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!