By: Gregg Elberg

 

A friend of mine started a Bank two years ago. Their
business plan was excellent and they were acquired by a Bank Holding Company
before they opened. In other words, the organizers made money before they
funded their first loan!

 

The bank was well capitalized and well run. No bad checks
and no bad assets were on the balance sheet. Nevertheless, my banker friend,
the President and CEO, was not happy. He quit at the end of last December. Why
would someone give up a fine salary at a successful Bank?

 

He quit because he hated working there. The main reason was
the conflict between the Holding Company’s pressure on the Bank to make more
loans, today’s economy, and the pressure of the U.S.
regulators not to make any unsafe or unsound loans. He was torn apart by these
two powerful forces. Gregg Financial Services believes that all banks are under
similar pressures.

 

Today’s Wall Street Journal reported on two of the world’s
most astute real estate investors, Tishman Speyer Properties and BlackRock Inc.
They defaulted on $4.4 Billion in debt that was used to acquire apartment
buildings in New York for $5.4
Billion in 2006. The investors are loosing over a billion dollars and the banks
that are taking a deed in lieu of foreclosure are probably going to also take
substantial losses. It appears that the same forces that tore my banker friend
apart caused this deal to collapse.

 

It is no secret that people are not borrowing money in
sufficient quantities to turn the economy around. Conversely, banks are not
lending money to many people who desperately need it. The residential mortgage
meltdown has seriously damaged the US
economy and the looming commercial mortgage meltdown may cause many more banks
to fail.

 

My banker friend estimated that another 1000 Banks will fail
this year. Another source estimates that as much as 40% of our 8000 banks are
at risk of failing. The FDIC insurance fund is insolvent. Freddie Mac and
Fannie Mae are technically bankrupt but for the indulgence of the US Treasury.

 

The bottom line: 2010 is going to be a tough year for the US
economy and asset lenders of all types. Accounts receivable financing, purchase
order financing and real estate financing face unprecedented challenges this
year.

 

