Source for Article: Business Week,  August 1, 2008 by Ricky McRoskey

It’s hard to get traditional loans these days. But as banks tighten their purse strings, hedge funds are offering asset-based loans to small companies.

In early 2008, Jim Gee hit an impasse. Over the previous five years, Gee had been expanding Trinity Communications, a small cable-TV company in Marion County, Tenn., that he founded in 2003. With startup costs of nearly $3 million, Gee had used personal funds to get the business rolling, laying fiber optic cables across two rural towns and attracting new subscribers. By 2008 he had 600 customers and 6 employees, but Gee couldn’t find additional funds to service new towns and sign new subscribers.

“Local lending was just not available,” says Gee. After he exhausted possibilities at traditional lenders, his attorney recommended that he reach out to a hedge fund that had recently started providing asset-based loans to small companies. So Gee met with Genesis Merchant Partners, a fund launched by the $145 million, Connecticut-based hedge fund Sands Brothers Asset Management. Within two weeks of the meeting, Gee had secured a 15-month, $500,000 loan from Genesis, carrying an interest rate of over 14% after fees, with a 10% penalty if he were to pay it off early. Trinity has nearly tripled its subscriber base since it secured the loan, says Gee. His company is now taking out a second loan for a similar amount from Genesis to continue its growth plan. He doesn’t consider the terms particularly onerous: “I was open to go as high as 15%.”

It’s clearly not easy for small companies to get traditional bank loans these days. Major financial institutions have written down over $400 billion in bad investments over the past year and banks are scrambling to raise depleted coffers. That usually hurts small companies more than their larger counterparts. “It’s not like a big company that can just sit on its hands for three years and wait the cycle out,” says David Grin, co-founder and portfolio manager at the $1.8 billion fund Laurus Valens in New York. “There are a significant amount of companies out there with virtually nowhere to go.”

With a new cadre of hedge funds (BusinessWeek.com, 10/31/05) and alternative lenders looking to fill that void, small companies, public and private, are competing for available funds. “Our members’ phones are ringing off the hook, says Andrej Suskavcevic, CEO of the Commercial Finance Assn., a trade association of roughly 300 asset-based lenders. The calls started pouring in during the fourth quarter of last year, says Suskavcevic, when companies started realizing they’d have to turn to new lending sources to survive.

“More Due Diligence”
So called asset-backed loans are commercial loans backed by company assets-anything from a company’s inventories to its accounts receivable. These loans differ from traditional commercial bank loans because they cost more, require lenders to scrutinize assets more thoroughly, and sometimes require physical inspections that most banks wouldn’t conduct, says the CFA’s Suskavcevic. “There’s more due diligence to verify it,” he says. While established lenders like Citigroup (C) and Bank of America (BAC) have had asset-backed lending arms for years, more hedge funds have recently jumped into the business. According to a 2007 report from the Commercial Finance Association, there were $545 billion in outstanding asset-backed loans in 2007, up 11% from 2006. Suskavcevic expects that number to grow in 2008.

Hedge fund loan rates vary across the board, but are usually considerably more than traditional banks’, which are 200 or 300 basis points (2 to 3 percentage points) higher than the prime rate, says Laurus Valens’ Grin. That’s why companies should consider traditional lending sources first, says Stratton Nicolaides, CEO of Numerex Corp (NMRX), a wireless provider and a client of Laurus.

But in a difficult lending climate like today’s, Nicolaides recommends alternative methods of financing. For example, businesses can sometimes secure loans by agreeing to give up future equity to lenders through convertible debt instruments (BusinessWeek.com, 8/19/04). Four years ago, Nicolaides reached out to Grin’s fund to finance a strategic acquisition when “money was very scarce.” Through Laurus Valens, Numerex secured a 3-year, $5 million loan that gave Laurus the option to convert debt to equity if the company’s share prices rose past a certain amount. When Numerex’s stock price rose, Laurus eventually exercised that option. The total cost of the loan, he says, was just under 20%, but it helped the company buy out a 40% shareholder and continue to grow.

The Smell of Success
What do lenders like Laurus look for in potential clients? “When you’re investing in small companies, you’re really investing in people,” says Grin. “So we need to believe the management team is strong.” A company’s management, no matter how big or small, must be able to convince an investor of the likelihood of success through a solid business plan and a healthy balance sheet, he says.

The best loan candidates also come to lenders with a wealth of background information, says Timothy Doede, director of research at Sands Brothers Asset Management, the fund that loaned to Trinity Communications. What stood out to Doede about Trinity’s Gee was his preparation: He provided a thorough business plan (BusinessWeek.com, 1/7/08) with supporting pictures and schedules, historical financial documents, and a listing of all company insurance policies. “Spend a ton of time to assemble a really good package,” Doede advises. “I sometimes look at 10 new opportunities in a given day, and if you do a lot of the work for me up-front, that’ll go a long way.”

Finally, networking is key. Smaller, newer lenders won’t always market themselves, so small businesses should build on existing relationships to find capable lenders. It was Gee’s attorney, also an adviser to Genesis Partners, who set up the first rendezvous. “It’s almost always business networking and talking to existing partners” that introduces new loan candidates, says Doede.

Grin says he continues to see waves of small companies coming his way seeking capital. As he puts it: “The trend is deepening.”