Verit View: Non-Bank Lenders Say ‘Welcome!’ to Private and Family Businesses
By John Solimine, Founding Member and Managing Director
Verit Advisors’ view is that with the expansion of non-bank capital available to middle market businesses since the Great Recession, private and family businesses should consider non-bank capital as a viable alternative to traditional bank borrowing.
When talking with private, multi-generational family business owners and their executive teams, even their chief financial officers, I am struck by how often debt equates only to commercial bank borrowing, typically a revolving line of credit.
While once true, since the Great Recession a vast pool of non-bank capital has become available to private, middle market businesses. Today, businesses as small as $50-100 million in revenue and $7-10 million in EBITDA, sometime smaller in select circumstances, can view capital from non-bank lenders as a complement to traditional bank borrowing and an alternative form of capital.
The non-bank, sometimes called private, debt market is decades-old, but it accelerated when banks restricted their lending to small and medium-sized businesses. Estimated at just $300 billion at the start of 2010, the non-bank lending market grew to nearly $700 billion in loans outstanding at the end of Q1 2018, reports Bank of America.
Non-bank lenders are a varied group, comprising business development companies, or BDCs, finance companies, insurance companies, private equity firms with middle-market lending arms, and other institutional capital providers. To these lenders, loans to private, middle market businesses represent an attractive new asset class. At the same time, the entry of fresh capital providers has broadened the overall market and enabled it to serve smaller borrowers.
The benefits of working with a non-bank lender emerge when considering how best to achieve a business owner’s objectives. At Verit, we often work with owners of family businesses who are evaluating strategic alternatives including succession options. These can include an outright sale or a partial or full ESOP. The ESOP alternative enables them to keep a meaningful interest in their company while gaining some liquidity and diversifying their holdings. Other business owners favor an ESOP transaction to keep their business private and independent vs. selling to a financial or strategic buyer.
In both situations, using a non-bank loan to fund the ESOP can often accommodate a higher debt threshold and a higher leverage multiple compared with traditional commercial bank debt alternatives. These benefits, combined with more flexible repayment or amortization structures, make non-bank debt financing an alternative worth considering.
Because bank and non-bank lenders’ appetites for private companies constantly shift, we routinely evaluate both capital pools when seeking financing for our clients. Often competition from one lender makes another one more competitive. As an example, for a Southeastern textile company that wanted to go from partial to full ESOP, we approached bank and non-bank lenders and secured over a dozen term sheets to determine the best long-term capital partner. This created a competitive process and a robust set of capital alternatives to evaluate. The ultimate solution was a very attractive senior credit facility provided by a large commercial bank lender with borrower-friendly pricing and terms.
Hypertherm, a maker of high-end arc plasma cutting tools, offers another example. It used a combination of traditional commercial bank debt and long-term non-bank capital to finance its transition to a full ESOP.
While most non-bank debt capital has traditionally funded private equity-backed leveraged buyouts, many new entrants have an enhanced appetite for non-sponsored, family-owned or ESOP-owned transactions. These lenders have gained an appreciation for the ever-larger companies pursuing an ESOP alternative and are intrigued by the tax savings that ESOPs provide as well as the benefits from their borrower’s greater free cash flow.
At the same time, non-bank lenders are beginning to appreciate that the middle market isn’t just private and family businesses looking for ownership succession vehicles. Consequently, we see a broader cohort of debt and equity capital providers looking to invest not just in new but also existing, mature ESOP companies. This can come in the form of private placements, uni-tranche facilities or structured equity that is substantially longer and more flexible than a typical five-year bank facility.
To tap the non-bank lending market, businesses must have the documents to support the lender’s due diligence and underwriting process. Essential documents include robust financial projections and typically audited financial statements and, potentially, a Quality of Earnings report that will help secure optimal financing. Generally, no additional reporting is required as compared to bank borrowing. Companies should expect to provide monthly financial statements, evidence of quarterly covenant compliance and annual financial statements and projections. In addition, most lenders will want to meet at least annually with the management team to review operations, strategy and performance.
While a private company can tap a non-bank lender directly, it generally makes sense to use a financial advisor. The financial advisor will help model and compare the results of various financing alternatives and run a structured process that is organized and competitive, tapping potential bank and non-bank lenders on the borrower’s behalf. The advisor then will solicit feedback and formal term sheets that can be benchmarked and compared, quantitatively and qualitatively, to obtain the best financing alternative.
Armed with requisite documents, a business owner should expect a capital raise to take 90-120 days. This will include reviewing and analyzing due diligence materials, preparing capital structure alternatives, and developing a “teaser” – a confidential overview of the company and prospective financing that is shared with prospective lenders and investors. At this point, the advisor will commence the marketing period and due diligence with prospective lenders. Term sheets will be obtained and evaluated, and the selected lender will close and fund the transaction.
Following a strong 2019 with robust new ESOP and non-ESOP transaction activity, we anticipate a promising 2020 for borrowers as leverage levels, pricing and terms from both bank and non-bank lenders remain attractive. Additionally, current interest rates provide an attractive cost of capital, and flexible repayment terms are an added benefit.
For all of these reasons, expansion of the non-bank lending market has been a boon to private and family businesses. To business owners who say, “We didn’t appreciate the breadth or menu of capital alternatives available to the middle market,” we respond, “A loan from a non-bank lender should be in your consideration set if you are tapping the debt capital markets this year.”
 “Non-bank Lenders Thrive in the Shadows,” Robin Wigglesworth, Financial Times, Feb. 3, 2019