© 2010 Gregg Financial Services

The Role of “Reverse Factoring” in Supplier
Financing of Small and Medium Sized Enterprises
Leora Klapper
Development Research Group
The World Bank
1818 H Street, NW
Washington, DC 20433
(202) 473-8738
lklapper@worldbank.org
Thanks to Marie-Renee Bakker, Andrew Claster, Thomas Glaeessner, Ulrich Hess,
Ashley Hubka, Peer Stein, Gregory Udell and Dimitri Vittas for helpful comments. A
special thanks to Gabriela Guillermo and Rafael Velasco at Nafin and Gamaliel Pascual
at DBP for their generous assistance. The paper has also benefited from helpful
conversation with Mexican buyers, suppliers and lenders that participate in the Nafin
program. This paper draws on an earlier paper, “The Role of Factoring in Commercial
Finance and the Case of Eastern Europe” by Bakker, Klapper and Udell, World Bank
Working Paper No. 3342, 2004. This paper was funded by the Rural Finance
Innovations (RFI) ESW, managed by Ulrich Hess.
2
Table of Contents
Chapter 1: Introduction ...................................................................................................... 3
Chapter 2: The Mechanics of Factoring............................................................................. 6
Chapter 3: The Advantage of “Reverse Factoring” ........................................................... 9
Chapter 4: The Benefits and Challenges to Reverse Factoring in Emerging Markets .... 10
Chapter 5: The Nafin Factoring Program in Mexico....................................................... 13
Chapter 5.1: Overview.................................................................................................. 13
Chapter 5.2 Products offered ........................................................................................ 15
Chapter 5.3: Benefits to Sellers, Buyers, and Lenders ................................................. 19
Chapter 5.4: Lessons Learned....................................................................................... 21
Chapter 6: International Experience ................................................................................. 22
Chapter 6.1: The Bankinter's Factoring Product in Spain ............................................ 22
Chapter 6.2: The Development Bank of the Philippines Factoring Product................. 22
Chapter 6.3: The Potential for Factoring in Sri Lanka.................................................. 23
Chapter 7: Conclusion....................................................................................................... 24
Annex 1:............................................................................................................................ 27
Boxes
Box 1: The mechanics of factoring.................................................................................... 6
Box 2: An example of an international factoring transaction ............................................ 8
Box 3: Factoring in Eastern Europe................................................................................. 12
Box 6: The experience of a Small Supplier ..................................................................... 19
Box 7: The experience of a Big Buyer............................................................................. 20
Box 8: Example of MAS Holdings.................................................................................. 24
Tables and Figures
Table 1: 2003 Factoring Turnover By Country (in Millions of EUR)............................... 4
Figure 1: Ordinary Factoring .............................................................................................. 9
Figure 2: Reverse Factoring................................................................................................ 9
Figure 3: The Nafin factoring Agreement ........................................................................ 17
Figure 4: The Nafin Purchase Order Agreement .............................................................. 18
3
Chapter 1: Introduction
A challenge for many small businesses is access to bank financing. In particular, many
firms find it difficult to finance their production cycle, since after goods are delivered
most buyers demand 30 to 90 days to pay. Sellers issue an invoice – recorded for the
buyer as an account payable and for the seller as an account receivable – which is an
illiquid asset for the seller until payment is received. Factoring is a type of supplier
financing in which firms sell their credit-worthy accounts receivable at a discount (equal
to interest plus service fees) and receive immediate cash. Factoring is not a loan. There
is no debt repayment and no additional liabilities on the firm’s balance sheet, although it
provides working capital financing. In addition, most factoring is done “without
recourse”, meaning that the firm that purchases the receivables, referred to as “the
factor”, assumes responsibility for the buyers ability to pay. Factoring is a
comprehensive financial service that includes credit protection, accounts receivable
bookkeeping, collection services and financing.
Factoring is used in developed and developing countries around the world. In
2003, total worldwide factoring volume was over US$ 750 billion, as the result of an
impressive growth rate of 135% in the five-year period 1996-2003. In some developed
economies such as the US, its importance as a primary source of working capital finance
tends to be concentrated in selected industries. In other developed economies such as
Italy, however, its importance as a primary source of working capital appears to be much
more widespread. As shown in Tables 1, both domestic and international factoring is
beginning to emerge as a major source of financing in developing economies.
The global pattern of factoring suggests that it may have an advantage compared
to other types of lending, such as loans collateralized by fixed assets, under certain
conditions. Factoring appears to be a powerful tool in providing financing to high-risk
informationally opaque borrowers. Its key virtue is that underwriting in factoring is
based on the risk of the accounts receivable themselves rather than the risk of the
borrower. For example, factoring may also be particularly well suited for financing
receivables from large or foreign firms when those receivables are obligations of
companies who are more creditworthy than the factoring client itself.
Factoring may also be particularly important in financial systems with weak
commercial laws and enforcement and inefficient bankruptcy systems. Like traditional
forms of commercial lending, factoring provides small and medium enterprises (SMEs)
with working capital financing. However, unlike traditional forms of working capital
financing, factoring involves the outright purchase of the accounts receivable by the
factor, rather than the collateralization of a loan. The virtue of factoring in a weak
business environment is that the factored receivables are removed from the bankruptcy
estate of the borrower and become the property of the factor.
4
Table 1: 2003 Factoring Turnover By Country (in Millions of EUR)
Companies Domestic International Total 5-Yr Growth Rate
Argentina 65 5 70 -95%
Australia 13,656 60 13,716 169%
Austria 2,598 334 2,932 46%
Baltics 2,012 250 2,262 381%
Belgium 9,500 2,000 11,500 51%
Brazil 12,000 40 12,040 -29%
Canada 2,131 1,030 3,161 62%
Chile 3,300 200 3,500 35%
China 2,400 240 2,640 8416%
Costa Rica 180 5 185 -18%
Cuba 30 63 93 -50%
Czech Rep 1,600 280 1,880 141%
Denmark 3,570 2,000 5,570 66%
El Salvador 100 2 102 .
Finland 8,545 265 8,810 56%
France 68,200 5,000 73,200 38%
Germany 27,131 7,951 35,082 76%
Greece 3,500 180 3,680 333%
Hong Kong 2,000 1,250 3,250 81%
Hungary 1,080 62 1,142 693%
India 1,500 115 1,615 528%
Indonesia 1 0 1 -97%
Ireland 8,800 50 8,850 44%
Israel 20 170 190 -13%
Italy 124,510 8,000 132,510 51%
Japan 60,000 550 60,550 9%
Lebanon 35 0 35 .
Malaysia 690 28 718 -11%
Mexico 4,435 100 4,535 28%
Morocco 130 30 160 181%
Netherlands 16,000 1,500 17,500 -15%
New Zealand 250 13 263 43%
Norway 6,800 825 7,625 79%
Oman 10 0 10 -52%
Panama 160 0 160 1355%
Poland 2,450 130 2,580 326%
Portugal 11,828 353 12,181 64%
Romania 90 135 225 508%
Russia 470 15 485 .
5
Table 1: 2003 Factoring Turnover By Country (in Millions of EUR), Cont.
Companies Domestic International Total 5-Yr Growth Rate
Saudi Arabia 50 0 50 .
Singapore 2,060 375 2,435 24%
Slovakia 296 88 384 140%
Slovenia 140 30 170 386%
South Africa 5,350 120 5,470 2%
South Korea 0 38 38 -100%
Spain 36,443 1,043 37,486 199%
Sri Lanka 94 8 102 65%
Sweden 9,650 1,300 10,950 45%
Switzerland 1,298 216 1,514 16%
Taiwan 11,700 4,300 16,000 666%
Thailand 1,400 25 1,425 41%
Tunisia 160 50 210 188%
Turkey 4,200 1,130 5,330 2%
U.S.A. 77,496 3,200 80,696 -8%
UAE 36 1 37 .
UK 158,270 2,500 160,770 56%
TOTAL 712,657 47,735 760,392 37%
Source: Factor Chain International, http://www.factors-chain.com.
Growth rates equal to “.” indicate values of zero in 1999.
6
Chapter 2: The Mechanics of Factoring
In factoring, the underlying assets are the seller’s accounts receivable, which are
purchased by the factor at a discount. The remaining balance is paid to the seller when
the receivables are received, less interest and service fees. For example, most factors
offer sellers financing up to 70% of the value of an account receivable and pay the
remaining 30% – less interest and service fees – when payment is received from the
buyer. In general, financing is linked on a formula basis to the value of the underlying
assets, e.g., the amount of available financing is continuously updated to equal a
percentage of available receivables.
Box 1: The mechanics of factoring
Step 1: Small Supplier, S, sells 1 million in tomatoes to its customer Big Buyer, B, a
large multinational exporter. S in a competitive gesture offers B 30-days trade credit. S
records the sale as 1 million in accounts receivable and B records the purchase as 1
million in accounts payable.
Step 2: S needs working capital to produce more inventory. A factor, F, purchases S’s
accounts receivable (S “assigns” its accounts receivable from B to F). S receives today
70% of the face value of the accounts receivable (700,000). B is notified that S’s
receivables have been factored.
Step 3: In 30 days, F receives the full payment directly from B, and S receives the
remaining 30% less interest (on the 700,000) and service fees.
An important feature of the factoring relationship is that a factor will typically
advance less than 100% of the face value of the receivable even though it takes
ownership of the entire receivable. The difference between this advance amount and the
invoice amount (adjusted for any netting effects such as sales rebates) creates a reserve
held by the factor. This reserve will be used to cover any deficiencies in the payment of
the related invoice. If and when the invoice is paid in full, the reserve amount is remitted
by the factor to its client.1, 2 A typical advance rate might be 70%, which establishes a
30% reserve. Thus, even in non-recourse factoring there is risk sharing between the
factor and the client in the form of this reserve account.
In most cases there are additional fees beyond the commission associated with
various components of the factoring relationship. For example, interest may be charged
1 The availability of this reserve account to cover deficiencies may vary. As described above the reserve is
applied only to the invoices of a specific account. Alternatively, the factoring contract could permit the
reserves against one account to be applied to deficiencies in other accounts.
2 The reserve account represents a liability of the factor to its client. In effect, the client has extended
contingent credit to the factor which exposes the client to risk. As a result, if the factor becomes insolvent
the client will become a general creditor of the factor and will be exposed to a potential loss up to the
amount of the reserve. Thus, from the client’s perspective the reputation and creditworthiness of the factor
may be an important consideration.
7
on the outstanding balance of receivables or on the balance on receivables outstanding
