It’s well documented that small businesses represent the largest segment of the U.S. economy by total number of businesses, total revenue and total employment. Community banks have been a vital part of small business success in the United States. However, most independent banks only enjoy a small percentage of the banking opportunities. There are at least three areas that most independent banks are missing in their small business strategy.
1. Specialty or cash flow collateral.
2. Commercial secured lending.
3. Commercial small ticket lending
Meanwhile, specialty finance (SpecFin) companies are leaders in each of these areas; as a result, the SpecFin sector has become a $300 billion industry. Even though we work with SpecFin companies every day, we know some bank leadership teams have concerns. But before bank boards discard this strategy, they should consider that the largest banks in the country all participate in commercial SpecFin. In addition to systemically important financial institutions, institutional investors funded over $100 billion in commercial SpecFin and esoteric securitizations in 2022 almost matching the issuances of traditional asset-backed securities, like auto, student loans and credit cards.
There are three types of specialty lending we recommend for community banks:
Specialty or Cash Flow Collateral
One of the most well-known areas of specialty finance is equipment finance. Equipment is a unique collateral class that requires expertise to build a successful portfolio because it is a depreciating asset with a limited useful life. Alternatively, the underlying asset for a loan can be cash flows as is the case in litigation and settlements finance. Like traditional bank products, these strategies are underwritten based on the value of collateral that is vital to the borrower’s financial success.
Commercial Secured Lending
Commercial specialty lending, such as asset-based lending (“ABL”) and factoring, offer a secured alternative to real property. ABL is a traditional bank product that most management teams and boards can get comfortable with but few independent banks offer. These loans are often secured by the company’s accounts receivables and inventory. Factoring on the other hand, takes it a step further by paying a discounted price for a company’s accounts receivable and collecting them directly from large, financially strong vendors.
Commercial Small Ticket Lending
A large percentage of small business loans are too small, risky or short-term for your typical independent bank. Merchant cash advance companies are technology-enabled lenders with sophisticated underwriting methodologies that can assess risk and fund small businesses quickly to support their capital and growth needs. These loans tend to be less than $100,000 with terms of less than 12 months.
Board directors and management teams should decide which of these commercial SpecFin products best fit their strategy and then determine the best way to engage among these three levels of involvement:
1. Acquisition: High Exposure, Maximum Benefit
Many banks have acquired SpecFin companies to obtain their lending expertise and maximize the revenue opportunity. Banks not only acquire the revenue generating potential of the company but also use their lower-cost funding to provide capital and increase profitability. Other synergies include deposit gathering and increasing wallet share with existing customers.
2. Lending: Minimal Exposure, Mid-Tier Benefit
SpecFin companies are nonbanks without deposits, so they require a steady flow of financing from institutional investors and banks. Interest rates for SpecFin companies tend to be attractive and higher than typical commercial and industrial loans or commercial real estate loans. Financing options include senior loans, warehouse facilities and rated subordinated debt notes.
3. Loan Purchases: Mid-Tier Exposure, Mid-Tier Benefit
Purchasing loans from other lenders is a common practice that many banks use to improve or supplement their loan portfolio. Similarly, banks can purchase SpecFin loans at a discount and hold to maturity in the equipment, ABL and other specialty finance verticals. SpecFin loans have attractive interest rates that can increase revenue and profitability but the acquiring bank retains the credit risk for the life of the loan.
Commercial SpecFin lenders can provide bank leadership teams a significant opportunity to enhance their small business strategy and profitability. Banks can gain exposure to specialty collateral lending, commercial secured lending or commercial small ticket lending through M&A, financing or loan purchases. These strategies will not only help a bank’s financial performance but will also serve a major employer and economic engine for the U.S. economy: small businesses.