In his letter to shareholders in April, Jamie Dimon, CEO of JPMorgan Chase, argued that shadow-bank market-makers – including short-term lenders, private equity houses and hedge funds – were “fair-weather friends” to businesses.
“They do not step in to help clients in tough times,” he wrote, whereas banks “flex their capital and provide their clients with a lot of loans and liquidity when they really need it”.
Dimon cited the liquidity provided by banks when the Covid crisis started in March 2020 as an example of this.
If these claims were accurate, businesses would surely be steering well clear of these “fair-weather friends”, but non-bank financial intermediation is already big business, having flourished since the 2007-08 global crash. In 2020, it accounted for 48.3% of financial assets worldwide, according to the Financial Stability Board.
Are banks any better as business lenders?
Moreover, as the crash and incidents such as the failure of Silicon Valley Bank have shown, banks are not always copper-bottomed. They can also be tentative when certain borrowers approach them for credit.
A recent report by Standard & Poor’s notes that regulatory reforms enacted in light of the crash – increasing the capital charges for lending to higher-risk enterprises – have resulted in less bank lending to small and mid-market firms. The upshot is that “markets are entering a moment of fundamental transition… Private markets have moved off the sidelines and into the spotlight for multiple industries and sectors.”
The report adds that non-bank lenders tend to operate with “a long-term investment horizon”, offering customised funding options that can be particularly useful to fast-growing new businesses.
As non-bank lenders become more important players, they are funding larger deals. In May, for instance, British software firm The Access Group raised an £850m add-on to an acquisition facility that was already the largest private credit deal in Europe last year, at £3.5bn. That was despite a lending climate in which access to liquidity in the conventional banking market was limited.
What’s the right funding mix?
How, then, should CFOs determine the right funding mix for their businesses? And, as more – and more patient – funders will be needed across many sectors and the regulatory pressure to move towards net zero increases, what makes for a good long-term borrowing relationship anyway?
Well, it turns out that “funding mix” may not be the right way of thinking about it, at least when it comes to bringing together loans from banks and non-bank lenders. For instance, the market has become more bifurcated than Dimon’s letter suggested, featuring less direct competition between the two types of lender.
Victor Basta, CEO of DAI Magister, an investment bank specialising in the climate and fintech sectors, explains that non-bank lenders “take on riskier borrowers and can be more dynamic than banks. But they will charge more and can impose covenants that place certain requirements or restrictions on a business.”
Some business leaders will find these stipulations too much of a constraint on their strategic decision-making power.
How are economic pressures changing funding arrangements?
The difficult economic environment is clearly making life harder for companies seeking debt finance. For firms that rely on more costly non-bank loans, this is playing out in how these loans are managed, although that doesn’t necessarily mean that borrowers are being pushed into default.
For example, Standard & Poor’s reports a rise in payment-in-kind (PIK) loans, which let borrowers make interest payments with equity or further borrowing, rather than cash. They can be a sign of stress, although deals are usually structured to ensure that a PIK option cannot be used to avoid default in a real liquidity crunch. The aim is to use them to cover growth periods when cash flow is tight.
The prospect of growth is vital, of course, because PIK loans are expensive. If a company opts to borrow to cover the interest payment, it effectively ends up paying interest on interest. Nonetheless, Standard & Poor’s notes that, for some funds in the US, up to 20% of their investments were making PIK payments in Q3 2022.
But what’s best for a company that needs to invest in growth, despite unfavourable trading conditions? If non-bank lenders are willing to take payments in kind to help a firm through a growth phase, does that make them better long-term partners? Not necessarily, especially in cases where there are several creditors.
Basta explains: “If you get into trouble as a company, things are easier to resolve if you have a couple of senior banks that hold all the strings. If you’re dealing with a number of non-bank lenders with different views, it can be challenging.”
Why net zero is opening up new sources of cash
But when it comes to raising debt finance to fund the shift towards net zero, CFOs may soon find themselves getting an easier ride.
“A lot of government money is about to become available worldwide, at very low cost, for companies involved in remediating climate change,” Basta says. “Depending on what they want to do, they might not have to borrow from the market at all.”
He believes that the blended cost of money to such firms in the next five to 10 years could be more than a third lower overall, predicting that “the cost of debt won’t make or break them”.
Given that the whole economy must work towards net zero, the increased availability of cheap public money is likely to shake up funding across the markets. In due course, the closest friends of firms that need loans for essential investment may turn out to be governments, not financial services firms at all.