more than a fixed number of days. Alternatively, the interest could be fixed and included
in the commission. In short, the fees and expenses associated with a factoring
relationship vary from relationship to relationship. In addition to interest fees, these may
include some or all of the following:3 application fee, credit checking fees, origination
fee, pre-contract due diligence fees—to conduct on—and off-site reviews of client’s
books and records, public records searches for tax liens or judgments, lawsuits,
bankruptcy filings, administrative actions, news items, press releases, etc.
Factoring can be done either on a “non-recourse” or “recourse” against the
factor’s client (the sellers). In non-recourse factoring, the lender not only assumes title to
the accounts, but also assumes most of the default risk because the factor does not have
recourse against the supplier if the accounts default. Under recourse factoring, on the
other hand, the factor has a claim (i.e., recourse) against its client (the “borrower”) for
any account payment deficiency. Therefore, losses occur only if the underlying accounts
default and the borrower cannot make up the deficiency. In developed countries it
appears that factoring is more frequently done on a non-recourse basis. In Italy, for
example, 69% of all factoring is done on a non-recourse basis (Muschella 2003).
Similarly, a study of publicly traded firms in the U.S. found that 73% of firms factored
their receivables on a non-recourse basis, but that both sellers with poorer quality
receivables and sellers who, themselves, were higher quality were more likely to factor
with recourse (Sopranzetti 1998). Since in emerging markets it is often problematic to
assess the default risk of the underlying accounts, most factoring is done on a recourse
basis.4
In addition, factoring can be done on either a notification or non-notification
basis. Notification means that the buyers are notified that their accounts (i.e., their
payables) have been sold to a factor. Under notification factoring, the buyers typically
furnish the factor with delivery receipts, an assignment of the accounts and duplicate
invoices prepared in a form that indicates clearly to the supplier that their account has
been purchased by the factor.
Factoring can be viewed as a bundle of activities. In addition to the financing
component, factors typically provide two other complementary services to their clients:
credit services and collection services. The credit services involve assessing the
creditworthiness of the borrower’s customers whose accounts the factor will purchase.
Factors typically base this assessment on a combination of their own proprietary data and
publicly available data on account payment performance. The collection services involve
the activities associated with collecting delinquent accounts and minimizing the losses
associated with these accounts. This includes notifying a buyer that an account is
delinquent (i.e., past due). and pursuing collection through the judicial system.
3 This list of fees and expenses is from “Factoring: Modern American Style” by Richard G. Worthy
presented at the World Bank Conference on “The Factoring Industry as a Key Tool for SME Development
in EU Accession Countries”, October 23-24, 2003.
4 An exception is the factoring of foreign receivables in some emerging markets, such as Eastern Europe,
which typically also involve some form of credit insurance.
8
Essentially, SMEs that utilize a factor are, in effect, outsourcing their credit and
collection functions to their factor. This represents another important distinction between
factors and traditional commercial lenders.
A factor may enjoy a number of important advantages in offering credit and
collection services along with its funding services. First, it may enjoy significant
economies of scale in both of these activities relative to its clients. Because the factor is
handling these services for a large number of different clients it can amortize the fixed
costs associated with these activities. Also, most small SMEs likely have very little
expertise in either of these two areas. Most entrepreneurs likely have backgrounds on the
product side of their businesses and not the finance side. Finally, factors generate their
own proprietary databases on account payment performance. The largest factors
essentially become the equivalent of large credit information exchanges essentially
offering an alternative source of information to private commercial credit bureaus and
public credit registries. They would also enjoy the same economies of scale in
information exchange that the credit bureaus and public credit registries do.5
These credit and collection services are often especially important for receivables
from buyers located overseas. For example, Export Factoring – the sale of foreign
receivables – can facilitate and reduce the risk of international sales by collecting foreign
accounts receivables. The factor is also required to do a credit check on the foreign
customer before agreeing to purchase the receivable, so the approval of a factoring
arrangement also sends an important signal to the seller before entering a business
relationship. This can facilitate the expansion of sales to overseas markets.
Box 2: An example of an international factoring transaction
Take the example of a Moroccan firm that sells its goods to a large French company,
which demands 60 days credit. A Moroccan factoring company will typically contact a
factoring company in France – via Factor Chain International, a worldwide association of
factoring companies – who will do a credit check on the buyer. If the buyer is approved,
the Moroccan factor will pay the Moroccan seller 70% of the face value of the receivable,
and the French factor, for a fee, will take on the responsibility of collecting the amount
due from the French buyer. This setup allows firms in emerging markets to sell their
goods overseas without facing the difficulties of overseas collections. In addition, the
French factor must conduct a credit check before agreeing to factor the French buyer,
which reduces the sellers need to do due diligence on potential buyers. Because the trade
credit extended by the Moroccan seller can be easily converted into cash, the Moroccan
firm is able to offer more competitive terms to its customers. Finally, the Moroccan firm
is able to improve its own risk management, by reducing its credit and exchange rate
risks.
5 See Kallberg and Udell (2003b) for a discussion and model of economies of scale in credit information
exchanges.
9
Chapter 3: The Advantage of “Reverse Factoring”
Drawing from the example in Box 1 in Chapter 2, Figure 1 show that in ordinary
factoring, the small firm S sells all its receivables – from various buyers (B, Y, Z, etc.) –
to a factor. The factor must collect credit information and calculate the credit risk for B,
Y, Z, etc, etc.
Figure 1: Ordinary Factoring
Ordinary factoring has in general not been profitable in emerging markets. First,
if good historical credit information in unavailable, then the factor takes on large credit
risk. Second, fraud is a big problem in this industry – bogus receivables, non-existing
customers, etc. – and a weak legal environment and non-electronic business registries and
credit bureaus make it more difficult to identify these problems. An alternative usually
used in emerging markets is for the factor to buy receivables “with recourse”, which
means that the seller is accountable in the case that a buyer does not pay its invoice, and
that the seller of the receivables (in our example, S) retains the credit risk. However, this
may not really reduce the factor’s exposure to the credit risk of S’s customers, since in
the case of a customer’s default, S may not have capital reserves to repay the factor.
Figure 2 shows the mechanics of “Reverse Factoring”. In this case, the lender
purchases accounts receivables only from high-quality buyers (e.g. any receivable owed
by B from any suppliers, including S, Q, and R). The lender only needs to collect credit
information and calculate the credit risk for B (in this case a large, very transparent,
internationally accredited firm). In Reverse Factoring, the credit risk is equal to the
default risk of the high-quality customer, and not the risky SME. This arrangement
allows creditors in developing countries to factor “without recourse” and provide lowrisk
loans to high-risk SMEs.
Figure 2: “Reverse Factoring”
Reverse factoring may be particularly beneficial for SMEs for a number of
reasons. First, as shown in these figures, ordinary factoring requires comprehensive
credit information on all the borrower’s customers, which may be difficult and costly to
determine in countries with weak credit information systems. Second, reverse factoring
S
Q
B Y Z
R
B Y Z
S
B Y Z
B Y Z
10
allows firms to transfer their credit risk and borrow on the credit risk of its creditworthy
customers. This may allow firms to borrow greater amounts at lower costs. Third,
factoring only requires the legal environment to sell, or assign, accounts receivables.
Factoring does not require good collateral laws or efficient judicial systems.
Another advantage of reverse factoring is that it provides benefits to lenders and
buyers as well. Lenders are able to develop relationships with small firms (with high
quality customers) without taking on additional risk. This may provide cross-selling
opportunities and allows the lender to build a credit history on the small firm that may
allow additional lending (for fixed assets, for example). The large buyers may also
benefit: by engineering a reverse factoring arrangement with a lender and providing its
customers with working capital financing, the buyer may be able to negotiate better terms
with its suppliers. For example, buyers may be able to extend the terms of their accounts
payable from 30 to 60 days. In addition, the buyer benefits from outsourcing its own
payables management (e.g. the buyer can send a payment to one lender rather than many
small suppliers). A detailed account of the benefits to suppliers and lenders is discussed
in Chapter 4.
Chapter 4: The Benefits and Challenges to Reverse Factoring in Emerging Markets
Factoring is quite distinct from traditional forms of commercial lending where credit is
primarily underwritten based on the creditworthiness of the borrower rather than the
value of the borrower’s underlying assets. In a traditional lending relationship, the lender
looks to collateral only as a secondary source of repayment. The primary source of
repayment is the borrower itself and its viability as an ongoing entity. In the case of
factoring, the borrower’s viability and creditworthiness, though not irrelevant, are only of
secondary underwriting importance.
In some countries, borrowers can use receivables as collateral for loans. The
difference is that the lender secures the working capital assets as collateral, rather than
taking legal ownership of the assets. Therefore, this type of financing requires good
secured lending laws, electronic collateral registries, and quick and efficient judicial
systems, which are often unavailable in developing countries.
Factoring is often used in middle-income countries. One reason is that in many
emerging market countries SMEs are unable to access sufficient financing from the
banking system, yet large domestic, foreign, and multinational firms have cheap access to
domestic and foreign bank and public-debt financing. Therefore, SMEs often depend on
their large customers and suppliers to provide them with working capital financing. This
may be in the form of 30-day credit from suppliers– which is repaid when the final goods
are sold – or cash advances from customers – which is settled when the final goods are
delivered. Inter-firm financing is also used more in countries with greater barriers to SME
financing. For example, recent work by Demirguc-Kunt and Maksimovic (2001) find
that in 39 countries around the world, trade credit use is higher relative to bank credit in
