Factors to Consider When Investing in Small Business Loans

Small Business loan application

This is a guest post from Rob Snow, the Co-Founder and Managing Member at Carillon Capital, an investment banking and advisory firm specializing in financial services primarily specialty finance, asset management, and technology, including major initiatives in crowdfunding. Over the past 19 years, Rob has purchased and sold over $10 billion in whole loans and led the issuance of more than $4 billion in asset-backed securities. In this post he compares consumer loans with small business loans and what investors need to consider when lending to small businesses.

As the world of individual investors buying consumer loans has grown and started to mature the acquisition of small business loans is still in its relative infancy. As a banker who has spent most of my career originating and managing both consumer and small business loans, I think it is important to point out some of the unique risk differences in these two asset classes.

In the small business lending market the type of credit can have impact on the expected loss rate. I will not discuss all of the types of loans available in the market: working capital, equipment finance, merchant cash advance receivable lines; I will, however, focus on the two most common loan types in the market: working capital loans and equipment finance.

Working Capital Loans

Working capital loans are those that are most closely associated with the current consumer unsecured loan market. These loans are based on a business’s identified need for capital but may not have a specific collateral to file a lien against. For example, a small business owner may want some money to spruce up their existing location or need the money for marketing programs. In the business lending world, the purpose matters.

Healthy businesses are those that are looking for capital to grow. Those that need the funds to covers existing expenses represent much higher risk. One notable exception to this can be seasonable business with a long track record of performance.

Equipment Finance Loans

Equipment finance loans can take many forms, but they are primarily being used to acquire business specific equipment, and in conjunction with the loan, the lender will perfect a security interest in the equipment. As with understanding the purpose in working capital loans, it is extremely important to understand if the equipment being acquired is essential to the business. To understand whether equipment is essential is as simple as thinking about what would happen to business if you pulled the equipment out. For example, if an auto body shop is buying a vehicle lift that is likely essential to the business; however, if they are investing in a computer network, that is probably not essential.

The other important factor to note when evaluating equipment finance loans is to understand from the onset that many types of equipment are difficult to value. As with any collateral, if a business significantly overpays for the equipment, this can actually lead to a much higher default rate. As an example, specialty medical equipment such as lasers can be sold at very different prices depending on the use or who it is being sold to. The same laser might be sold to one practice for $30,000 and to another at $75,000. This will obviously cause significant differences in the collateral value supporting the loan.

Credit Metrics for Small Business Loans

Whether we are talking about working capital or equipment finance paper, there are a few common credit drivers. Unlike, in the consumer loan world where FICO and the detailed credit bureau attributes can be predictive of the frequency of default, in the small business world FICO plays a much smaller roll. It is very common for small business lenders to obtain personal guarantees from the owners of the business and to report their personal FICO scores in conjunction with the loan. Unfortunately, the owners’ FICO scores do not correlate highly with the success or failure of the business. The likelihood of default is highly correlated to the success of the business enterprise and its management.

There are a few different business related credit metrics that provide reasonable predictability. For example, the PayNet MasterScore is a predictive model that was built using the actual performance of small businesses and has been validated accordingly. Another model that is commonly used by lenders is the FICO SBSS Score. This score again is a predictive model that pulls data from both business performance databases as well as certain personal credit attributes.

Both of these models allow users to project default frequency for small business loans based on a validated data set. The biggest benefit of these business focused models is that they separate and identify risks based on various risk cohorts such as industry and business type. These factors are not incorporated in the personal FICO scores of the business owners. As with consumer credit reports, the depth of the credit file is equally important in evaluating the business reports. Thin file credit reports reduce the viability of the models predicted loss.

The Two Key Risk Drivers

As we move beyond the scoring models, it is most important to look at factors associated with a specific business to evaluate the endemic risk. Two key risk drivers: the borrower’s time in business and the cash flow of the business over a number of months. Businesses that have been in operation for 5 or more years represent a much lower risk of default than those that have been open for one or two years. Cash flow can be evaluated by looking at bank statements and the average balance over 3 months. If the average balance is very low relative to the loan amount then watch out. It may be stating the obvious, but cash flow that is not verified by the lender has little value.

There are many factors that go into the evaluation of loan investment and it is always good to understand the big picture of the request and the purpose. The biggest similarity in the investment of business loans as compared to consumer loans is to keep investments in individual credits small and diversify the risk. Even the best credit evaluation does not predict life events!

