In a corporate finance universe in which all other factors were equal, a business in search of, say, £40,000 would naturally gravitate to the cheapest provider of capital. After all, money is money, so why pay higher interest rates or hand over more equity than is strictly necessary?
But in the real world, a business may opt for a more expensive source of capital, because there are very good reasons to do so.
For instance, equity finance is usually calculated to be more expensive than debt finance, but depending on the circumstances and ambitions of the business in question, there may well be good reasons to sell shares rather than borrow. Those reasons might include a natural wish to avoid repayments in the short term, even if the cost of capital is ultimately more expensive, or – more positively – a hope that key investors will also act as mentors, directors or providers of contacts within their industries.
To take another example, mezzanine finance is more expensive that conventional debt, but it can often fill a funding gap when a business is embarking on a high risk strategy, such as an acquisition or management buy-out. Not only do mezzanine investors have a higher appetite for risk (reflected in higher interest rates and an equity component), they will also, typically, structure a loan to reduce the repayment burden towards the beginning of the term. This gives the business, time to bed in a growth strategy or maximise the benefits of a buyout.
Beyond the Default Position
In other words, while the default position of many businesses will be to seek out the least costly finance available, there are times when factors, such as the structure of a loan package, the appetite for risk displayed by investors, or the ability of equity investors to add value will direct a company towards a more expensive option. There is also the question of availability of finance. For instance, many high street lenders – particularly in the long tail of the financial crisis – are reluctant to provide growth capital. In such circumstances, an ambitious company may well have to seek out alternatives.
The AltFi Solution
In the post-financial crisis world, the Alternative Finance marketplace has filled at least some of the gaps left vacant by conventional financiers. Crowdfunding and Peer-to-Peer lending, in particular, are enabling companies to seek out loans and equity investments that might not otherwise have been available.
But the same rules apply. As is the case in the traditional corporate finance world, the lower-cost option is not always the most appropriate. Much will depend on the circumstances of the business in terms of its resources, assets, trading record and ambition.
Often the ostensible higher cost of a source of funding can be outweighed by the fact that it perfectly matches the circumstances of a particularly company. Invoice finance – still considered an alternative finance product and now available through Invoice Trading platforms – is a case in point. Although more expensive than term loans or overdrafts, an invoice finance facility enables a business to borrow against its debtor book. Thus when orders rise (with payment not due for perhaps three months after delivery), the business can borrow increasing amounts to cover short term cash-flow shortfalls.
The Transparency Effect
In theory at least, however, the emergence of platform based lending should flatten out the cost of borrowing. Peer-to-Peer lending sites are typically very transparent in terms of interest charged on loans, making it relatively easy for a business to make comparisons between one platform and another. This, in turn, makes it harder for one platform be noticeably more expensive than the next in terms of the cost of capital.
However, there are factors other than cost to be taken into consideration. For instance, in the Peer-to-Peer debt marketplace, lenders will usually offer a range of repayment periods – running, say, from one to five years. Typically, shorter repayment periods are matched with lower interest rates. Thus a one year loan will be cheaper than one repaid over five years. However, it might make sense to go for the more expensive option spread over a longer period.
Risk and Creditworthiness
Interest rates will also be determined by an assessment of risk and creditworthiness. This is where there is scope for a significant degree of variation between lending platforms. At a time when bank savings rates are low, peer to peer platforms offer ‘retail’ customers a place to invest their savings and secure higher returns than would be available from conventional savings accounts. It has proved to be a popular model, but the everyday investor probably isn’t seeking to be exposed to deals that are potentially high risk.
For instance, a borrowing company may be facing a special situation, such as sudden downturn in revenues due to the loss of a major client. Alternative customers have come on stream but cash is needed in the short term to shore up the business until the new clients pay their bills. Situations such as this can be difficult for everyday investors to assess.
So if a business is seeking to borrow money for higher risk projects, a more specialist lending platform may be the best option. The Route – Finance’s Private Debt Platform is a case in point. Funded by a community of High Net Worth individuals, The Route specialises in stressed situations where businesses need capital to address a particular problem.
Underpinned by an efficient due diligence process, The Route can offer a rapid decision once an application has been made. The platform’s community of sophisticated investors will fund projects that might fall outside the investment criteria of more generalist Peer-to-Peer platforms. Interest charges reflect the special situations, but The Route – Finance typically is offering a funding option that can be ideal for businesses requiring capital (£0.5M-£5M) to address specific challenges.
The Alternative Finance universe offers solutions for businesses across a range of circumstances and no two providers are the same. To help brokers and businesses identify appropriate providers, the Route – Finance has published The Alternative Finance Guide 2017. Download here.