countries with weak legal environments, which make bank contracts more difficult to
write. Fisman and Love (2002) highlight the impact of inter-firm financing by showing
11
that industries with higher dependence on trade credit financing exhibit higher rates of
growth in countries with relatively weak financial institutions.
Van Horen (2004) studies the use of trade credit in 39 countries and finds that
trade credit is used as a competitive tool, particularly for small and young firms. Fisman
and Raturi (2003) find that competition encourages trade credit provision in five African
countries. In addition, McMillan and Woodruff study the use of trade credit in Vietnam
and find that small firms are more likely to both grant and receive trade credit than large
firms. This evidence suggests that small firms in emerging markets generally provide
trade credit and hold illiquid accounts receivable on their balance sheets.
In addition, firms in developed countries often refuse to pay on receipt to firms in
emerging markets since they want time to confirm the quality of the goods and know that
it could be very difficult to receive a refund from firms in countries with slow judicial
systems. In addition, a global trend is the outsourcing of intermediate goods and services,
as a way for multinational firms to address the problem of restrictive local labor laws.
For example, in many countries firms cannot fire employees during economic
slowdowns. An alternative is to hire outside firms – often former employees – to provide
the goods or services. This includes, for example, drivers, gardeners, and cleaners, as
well as producers of some intermediate goods, such as fabric cutters. As a result, more
SMEs have receivables – rather than salaries – from large firms.
The challenge faced by many SMEs in emerging markets is how to convert their
accounts receivable to creditworthy customers into working capital financing. Bank
loans secured by accounts receivable – which is the primary source of SME financing in
the US – is often unavailable in emerging markets. First, it requires the lender to be able
to file a lien against all business assets of the firm. For example, in the US the UCCSection
9 allows banks to secure “all current and future inventory, receivables, and cash
flow” of a firm. Furthermore, this type of financing requires sophisticated technology
and comprehensive credit information on firms. For instance, receivable lenders in the
U.S and U.K. generally depend on “electronic ledgers” – firms input all receivable
information on-line along with their customers’ Dunn & Bradstreet (D&B) ID numbers.
The D&B rating is a credit score calculated by D&B based on the firms current and
expected future performance and is automatically electronically received and receivables
are instantaneously accepted or rejected as collateral. In the case of approval, the
borrower’s credit-line is automatically increased to reflect the new receivables.
However, most developing countries do not have laws allowing lenders to secure
“intangible/ floating” assets and do not have judicial systems that are sufficiently quick
and efficient to enforce such contracts. Furthermore, most emerging markets do not have
the technological infrastructure or access to commercial credit information necessary to
allow this type of financing.
12
Box 3: Factoring in Eastern Europe
The environment in the EU-accession and transition countries makes it quite
likely that factoring will grow in importance and that it will likely have some key
advantages over other lending products.
There are several characteristics of factoring that may give it an edge in Eastern
Europe. First, factoring removes receivables from the borrower’s estate in bankruptcy,
which may be particularly important if the judicial system is less developed or inefficient.
Both of these conditions likely apply to most countries in Eastern Europe, as confirmed
by the World Bank’s Insolvency and Creditor Rights ROSC reports (Reports on
Observance of Standards and Codes) for selected countries in the region.6
Second, factoring is a type of asset-based financing that has a distinct advantage
in providing funding to higher risk and informationally opaque firms, especially SMEs.
This is particularly relevant in transition countries whose private sectors are young and
continuing to develop and expand in order to catch up to Western Europe. Furthermore,
weak accounting standards and a shortage of audited financial statements is characteristic
of the region. Factors can base their lending decision primarily on the condition of the
underlying accounts (buyers) rather than the creditworthiness of their SME customers
(suppliers).
The weak information infrastructure systemic in transition countries could be
problematic for factors. The general lack of data on payment performance, such as the
kind of information that is collected by public credit registries, private business credit
bureaus, credit insurance companies, or by factors themselves, can discourage ordinary
factoring. However, the large presence of multinational buyers makes attractive the
potential for reserve factoring of receivables from foreign and large domestic firms.
Reverse Factoring is an effective solution to weaknesses in credit information on
buyers, which increase the difficulty of collection credit information on a large number of
buyers. However, there are a number of additional tax, legal, and regulatory challenges
to ordinary and reverse factoring in many developing countries. For instance, the tax
treatment of factoring transactions often makes factoring prohibitively expensive. For
example, some countries that allow interest payments from banks to be tax deductible do
not apply the same deduction to the interest on factoring arrangements, VAT taxes may
be charged on the entire transaction (not just the service fee), and stamp taxes may be
applied to each factored receivables. Factoring companies that do not take deposits are
sometimes subject to burdensome and costly prudential regulation. In addition, capital
controls may prevent non-banks from holding foreign currency accounts for cross-border
assignments.
The legal and judicial environment may also play a critical role in determining the
success of factoring. A key legal issue is whether a financial system’s commercial law
6 For country-level Insolvencv and Creditor Rights ROSC reports, see:
http://www.worldbank.org/ifa/rosc.html.
13
recognizes factoring as a sale and purchase. If it does, then creditor rights and
enforcement of loan contracts diminish in importance for factoring because factors are
not creditors. That is, if a firm becomes bankrupt, its factored receivables would not be
part of the bankruptcy estate because they are the property of the factor, not the property
of the bankrupt firm. However, creditor rights and contract enforcement are not entirely
irrelevant to factors, even in non-recourse factoring arrangements, since they describe the
environment under which the factor engages in its collection activities, which might
affect the expected costs and efficiency of factoring. Another issue is whether a country
has a Factoring Act or a reference in the law (or civil code), which legally recognizes
factoring as a financial service. This recognition serves multiple purposes. It serves to
clarify the nature of the transaction itself. For example, a Factoring Act explicitly
dictates how judges must rule towards factors in the case of default of sellers or
customers. It also tends to legitimize the factoring industry. In a sample of Central
European countries, factoring (as a percentage of GDP) is higher in countries with
Factoring Acts, although the development of such Acts may in part be in response to the
development of, and pressures from, domestic factors. However, the indication is that a
supportive legal and regulatory environment encourages the factoring industry to grow.
Finally, an advantage to factoring is that it’s generally linked on a formula basis
to the value of the underlying assets, which allows quick credit approval and
disbursement. However, this depends on a good technology infrastructure and supporting
electronic security laws that allow the electronic sale and transfer of electronic securities
(accounts receivable). Furthermore, there must be a supportive regulatory environment
for electronic security, so that factors and borrowers are assured that their transactions are
confidential and secure. As discussed in the following section, the success of reverse
factoring requires a legal environment that facilitates safe and easy electronic
transactions.7
Chapter 5: The Nafin Factoring Program in Mexico
Chapter 5.1: Overview
As discussed in the previous section, ordinary factoring requires lenders to have timely
and comprehensive credit information and suppliers to have sophisticated technology and
MIS systems. However, Reverse Factoring only requires complete credit information on
one or more creditworthy firms. There are potentially advantages for all participants: for
the lender, who benefits from low information costs and credit risk; for the (high-risk)
seller, who benefits from access to short-term, working capital financing; and for the
(creditworthy) buyer, who benefits from the ability to outsource its receivable
management and negotiate better terms with its suppliers.
A successful example of reverse factoring in a developing country is the case of
the Nacional Financiera (Nafin) development bank in Mexico, which offers on-line
7 For additional information see Glaessner, Kellermann, and McNevin (2002) and Claesssens, Glaessner
and Klingbiel (2001).
14
factoring services to SME suppliers.8 The program is called the “Cadenas Productivas”,
or “Productive Chains” program and works by creating “Chains” between “Big Buyers”
and small suppliers. The Big Buyers are large, creditworthy firms that are low credit risk.
The suppliers are typically small, risky firms who generally cannot access any financing
from the formal banking sector. The Nafin program allows these small suppliers to use
their receivables from Big Buyers to receive working capital financing, effectively
transferring their credit risk to their high-quality customers to access more and cheaper
financing.
What makes Nafin special is that it operates an electronic platform that provides
on-line factoring services, which reduces costs and improves security. Over 98% of all
services are provided electronically, which reduces time and labor costs. The electronic
platform also allows all commercial banks participate in the program, which gives
national reach, via the internet, to regional banks. Nafin also uses the Internet and
regional “contact centers” to market and provide services. Technology has allowed a
successful economies of scale – Nafin grew from a 2% market share of factoring in 2001
to 60% of the market in 2004.
There are a number of additional characteristics (described in more detail in the
following sections) that make the Nafin program unique. For example, all factoring is
done on a non-recourse basis, which lets small firms increase their cash holdings and
improve their balance sheets. Also, Nafin has a “Multi-bank” approach, which allows
lenders to compete to factor suppliers’ receivables. In addition, Nafin pays for the costs
associated with their electronic factoring platform and all legal work, such as document
transfers, preparing and signing documents, etc., so that banks charge only interest and
not service fees. Nafin covers its own cost with the interest that lenders pay for their own
financing or service fees.
Nafin was created by the Mexican government in 1934 as a state-owned
development bank with the goal of providing commercial financing. It has 32 statebranch
offices throughout the country. When a new government was elected in 2000,
Nafin was given new management and direction with the goal to (1) use new technology
to provide microenterprise and SME loans and (2) complement lending with greater
training and technical assistance. The factoring program is integrated with the Mexican
e-government model that aims to use the internet to provide quicker and cheaper
