'Tis the Best of Times (but not for all): Access to Capital Remains Uneven for SMBs

Capital access for franchisees has been a primary concern since the 2008 financial crisis. Although healthcare and other issues that Washington has managed to wrap in uncertainty have out-shouted capital access, it still is a big issue for many small businesses.

The media seem to be sending mixed signals. Some articles point to a continued lack of capital availability for small businesses; others to the lending returning. I am fairly certain both points of view are right, depending on the vantage point. To understand why, and the implications for operators, let's look at how far along we are toward financial recovery since 2008.

History confirms that, following a major economic downturn precipitated by a financial crisis, there usually are three phases in the lending cycle. The first is lending contraction, which we experienced from 2008-2010. Since banks can't accurately predict the value of their lending portfolios immediately after a crisis, they (and the regulators) can't determine the amount of capital they should have to support portfolios. Not losing money trumps trying to make money, which banks do by lending. Therefore, lending shuts down, and with it access to capital.

Phase two is a transition for lenders from (1) not losing money to (2) starting to make money by lending. This phase begins with a big imbalance in deposit-to-loan ratios. This is where we are today. Banks have several trillion dollars more in deposits than loan assets, pressuring them to start making money again. As we move through phase two, lenders begin to respond to that pressure by initiating very conservative lending to proven operators.

For most multi-unit operators, this is good news--and a great time to seek expansion, remodeling, and refinancing capital. The reason media reports seem confused about capital access in this phase is that they hear from experienced operators that banks are beating each other up to offer better terms. Some in the media conclude that the lending good times are back; and they are right, if only for experienced operators who represent relatively low risk as viewed by bank credit committees. As we move through phase two, think of small-business credit access as a "Tale of Two Cities."

Progression through phase two is also marked by much more active SBA lending. From a credit committee perspective, taking on greater credit risk during a weak economic recovery is not appealing, even with a higher potential interest rate return. However, being able to protect 75 percent of higher-risk loan assets is a bit more attractive, which is why we see a lot of SBA activity in this phase, and which will continue well into the next phase.

Phase two ends when lenders start out on the lending risk curve with conventional (as well as SBA) loans to borrowers possessing less financial strength and demonstrated operational track records (this means new franchisees and one-, two-, and three-unit franchisees). The move to conventional lending is seen when credit committees offer to approve riskier borrowers... if they are compensated for doing so. Thus, when we start seeing a range of interest rates and term sheets that depend on perceived borrower risk, we know we are entering the third phase, when loan demand and loan supply are in balance.

As noted, the media seem to be confused about the current state of capital access for small businesses. For example, they quote the lowest-risk operators who are getting lots of interest from banks, while missing the majority of small businesses that don't. Further mixed messages come from larger banks that say small businesses aren't interested in borrowing. On the surface, that seems to make some sense. After all, larger corporations have deleveraged over the past six years and have lots of cash. Why shouldn't small businesses do the same? Some have. But we know that while small businesses are more nimble and opportunistic than their larger corporate battleship brethren, they have much less ammunition in the form of capital--and many still can't get it.

As we climb slowly, inconsistently, and uncertainly into the new economic many franchised small businesses are ready to pounce as opportunities arise. Whether expanding or acquiring, opportunities are there, and the indefatigable American business optimism is pushing small businesses up the economic mountain. Those with solid performance are already in good shape for capital access. We need a couple more years before that's true for small businesses that are new, emerging, or cash-flow challenged.

I recently spoke to an organization of credit risk officers from large banks. They validated the above views, but also added an additional aspect to my thinking: small businesses should not look for large banks to lead the movement out of phase two. These banks, overseen by the Federal Reserve and the Office of the Comptroller of the Currency, operate under such intense regulatory reporting pressures that a serious, unintended consequence is that they have been backed into not taking on much lending risk.

For new and emerging franchisees, your path to capital access will first go through smaller banks, non-bank lenders, and the SBA lending units at banks of any size. For good multi-unit operators, however, it is the best of lending times. And for those whose success still lies ahead, the good news is we're off the capital access bottom; but for the next couple of years, be prepared to hear "no" a lot before you encounter a "yes."

Darrell Johnson is CEO of FRANdata, an independent research company supplying information and analysis for the franchising sector since 1989. He can be reached at 703-740-4700 or djohnson@frandata.com.

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