Businesses likely to pay more for capital
By Matthew Bristow - 10/25/2010

Tulsa Business Journal Article: http://www.tulsabusiness.com/industry_article.asp?cID=3&aID=361750302.1499423.674453.647261.6469432.610&aID2=51872

How much will your business pay for capital in 2011?

The short answer is likely to be: more than you expect. If you own, operate or manage the finance function for a midsized business and need financing in 2011 for working capital, growth, acquisitions or equipment, we hope to provide some insight into the likely availability and cost of capital for your company in 2011.

For many businesses, borrowing has the potential to be even more of a challenge in 2011. According to a recent Duke University survey, 30 percent of chief financial officers said borrowing is more difficult today than a year ago, while 25 percent said it is easier. This is in contrast to some market commentary, which points out historically low lending rates available for businesses.

If you look at only headline rates, it appears the cost of capital for business has declined. And for maybe 25 percent of businesses, that is true. For many companies, however, despite the lower headline rates, the cost of capital in 2011 is going to be higher, as many will no longer be approved for lower rate traditional cash flow loans.

To understand why this is the case, picture a chart with risk of default on the X axis and required return on the Y axis.

Ideally, a business would seek the cheapest form of cash flow lending from a bank, which would be on the left of the curve with low risk of default and, hence, a low interest rate. If, however, your business is rejected from a traditional bank loan, which, according to a Pepperdine University survey, happened with 72.5 percent of applications in early 2010, you need to access a different form of capital.

In this case, you may have to consider a collateralized loan, asset-based loan, raising additional equity or other alternative forms of debt.

The problem is that the further right you go along the X axis, the higher the perceived risk of default and higher return expectation, hence a higher cost of capital for your business.

Nationally, bank lending levels for business in 2010 are down 30 percent from the beginning of 2009 (and that’s not even including the worst performing sector, real estate). In the simplest terms, there is less money flowing to businesses and a lower appetite for risk among lenders. Many lenders are also handcuffed by capital adequacy requirements.

Another factor holding down traditional bank lending is that cash flow (debt-service ratio) is the most important factor when lenders are making a loan decision, according to Pepperdine’s survey. The problem is many companies had erratic cash flow this year, which essentially ruins the likelihood that they can comply with the bank’s debt-service ratios. In fact, more loans are rejected due to poor quality of cash flow than any other reason.

Moving along the X axis from traditional bank lending, we come to asset-based loans. Now, the lender may be a commercial bank, business bank, pure asset-based lender or commercial finance company, i.e. a firm with which you do not have an existing relationship.

The advantage for your company shareholders is that an asset-based lender will typically have fewer and less restrictive covenants, which means you are more likely to be able to access capital. These loose restrictions, however, come at a price. While the headline spreads for an ABL may be similar to a cash flow loan, there are also closing fees, modification fees, commitment fees and unused line fees, which can add another 3 to 3.5 percent to the loan. Median all-in rates for ABLs for working capital are 8 percent, real estate is 10 percent and equipment is 15 percent.

If you add into your business capital structure the need to raise money from new equity investors, who typically expect returns of 25 percent or more, as well as subordinated debt, which can cost upward of 18 percent, it quickly becomes apparent that capital for your business is likely to be more expensive than you have been budgeting for next year.

As a result, considerable time and effort needs to go into corporate finance planning and budgeting for 2011, which is the theme of our column in the next issue of TBJ.

Source data: Tulsa Business Journal.
http://bschool.pepperdine.edu/research/pcmsurvey/reports.htm. To ensure consistency of data, we used the median data for a $5 million loan.