government services. Nafin is primarily a second-tier development bank: About 90% of
lending is done through refinanced bank loans and about 10% is made directly to
borrowers (primarily public projects). About 80% of the second-tier business is the
factoring of receivables of commercial firms. In Dec 2000, Nafin reported assets of
$23.9 billion and a deficit of $429 million. In Dec 2003, reported assets of $26.75 billion
and a surplus of 13.23 million. Factoring has helped contribute to the turn-around in
Nafin’s balance sheet.
8 Additional information is available at www.nafin.com.
15
About 99% of registered firms in the formal economy – about 600,000 firms – are
classified as small and micro enterprises.9 It is estimated that the informal sector includes
over 1.8 million small and microenterprises. SMEs comprise 64% of employment and
42% of GDP. The typical Mexican SME receives 65% of its working capital from family
savings and other personal funds, another 18% from friends and parents – and less than
1% from banks (Kun 2002). The goal of Nafin was to target this segment of small firms
with banking services.
Nafin has succeeded in providing financial services to Mexican SMEs. Nafin has
established Productive Chains with 190 Big Buyers (about 45% in the private sector) and
more than 70,000 small and medium firms (out of a total of about 150,000 participating
suppliers). About 20 domestic lenders are participating, including banks and
independent finance companies. Nafin has extended over US$ 9 billion in financing
since the program’s inception in September 2001 and has reached month factoring
amounts of over US$ 600,000. Nafin has brokered over 1.2 million transactions – 98%
by SMEs, at a rate of about 4,000 operations per day. The following sections discuss the
mechanics of the Nafin program and its benefits to small suppliers, big buyers, and
lenders.
Chapter 5.2 Products offered
The Productive Chain program integrates supply chains, primarily of small suppliers to
large enterprises and the federal government. Services include:
1. Factoring, which is offered without recourse or any collateral or service fees,
at a maximum interest rate of seven percentage points above the bank rate (five
percentage points, on average), which is about eight percentage points below commercial
bank rates.10 Importantly, the sale of receivables from the supplier and the transfer of
funds to the supplier are done electronically, once the SME is registered on-line or on the
phone and has an account with a bank or factor that has a relationship with its buyer.
The funds are transferred to the supplier’s bank account, and the bank becomes the
creditor (e.g. the buyer repays the bank directly). The Bank collects the loan amount
when the buyer pays the supplier (in 30 to 90 days).
Nafin maintains an internet site with a dedicated page for each Big Buyer.
Suppliers are grouped in “chains” to big buyers to whom they have a business
relationship. Nafin also plays a critical role in handling the sale and delivery of
electronic documents. The suppliers and Nafin sign a pre-agreement allowing the
electronic sale and transfer of receivables. Additional contracts between the banks and
9 Microenterprises are defined as manufacturing firms with up to 30 employees and service firms with up to
20 employees. Small firms are defined as 31-100 employees in the manufacturing sector and 21-50 firms
in the service sector and Medium firms are defined as 101-500 employees in the manufacturing sector and
51-100 firms in the service sector.
10 Beginning in July 2004, banks will be able to compete with one another on the interest charged for
factoring. For example, a good bank customer may receive preferential rates.
16
buyers and Nafin define their obligations, such as the requirement for buyers to remit
factored receivables to the banks directly.
Once a supplier delivers its goods and an invoice to the buyer, the buyer posts on
its Nafin webpage a “documentos negociables”, or “negotiable document”, equal to the
amount that Nafin should factor. In general, this is equal to 100% of the value of the
receivable. 11 Next, the supplier uses the internet to access its buyer’s Nafin webpage and
clicks its receivable.12 Any lender that has a relationship with the buyer and the supplier
and is willing to factor the receivable will appear on the next screen, along with a quote
for the interest rate at which it’s willing to factor this specific receivable.13 To factor its
receivable, the supplier clicks on a shown factor and the amount of its negotiable
document less interest is transferred to its bank account.14 When the invoice is due, the
buyer pays the factor directly.
Even though the buyers are high quality, a remaining risk to the lenders is in the
case of returns – if the buyer is unsatisfied with the quality of the goods or services
received, they generally have the right to return the goods, for a full refund, within a
certain number of days. However, banks are responsible to pay Nafin on the day the
invoice expires, regardless of whether the buyer pays the bank the full amount.15 Nafin
and the buyers help banks reduce their losses in two ways: First, buyers must “invite”
sellers to join their chain and participate in the program. Buyers generally require sellers
to have a relationship of a minimum length and performance record before participating.
Second, in the case of returns, the factor receives future receivable payments directly
from the buyer and the buyer adjusts the amount of the negotiable documents on future
receivable payments posted on the Nafin website by the amount of the receivables due to
returns.
The Nafin factoring program is successful because it uses an electronic platform
for cheaper and quicker transactions. Today, all transactions are completed within 3
hours and money is credited to suppliers account by the close of business. This provides
immediate liquidity to suppliers. The Nafin factoring program is also less expensive
than commercial factoring because Nafin waives the service fee by paying the overhead
and legal costs associated with maintaining the electronic platform and writing the
contracts.
The Nafin factoring program has succeeded because of supporting electronic
security laws. Annex 1 provides the translation of a comparative table of electronic
11 A buyer may choose to hold a “commercial reserve” for the case of returns, which is done by posting to
its Nafin website a “negotiable document” less than 100% of the invoice. In this case the buyer is
responsible to pay the difference to the supplier when the invoice is due.
12 Factoring can also be executed by phone for no extra fee.
13 An advantage of the multi-bank Nafin model is that a lender may be unable to factor a receivable if it has
reached its lending limit to that particular buyer.
14 In most factoring arrangements the supplier receives a percentage of its invoice today and the remainder
less interest when the factor is paid by the buyer. In comparision, the Nafin program generally pays the
supplier 100% of its invoice, less interest today and the factor keeps the full amount paid by the buyer.
15 As a result of this condition, Nafin has reported zero loses from factoring.
17
security laws in Mexico and other countries (AMECE, 2004). For example, in May 2000,
the “Law of Conservation of Electronic Documents” was passed giving data messages the
same legal validity as written documents, which is necessary for electronic factoring. In
April 2003, the “Electronic Signature Law” was enacted, which allows secure
transactions substituting electronic signatures for written signatures, which permits the
receiver of a digital document to verify with certainty the identity of the sender. In
January 2004, modifications to the Federation Fiscal code included amendments
necessary for electronic factoring, including digital certification. These laws allow
secure and legally binding factoring transactions.
Figure 3: The Nafin factoring Agreement
Contract Financing, which provides financing up to 50% of confirmed contract
orders from Big Buyers with Nafin supply chains, with no fees or collateral, and a fixed
rate (generally seven percentage points above the bank rate). First, the supplier signs a
contract with Nafin stipulating that (i) Nafin will provide a Line of Credit equal to up to
50% or the purchase order and that (ii) the supplier will factor its receivables to the lender
when its goods are delivered. Once the supplier receives a contract order from a big
buyer, Nafin provides a line of credit for up to 50% of the order at the bank rate + 7%.
After the goods are delivered the buyer receives an invoice and posts a negotiable
document to its Nafin website. Nafin factors the negotiable document and takes as
payment the amount of the negotiable document equal to the outstanding line of credit
plus interest, up to 100% of the negotiable document.16 The remainder is paid to the
supplier less the interest paid on factoring, equal to the lower interest rate of the bank rate
16 Since Nafin only factors up to 50% of purchase orders, the Nafin loan would only eual 100% of the
receivables in the case that the firm does not deliver its full order or some goods are returned.
Day 1 Day 10 Day 50 Day 80
S makes a delivery to B,
and B posts a documentos
negociables on its Nafin
website, payable to S in
30 days
S uses the Nafin website to factor its
recevables from B with F (at an
average interest of bank rate + 5%) and
receives today the full amount of the
documentos negociables, less interest
B repays F directly the
full amount of the
documentos negociables
S receives a purchase
order from B, due in
40 days
Supplier S, Buyer
B and Factor F sign
contracts with Nafin
to allow factoring
agreements
Factoring
18
+ 5%. Nafin is paid directly by the buyer when the invoice becomes due. This funding
allows creditors to buy raw materials to complete the new order. Nafin introduced this
program in 2004 and as of July 2004, provides the financing directly to small suppliers
and holds the future receivables until the buyer remits. However, it is the intent of Nafin
to develop a tract-record of profitability and low defaults rates with this program so that
private lenders will participate (with Nafin financing).
Figure 4: The Nafin Purchase Order Agreement
3. Training, which includes on-line and attendance courses on accounting
standards, how to apply for credit, business ethics, marketing, and strategy.17 SMEs are
also offered discounts at affiliated university classes. About 70% of SMEs participated in
some form of training.
4. Technical Assistance, which offers participating suppliers e-mail responses to
e-mailed questions within 48 hours. Suppliers can also receive information on publicsector
selling opportunities provided by Compranet, the Mexican government’s eprocurement
initiative. Nafin also has a call-center to answer questions and provide
assistance with on-line transactions (for no extra fee). Suppliers that cannot access the
internet can also use the call centers to do all transactions by phone, for no additional fee.
17 A complete list of courses is available at www.nafinsa.com.
Day 1 Day 10 Day 50 Day 80
S delivers the order and B
posts a documentos
negociables on its Nafin
website, payable to S in 30
days
Nafin factors the receivables
from B as payment: Nafin
deducts an amount equal to the
used portion of the line of credit
plus interest (bank rate + 7%)
and S receives the difference
less interest (at an average
factoring interest rate of bank
rate + 5%)
B repays Nafin directly
the full amount of the
documentos negociables
Purchase order
financing
S receives a purchase
order from B, due in
40 days
Supplier S and Buyer
B sign contracts with
Nafin to establish a line
of credit facility against
future purchase orders
S receives a line of
credit from Nafin,
equal to 50% of the
purchase order (at an
interest of bank rate
+ 7%)
Factoring
19
The call center is also used to generate new business. The call center has about
160 employees in three locations. Callers contact large buyers to form relationships.
