Why Cash Flow Loans Are Gaining Traction In the Middle Market?

Posted on: May 19th, 2017

While bank loans are still the most favored form of financing for the middle market, market trends are pointing towards cash flow loans gaining more traction.

A survey conducted by the Federal Reserve Bank of New York confirmed this trend when it revealed that SMEs are increasingly turning towards cash flow lenders instead of approaching a traditional or regional bank for their various financing requirements.

A closer inspection found that businesses are increasingly preferring cash flow loans due to the following reasons.

Cash flow loans are not tied to balance sheet statistics

Many companies have strong earnings and growth, but lack hard assets on the balance sheet. This makes the company non-bankable, in the traditional sense.

Most technology or service companies have little to no inventory, no equipment and no real estate in their balance sheets. These same companies can also have high gross margins (>30%) and recurring revenue.

Cash flow lenders overlook the balance sheet and look to the underlying strength and profitability of the business’ cash flow.

Cash flow loans tend to be larger than asset based loans

Most banks only provide an advance rate against the appraised value of an asset, when extending a loan. Cash flow lenders provide a loan equal to a multiple of a company’s pro forma cash flow.

The multiple can range from a low of 2 times to a high of 4 times, providing much more funding than you can get from a bank. Cash flow lenders go deeper with their loans and fund into the equity value.

This helps you fund the gap when you are either growing rapidly or purchasing another company.

Cash flow loan approval is more flexible

Cash flow lenders use a variety of tests to approve a loan and are less tied to formulaic loan approval approaches. They are understanding of companies that have gone through a tough year and are able to think outside of the box, and give credit for pro forma adjustments and cost take outs.

They are very focused on the quality of the management and the strength of the growth story. If you have a quality team and a strong growth trend, they are able to be more flexible and approve loans that most banks will not touch.

Although, cash flow loans do come with certain negatives- it being more expensive than bank loans and the chances of gaining approval being much lesser- such debt instruments are gaining momentum since its benefits ultimately overweigh its few disadvantages.

Cash flow loans, like mezzanine financing, have a distinct advantage for middle market companies seeking loans for acquisitions, growth, recapitalizations or refinancing.

As the Fed decides to ease interest rates, middle market acquisition financing structures will benefit in a number of ways. The underlying values of middle market companies will increase leading to a higher enterprise value and lower loan to value ratios for existing portfolio companies of acquisition financing lenders.

The role of acquisition financing is infrequently elevated above a functional transactional one. When a business needs financing to acquire, they go to the market and source acquisition financing to supplement their equity investment to close the deal. Despite existing in many different forms, acquisition financing is rarely explained in terms of the value it brings to the acquirer.

Acquisition financing underwriting usually focuses on business and financial issues that underpin the stability of cash flow. Providers of acquisition financing usually validate the durability of a company’s competitive advantage and the depth of its resource base. Environmental issues are usually not a major part of the analysis in today’s service and technology-based economy.