This article was written by George Souri who is the founder and CEO of both LQD Business Finance and The Atria Group with over 15 years of entrepreneurial and private equity experience, with a focus on finance, M&A, fast growth, exit positioning, and complex situations.
As banks like JPMorgan Chase begin tapping into the subprime small business lending market, we might be seeing a repeat of the aggressive risk taking that caused the 2008 economic crash. While the seemingly innovative partnerships between big banks and certain alternative small business lenders are being reported as beneficial to the prosperity of small businesses, the whole story is not being told.
To start, not all alternative lenders are the same. Some companies, like OnDeck and Can Capital, focus primarily on subprime credit and predominantly offer merchant cash advances, which are short term loans with very high rates (oftentimes greater than 50% APR). In contrast, companies like LQD Business Finance, Lending Club, and Funding Circle offer traditional loans to businesses with higher credit worthiness, and at lower rates and longer terms.
Is history repeating itself?
Based on the events leading up to 2008 and the mortgage crisis, it should be obvious by now that nothing good can come from big banks being involved in the subprime market – which is why JPMorgan Chase’s recent partnership with OnDeck is so concerning. As was the case in the mortgage crisis, the demand for new loan growth created by such partnerships creates the potential for an environment that is more focused on quick and high commissions rather than making sound business loans. As a result, the loan process is becoming increasingly accelerated, and managed in a framework of questionable criteria.
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Although many MCA companies claim to have algorithmic underwriting technology, most MCA loans are offered based on barely more than a few months of the business’s bank and credit card statements. This process means that credit decisions are being made without a full evaluation of the borrowing business, and as a result, MCA companies have experienced default rates that are higher than those seen in the mortgage crisis.
Comparable to the mortgage crisis, unsophisticated borrowers are being driven by fast talking loan brokers and loose underwriting criteria – ultimately taking on more debt than they can afford to ever pay back. Consequently, these businesses get into a cycle of having to take on one advance to pay off another – a tactic called “stacking” in the industry.
“It’s getting progressively worse. We’re seeing businesses coming to us for a traditional loan to consolidate 5 or 6 merchant cash advances a broker talked them into. Often times the debt the business is carrying exceeds the business’s revenues” says George Souri, CEO of LQD Business Finance.
The access to quick cash is leading businesses to take on debt that they will not be able to pay back. As these loans are aggregated and sold off to big banks, this leads for the potential of a repeat of 2008.
So, how can a repeat of 2008 be avoided?
First off, a business must take a sober account of the amount of debt that they can realistically pay back and avoid the allure of quick cash. Secondly, greater transparency is needed in the merchant cash advance space, particularly as it relates to the practices of unregulated brokers and the terms offered by unregulated merchant cash advance companies. Finally, businesses should avoid short-term, high-rate products like merchant cash advances, and instead look for traditional loans offering better terms from companies like LQD Business Finance and Lending Club.