Buyers then provide Nafin with a list of all their suppliers, which Nafin call to introduce
the factoring product and collect information about the firm. This information is used to
set up a credit profile that can later be used to set up banking and factoring relationships.
Chapter 5.3: Benefits to Sellers, Buyers, and Lenders
For the Small Supplier:
The Nafin factoring program reduces the borrowing and transaction costs of small
suppliers. First, factoring offers working capital financing at favorable rates. Factoring
provides instant liquidity, which allows businesses to grow with funds that were
previously tied up in receivables. In addition, all interest charges are tax deductible.
The Nafin program also has advantages over traditional factoring products. Since reverse
factoring transfers the credit risk of the loan to the suppliers’ high-quality buyers, Nafin
can offer factoring without recourse to SMEs, even those without credit histories. This
allows SMEs to increase their cash stock – and improve their balance sheets – without
taking on additional debt. In addition, Nafin charges no commissions (to the seller) and
offers capped interest rates. The competitive structure, which allows lenders to compete
for suppliers’ receivables, allows firms to pick their own lender.
Second, factoring reduces transaction costs. Previously many rural SMEs needed
to travel to customers in the city to present bills, collect payments, pay suppliers, etc. By
factoring its receivables, the supplier eliminates its collection costs by effectively
outsourcing its receivable management. Nafin also provides free technical assistance on
using the electronic system.
Many suppliers have no other sources of financing. In discussions with suppliers,
many reported that they had no external financing before receiving financing from Nafin
and most depended on internal funds and credit from their own suppliers. In addition,
suppliers stated that the Nafin financing is preferable to bank financing, since banks are
slow to make credit decisions, would offer less credit and charge higher rates. Some
small firms reported that they had previously factored with other lenders, but at higher
rates plus high service fees. Overall, suppliers commended the Nafin program.
Box 6: The experience of a Small Supplier*
This Small Supplier in the agribusiness sector sells processed food to large Mexican
supermarkets. The firm began operations four years ago and has about 30 employees.
Prior to factoring with Nafin, the firm factored its receivables with a factor that required
the supplier to physically collect its receivables from the buyers and deliver its
receivables to the bank. This supplier reports that factoring on-line and using electronic
document transfers allows for quick payments and lower costs.
This supplier requested anonymity.
20
For the Big Buyer:
The benefit to the buyer is that the lender provides receivables management and the
buyer often develops stronger relationships with its suppliers. For instance, buyers
decrease their administrative and processing costs, by effectively outsourcing their
payment department, e.g. the buyer writes one check to a bank rather than to hundreds of
suppliers. By providing its suppliers with working capital financing, buyers can also
improve their reputation and relationship with suppliers. For example, buyers can often
negotiate better terms with suppliers, e.g. extend payment terms from 30 to 60 or 90 days.
Participating in the Nafin program can also help the development of suppliers and the
growth of the SME sector, which can lead to increases in competition and improvements
in the quality of goods.
Box 7: The experience of a Big Buyer*
This Big Buyer has about 4,500 suppliers of which approximately 80% are small and
medium firms with less than 100 employees and about 15% are “Personas fisicas con
actividad empresarial”, loosely translated as non-corporate entrepreneurs. Suppliers are
offered factoring and purchase order financing through Nafin. As of July 2004, over
1,000 suppliers receive financing through Nafin.
This firm holds 10% of invoices as reserves; in other words, suppliers can factor up to
90% of their receivables. In order to be “invited” to join its chain, firms must meet three
criteria:
1- Have been a supplier for at least six months and have been fully compliant with all
purchase orders;
2- Have completed at least one purchase order per month (i.e. are a regular supplier);
3- Have had negligible returns and losses.
Since participating in the program, the buyer has increased the maturity of its payables
from 45 to 90 days. The buyer is pleased that the program has reduced its own cash
management costs and helped develop more loyal and reliable customers.
This buyer requested anonymity.
For the Lender:
Factoring is a way for banks to develop new relationships with suppliers – banks can
use factoring to build a credit history on firms, including information on their cash,
accounts receivable and inventory turnover, and cross-sell other products such as credit
cards, truck financing, payroll, etc. The advantage of a bank to reverse factoring is that it
includes a broad base of customers, diversified across industries. In addition, because
reverse factoring only includes high quality receivables, banks can increase their
operations without increasing their risk.
Banks also have incentive to participate in the Nafin program, since Nafin provides
low-cost (re)financing. Most banks refinance their factoring activities with Nafin, in
21
which case the bank earns the spread between what the suppliers pay and the Nafin rates.
Some larger banks with cheaper sources of funding, use their own funds and pay Nafin
from 42 to 100 basis points commission. However, about 99.6% of factoring is done with
Nafin financing. Five banks and factoring companies represent 54% of all factoring
transactions: Banorte, Mifel, Interacciones, Heller (GE Capital) and Bital (HSBC). The
Nafin platform also allows low transaction costs. The E-platform eliminates the need to
physically move documents, which is a large expense in off-line factoring.
Another advantage is that for regulatory purposes, banks can use lower risk
weights on factored transactions; e.g. if the factoring is done without recourse, banks can
use the risk of the buyer rather than the higher risk of the supplier. This is an important
reason that banks will lend to small and risky customers only in factoring arrangements.
In addition, an advantage of the Nafin platform is that it prevents fraud, which is systemic
in the factoring business in the U.S. and other developed countries. Since the buyer
enters the receivables (not the customers), the seller cannot submit fraudulent receivables.
In addition, since the bank is paid directly by the buyer, suppliers cannot embezzle the
proceeds.
In the future, Nafin can also play a role to securitize receivables. For example, a
security backed by Walmart receivables might be an attractive security, equal to the
credit risk of Walmart. Nafin could play an important coordination role bundling
receivables of one large buyer across lenders, since no one lender has a large enough
portfolio to securitize independently. Nafin is also committed to working towards the
development of capital markets in order for small and midsize non-bank (non-deposit
taking) financial intermediaries to participate. For example, independent leasing and
factoring companies generally raise capital on the public debt and equity markets (e.g. in
the U.S. NBFIs are the largest issuers of commercial paper).
Chapter 5.4: Lessons Learned
The Mexican economy has improved the past few years, as the result of macro
stability and the continuing recovery of the banking sector from the 1990s crises, and
banks are aggressively entering SME lending. However, factoring remains the cheapest
form of financing for small suppliers in Mexico and most suppliers that participate in the
Nafin program have no other sources of formal financing. The success of the Nafin
program spotlights the role of factoring as an important source of working capital
financing.
The success of the Nafin program highlights how the use of electronic channels
can cut costs and provide greater SME services. The Nafin factoring program is used as a
model in Mexico for the automation of other government agencies and service providers.
Advances in technology can reduce the costs of lending that can allow banks to lend at
lower margins, which make borrowing feasible for small firms. On-line banking services
also allow lenders to penetrate rural areas without banks and provide incentive for firms
in the informal sector to register and take advantage of financing opportunities. The
success of the Nafin program depends on the legal and regulatory support offered in
22
Electronic Signature and Security laws that should be a model for other developing
countries.
Nafin has entered an agreement with a development bank in Venezuela to develop
a similar product and the model is being considered for replication in other Latin
American countries such as Argentina, Chile, Costa Rica, El Salvador, and Nicaragua.
Like Nafin in Mexico, this model is also an intriguing way to invigorate, redefine and
refocus a state-owned development bank. The Nafin program has shown that in addition
to financing, a development bank can also be utilized to provide training and information.
Factoring is an ideal source of financing in countries with small, risky suppliers and large
and foreign buyers. However, successful factoring programs require government support
in setting up a legal and regulatory environment that allows a secure and electronic sale
of receivables.
Chapter 6: International Experience
Chapter 6.1: The Bankinter's Factoring Product in Spain
<Lessons can be learned from reverse factoring products in developed countries… To be
discussed >
Chapter 6.2: The Development Bank of the Philippines Factoring Product
Using a development bank to offer factoring services is not unique to Mexico –
the Development Bank of the Philippines (DBP) and SMetrix have collaborated to offer a
similar, yet more limited, service. The DBP Marketplace for SME Receivables
Purchases (M4SME-RP) facilitates factoring, without recourse, to address the working
capital needs of SMEs that have creditworthy customers but have limited financial
resources and very limited access or no access at all to other regular bank facilities,
because of their own high credit risk. Although this product is new (currently in a pilot
stage), it has the potential to become an important source of working capital financing for
SME suppliers. The DBP factoring program highlights the importance of a legal and
technological infrastructure to support electronic signatures and security transfers.
DBP will use credit scoring methodologies to identify investment grade
companies, who will in turn enroll their suppliers. In the initial pilot, DBP is
collaborating with San Miguel Corporation (SMC), the largest food and beverage firm in
the country. SMC has provided a list of SME suppliers to DBP, which are suppliers with
whom SMC has an ongoing and satisfactory relationship. For those suppliers who wish
to participate, DBP will post for electronic auction any digital receivables that these
suppliers receive from SMC. DBP plans to operate an “Alternative Trading System”,
effectively an electronic brokering system, which allows fixed income investors – for a
fee – to directly provide the financing.18 DBP will not take any underwriting or credit
risk. Similar to the Nafin program, the credit risk to investors is reduced because SMC
18 The DBP has submited to the Philippine Securities and Exchange Commission an application for a
licence to operate a Alternative Trading System.
23
cooperates with DBP and pays directly a “trustee” who repays the investors directly.
This results in a credit risk transfer from the supplier to that of SMC. This feature allows
DBP to offer factoring without recourse to small and risky suppliers.
In the case of returns, SMC is still responsible to repay investors and an