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May. 22, 2014 10:01 am
May. 28, 2014 12:24 am
Reply to  ana

I’m happy to see a post devoted to the subject or credit risk but was disappointed with this post. It’s certainly true that the guarantor’s experience/time in the business and the business’ recent cash flow are critical elements, but there’s so much more to analyzing a small business’ credit risk. Investors should employ several tests to determine what factors are most likely to prevent the business from repaying the loan in full. For example, a business may be profitable, but why did revenues and cash flow drop year to year? Why was the loan requested? How much existing debt does the business have? How much equity does the guarantor have in the business? Does the guarantor have any outside assets that could be relied upon as a secondary source of repayment? Etc.

The comment that the guarantor’s personal credit score isn’t “highly correlated” to the performance of the business loan is just misleading. Fico may not be perfectly correlated, but a guarantor with a recent foreclosure or a recent tax lien is extremely high risk. And a guarantor who has maintained a solid fico after years of ownership is obviously doing something right.

Paynet and SBSS may occasionally be helpful as complementary tools, but they shouldn’t be factored too heavily in an investment decision. They’re predictive models with a historical bias and tend to provide statistics on broad industries rather than providing any real insight on the subject business.

Also, are peer to peer loans accurately priced relative to risk? How can LC justify a starting rate of only 5.9% (for prime borrowers) fixed which would probably net 4%+ after losses? A return of 4%+ isn’t much more than long term treasuries but small business loans are considerably more risky and are still very illiquid at this point.

As small business lending increases in popularity, I really think it would be worthwhile to have a forum to address these issues. My sense is that most investors are overly optimistic and are underestimating the risks involved in investing in small business loans. You’ve done an excellent job educating folks about consumer p2p loans and I’ve enjoyed following your blog.

Rob Snow
May. 30, 2014 2:30 pm
Reply to  Oak_sf

Thank you for the thoughtful response.

I agree that many of the factors that you cite regarding the performance of business loans are valid predictors of risk. Specifically, the business cash flow and level of debt relative to cash flow have been shown to be highly predictive of default frequency. The challenge for many small business lenders who originate loans less than $100,000 is that most competitors do not require financial statements to verify the cash flows. Lenders are left to assess cash flow based on bank statements which can be misleading due to seasonality of many businesses.

Placing undue reliance on the credit scores of the personal guarantors can lead an investor to understate the likelihood of default. Many small business have more than one owner and often times these owners have vary degrees of involvement in the business. Relying on a high credit score from a silent investor will not help predict the performance. However, I do agree with the comment that a PG credit report that shows recent serious delinquency is a high risk indicator. Many lenders will use this information to decline or require additional equity. My point is to use the credit score in the context of the overall deal rather than the primary decisioning tool.

When evaluating risk of small business loans it is important to use all of the information that is available to understand the whole picture when investing rather than relying on a few data points.

Rob Snow
Jun. 3, 2014 1:26 pm
Reply to  Peter Renton


May. 23, 2014 2:59 pm

Another consideration of equipment loans is the liquidity. Some equipment is very costly to move or it gets out dated, resulting in very low or no recovery values even if it was low LTV at the time.

In terms of credit scores for businesses, I’ve seen D&B Credit Rating and PAYDEX® Interpretation Tables used more often than the other models mentioned.

May. 24, 2014 10:00 am

I would think that Uhaul’s p2p option might have made a mention here? haven’t heard much about them in while, but it’s small business lending that has been available for a while now with asset backed options. I know the returns aren’t what we are seeing in other places . . . but the risks are also lower.

Otherwise, great article. It’s going to take a while to get a handle on everything involved with small business lending, but it’ll be fun to watch it grow.

May. 27, 2014 8:17 am
Reply to  Peter Renton

Peter, you seem to focus on interest rates a lot. Don’t forget credit risk just because it doesn’t manifest itself until periods of stress.

Nick Sandrews
Jul. 25, 2014 6:39 am

Great to come across such article. It is true that there is risk involved in the small business loans and investors underestimate risks involved in such type of loans. Great factor sited in the article and I completely agree with the author.Thanks for sharing this.

Manju Joshi
Mar. 16, 2018 12:36 am

A small business loan is an essential requirement for a business. Before investing or applying for the small business loan the borrower should completely understand the requirements of its business and also all the terms related to business loans. The borrower should learn about CIBIL score, Loan repayment period, Collateral, eligibility criteria, working capital.