans, banks can write standardized debt that fits neatly into investor-ready pools, and move away from personal, relationship-based lending. “Many banks have a more cookie-cutter approach to making loans,” Goodrich says. “The art of packaging means homogeneous loans are a bit better than loans with unique provisions. The relationship aspect has eroded, and that’s allowed other players into the game.”

If a borrower can’t have a personal relationship with a bank, she’s apt to simply go with the best financial offer—and that best offer is increasingly coming from nontraditional lenders. Those lenders have traditionally charged high rates for loans that banks don’t want, but now often offer ultra-competitive rates for deals that would interest a bank. Brad Krohn, chairman and CEO of The Business Bank in Minnetonka, says he’s seen stiff pricing competition from brokerage houses, for example. “Their pricing is lower than I would think reasonable,” he says.

Though the nontraditional lenders have low prices and large loan amounts in common, each type of lender has evolved in a different way.

Hedge Funds: Putting Money to Work

Hedge funds seek to protect traditional equity positions by using complicated financial techniques: short selling, swaps, leverage, arbitrage, and derivatives. They also take debt positions, traditionally by buying distressed debt and then selling the company’s stock short, Donohue says. In the past, hedge funds have typically attracted high-net-worth individual investors.

Now, though, hedge funds are showing strong returns, and conservative institutional  investors—which once avoided them as too risky—have become more comfortable with hedge fund investments. The result, Donohue says, is that “the hedge fund structure has attracted a lot of capital.”

And they’ve begun competing with banks for commercial loans. “Hedge funds have so much money to invest, and they’ve had to push down into investment strategies like this in order to get their capital employed,” says John Falb, senior vice president and regional manager for LaSalle Bank, NA, in Minneapolis.

“Hedge funds are very active participants in direct lending,” Goodrich agrees, adding that he sees more and more small and medium-sized businesses getting hedge fund financing. “Most, if not all, lending markets could be under siege from hedge fund capital.”

With fewer regulations than banks, hedge funds can also offer creative loan structures. A hedge fund loan might involve a low interest rate that increases with the term of the loan. Hedge funds can also structure a loan to include equity participation, usually in the form of options and warrants. A hedge fund might also ask for less information from a borrower, require less oversight during the loan’s term, and offer a quicker closing than a bank.