By: Gregg Elberg

This article updates this author's opinion from 2008 in an article called "The Mortgage Meltdown." Banks
lend money to people and businesses. The money is used for investment purposes
and consumer purchases like food, cars and houses. When these investments are
productive the money eventually finds its way back to the bank and an overall
liquidity of a well functioning economy is created. The money cycles round and
round when the economy is functioning effectively.



When the market is disrupted financial markets tend to seize up. The liquidity
cycle may slow, freeze up to a degree or stop completely. This is true because
banks are highly leveraged. A well capitalized bank is only required to have 6%
of their assets in core capital. It was estimated in 2008 that the residential
mortgage meltdown would cause credit losses of about $400 billion dollars. This
credit loss is about 2% of all U.S.
equities. This hurts the bank’s balance sheets because it impacts their 6% core
capital. To compensate, banks have to charge more for loans, pay less for
deposits and create higher standards for borrowers which leads to less lending.

Let’s
fast forward to November, 2009. Since February 2007, assets of all U.S. bank failures totaled a staggering
$483.3 billion with deposits totaling $326.1 billion. Through October 23rd, there have been 105 bank failures in 2009 with assets totaling $107.1 billion and at a cost to the FDIC's Deposit Insurance Fund
(DIF) of billions, the three
largest bank failures
being BankUnited with $12.8 billion in assets, Colonial Bank with $25 billion in assets and Guaranty Bank with $13
billion in assets. In 2008, there were 25 bank failures with assets totaling $373.6
billion. Washington Mutual Bank, which failed February 2008 and with assets
totaling $307 billion, is by far the largest US bank failure in recent history.

Today
the FDIC’s Deposit Fund is literally broke. To avoid borrowing from the US
Treasury, the FDIC is requiring health Banks to pay in advance three years of
deposit insurance incrementally to recapitalize the fund. Query: will this strategy
work?

Since
2007, 29 Credit Unions have either failed or entered into Conservatorships with
their regulators. The write-downs at major banks exceed $1.5 Trillion as follows: Wells Fargo- $138.6B; Goldman Sachs- $129.0B; Morgan Stanley-
$121.0B; SunTrust- $2.0B; JP Morgan Chase & Co- $221.7B; US Bancorp- $3.0B;
Bank of America $9.0B; Fifth Third Bancorp- $3.5B; Citigroup- $309.7B; UBS-
$228.6B; Credit Suisse- $94.5B; BNP Paribas-
$10.4B; Commerzbank- $32.1B; Mizuho MFG- $5.5B; Mitsubishi Financial Group-
$760B; CIBC- $10.7B; Bank of Montreal- $1.2B; Deutsche Bank- $68.0B; Societe
Generale- $30.1B; HSBC Bank- $27.7B; Barclay’s PLC-
$15B; Royal Bank of Canada- $1.4B; Bayern LB- $9.8B; WestLB AG- $4.8B; Natixis-
$3.4B; Credit Agricole SA- $13.8B; Bank of NY Mellon- $118M; Sovereign Bancorp-
$1.580B;  DZ Bank AG- $2.1B; HSBC- 26.5B.

According
to CNN.com as of October 31, 2009
nearly a fifth of U.S.
borrowers owe more on their mortgages than their homes are currently worth.
This is over 7.5 million homeowners. 10 major markets have seen home values
fall 17.7% over the past 12 months, and experts expect the declines to
continue. Third quarter foreclosure numbers saw a sharp rise compared to last
year; in September, 81,312 homes were repossessed by lenders. The sales pace of
new homes was the lowest since January 1991 as prices hit a four-year low and
inventory remains high.

According
to Freddie Mac and Fannie Mae officials the housing market is not expected to
recover until some time in 2011. There are similar predictions for the
commercial property market. According to the US Department of Labor Bureau of
Labor Statistics over 10.4 Million US workers are unemployed. The New York
Times states this is a 16 year high  record for job losses. But the number of unemployed
people may be vastly higher because of the methodology used to calculate this
statistic does not count all of the people that have just given up looking for
a job.

