In 2012, bank regulators introduced new complex regulatory rules (Basel III) to reinforce the financial stability of the banking system. These regulations coupled with others proposed under the Dodd-Frank Act and the Federal Reserve have required commercial banks to closely scrutinize risk-weighted assets, portfolio concentrations, and other matters. The net impact of this increasing regulation for banks is a desire to book larger higher quality financings, enforcement of stricter credit standards, and in some cases, a reduction of assets deployed by banks into certain sectors. As a result, non-bank alternative capital providers (i.e., finance companies, business development companies, and private funds) are expanding to address more complicated asset financing situations and fill the credit void left by banks.

Sophisticated company advisors, CFOs, and other intermediaries now recognize when not to call commercial banks. An alternative lender may be required to complete more complicated financings and fill the credit void by (i) providing large term loans on illiquid assets, (ii) financing atypical assets, (iii) lending in foreign jurisdictions, or (iv) extending credit to higher risk borrowers (including those which may have insolvency, headline or regulatory issues).

Given the relative ability to recover a loan through asset disposition, commercial banks are traditionally most comfortable with advances against current assets, which have a higher predictability of recovery. Conversely, commercial banks have a much more limited appetite for larger term oriented advances against non-current assets. Increasingly, alternative lenders are entering into the secured lending market by providing term heavy financing secured by illiquid assets such as real estate or machinery and equipment, the recoveries of which are less certain or lengthy in a downside scenario.

Alternative lenders are also exploiting a niche in providing credit against other non-current or atypical assets such as intellectual property or foreign domiciled collateral. Due to the difficulties quantifying collateral coverage and recovery values, diligence issues, as well as the steep experience curve associated with securing liens in foreign jurisdictions (e.g., Europe, Canada, etc.), non-bank alternative lenders may have a distinct advantage relative to commercial banks in these asset categories given their relative knowledge and experience.

Finally, by not having the same regulatory oversight and finite weighted cost of capital allocations, non-bank finance companies are able to lend to higher risk borrowers including those which have high insolvency risk, headline risks or operate in out of favor industries. Commercial banks must risk rate their capital allocations and have traditionally had low appetites for companies with continuing losses, uncertainty in their business plans, or in other transition (i.e., including rapid growth). While such loans may be “asset good”, the prospects of recovery are less apparent in bankruptcy and these loans may be subject to additional regulatory oversight within banks. Further, commercial banks routinely avoid any headline risk which could put them under any undue current or future media scrutiny. These situations might include shareholder or management background issues, outstanding lawsuits, or even providing credit to industries subject to constant regulatory changes (i.e., such as subprime consumer finance).

Given their comparative cost of capital, alternative lenders will always be more expensive than traditional commercial banks, but their incremental credit, knowledge and experience often justifies the higher costs. To split credit risks and provide borrowers some lower cost bank capital, alternative lenders may indeed also partner with traditional banks in a variety of structures included bifurcated collateral pools, first-out, or second lien situations.

Although the bulk of asset lending will certainly remain with regulated commercial banks, knowing when to bring in an alternative lender will remain a key factor to completing more complicated finance structures.