Why did this happen? Some people believe it was because of fraud; others
believe it was greed. It probably involved both fraud, greed, and unreasonable
expectations of purchasers of real estate who thought price could only go up
and variable rate mortgages would somehow be affordable when rates were
adjusted.

Once
upon a time after the great depression of the 1930’s a new national banking
system was created. Banks were required to join to meet high standards of
safety and soundness. The purpose was to prevent future failures of banks and
to prevent another disastrous depression. Savings and Loans (which still exist
but call themselves “Banks” today) were created primarily to lend money to
people to buy houses. They took their depositor’s money, lent it to people to
buy homes and held these loans in their portfolio. If a homeowner failed to pay
and there was a loss, the institution took the loss. The system was simple and
the institutions were responsible for the building of millions of homes for
over 50 years. This changed drastically with the invention of the secondary
market, collateralized debt obligations which are also know as collateralized
mortgage obligations.



Our government created the Government National Mortgage Association (commonly
known as Ginnie Mae) and the Federal National Mortgage Association (commonly
known as Fannie Mae) to purchase mortgages from banks to expand the amount of
money available in the banking system to purchase homes. Then Wall Street firms
created a way to expand the market exponentially by bundling up home loans in
clever ways that allowed originators and Wall Street to make big profits. The
big stock market firms were securitizers of mortgage-backed securities and
resecuritizers who sliced and diced different parts of the groups of home loans
to be bought and sold in the stock market based on prices set by the market and
market analysts. Home loans, commercial loans, and even rights to music
portfolios were packaged as securities, and bought and sold like stocks and
bonds.



In the quest to do more and more business, the standards to get a loan were
lowered to a point where, at least in some cases, if a person wanted to buy a
house and could assert they could pay for it they received the loan. They paid
a little bit more than borrowers that could document income for this privilege.
Borrowers with weak or poor credit histories were able to get loans. These
loans cost the borrowers a little more and the loans were called “subprime”.
Some people believed that this higher rate would compensate for the additional
risk. There was little risk to the lender because unlike the earlier days when
home loans and commercial loans were held in their portfolios, these loans were
sold and if the loans defaulted the investors or purchasers of these loans
would take the losses i.e. not the bank making the loan. The result today is
tumult in our economy from the mortgage meltdown which has disrupted the
overall financial system and affects all lending in a negative way. When Ginnie
Mae and Fannie Mae declared they were bankrupt this year, the US Government
bailed them out with TARP funds.

According
to a CBO report TARP allows the United States Department of the Treasury to
purchase or insure up to $700 billion of "troubled" assets.
"Troubled assets" are defined as "(A) residential or commercial
mortgages and any securities, obligations, or other instruments that are based
on or related to such mortgages, that in each case was originated or issued on
or before March 14, 2008, the purchase of which the Secretary determines
promotes financial market stability; and (B) any other financial instrument
that the Secretary, after consultation with the Chairman of the Board of
Governors of the Federal Reserve System, determines the purchase of which is
necessary to promote financial market stability, but only upon transmittal of
such determination, in writing, to the appropriate committees of
Congress."

 Unfortunately the pendulum for risk rating
loans has turned into an extremely risk averse posture. It is very difficult to
get a loan from a bank today. Compounding the economic nature of our problems
there is the force of the Federal Regulators, such as the Office of Thrift
Supervision and the Federal Deposit Insurance Corporation breathing down the
necks of the Boards of Directors of all banks and second guessing their loan
decisions.

For
instance, an attorney was putting 70% down to purchase a home with a small
rental cottage in the back yard. This breaks a rule of Freddie and Fannie so he
must go to a local lender, and pay a higher rate to purchase the property. If
you want a loan on a hotel or a gas station most lenders will categorically say
“no”. The facts are simply ignored. Under the premise that many appraisers were
not honest the appraisal rules have been changed. For banks today they must
select an appraiser from a pool of appraisers, many of whom are unfamiliar with
the local areas of real estate that they are appraising. In many cases
competent, honest appraisers are being replaced by a system that selects less
competent appraisers.



Who is responsible for this situation? All loan originators, including banks,
are responsible for turning a blind eye to loans that were based on poor credit
criteria. Under the label of “subprime” loans there were low documentation
loans, no documentation loans and very high loan to value loans- many of which
are the foreclosures we read about on a daily basis. Wall Street is responsible
for pumping this system into a financial disaster that may grow from the old
$400 billion dollar estimate to many trillions of dollars. Realtors, mortgage
brokers, home buyers and speculators are responsible for their willingness to
pay higher and higher prices for homes on the belief that prices would only go
higher and higher. This basically fueled the system for the mortgage meltdown.
In today’s global economy these interconnections have negative effects
worldwide.



Are there any similarities regarding today’s woes to the saving and loan crisis
of the 1980’s? Between 1986 and 1995 Savings and Loans (S&L’s) lost about
$153 billion. The institutions were regulated by the Federal Home Loan Bank
Board and the Federal Savings and Loan Insurance Corporation. These entities
passed laws that required the S&L’s to make fixed rate loans only for their
portfolios. The rates that could be charged for these loans were determined by
the marketplace. Imagine an institution with $100 million in loans at 6% to 8%.
For years the interest rates on deposits were also regulated by the government.
The interest rate spread between the two allowed institutions to make a small
profit.



In 1980 the U.S. Congress passed the Depository Institutions Deregulation and
Monetary Control Act of 1980 (DIDMCA). A committee was established in Congress.
Over a period of years the committee deregulated the rates S&L’s could pay
on savings. Nothing was changed with respect to what could be charged for home
loans. Many institutions started to loose huge amounts of money because they
had to pay market rates of 10% to 12% for their savings, yet they were stuck
with their old 6% to 8% loans. Some executives in the savings and loan business
referred to this committee as the damned idiots in Washington.



Many books have been written about these events. There is documented evidence
of substantial wrongdoing by S&L executives who were trying to invest funds
to save their institutions, sometimes for personal gains. Some were
sophisticated criminals. Congress recognized their mistake in 1982 when the
Garn-St.Germain Depositary Institutions Act was passed to allow S&Ls to
diversify their activities to increase their profits. It also allowed S&L’s
to make variable rate loans. It was too little too late. After bankrupt
institutions were liquidated by the government, the surviving S&Ls were
assessed billions of dollars by the Federal Deposit Insurance Corporation to replenish
the fund that insures the depositors of all U.S. banking
institutions. Deja vu in 2009.

The mortgage meltdown and the savings and loan crises are similar with regard
to the presence of greed and criminal activity. They are very different with
respect to the fact that the S&L crises originated from a broken government
mandated regulatory system and the mortgage meltdown has been caused primarily
by a system that went wild with greed, especially on Wall Street. It is
incredible that in 2009 Billions of dollars of bonuses will be paid again to
executives on Wall Street in light of the economy’s current situation.



This has impacted non-bank lenders such as private commercial finance companies
that provide hard money real estate loans, purchase order financing and
accounts receivable financing. Most of these firms have raised their prices and
their origination standards for safety and soundness of operations. The largest
non-bank lender, CIT, is
expected to declare bankruptcy next week. Over 150,000 people and entities will
cast ballots to determine CIT’s fate. CIT has $65B
in debt and they clearly are in trouble. CIT finances
about 1 million business clients who may be adversely affected by a CIT
Bankruptcy.



The bottom line: Bank lending can be replaced by other, more expensive, sources
such as venture capital and commercial finance companies to some degree. A
limitation is that many commercial finance companies are financed by banks. The
world of money is interrelated. Hard money, purchase order financing and accounts
receivable financing will help some businesses grow during these difficult
times. But for the average borrower, businessman, or business owner these are
difficult economic times, caused in large measure by the mortgage meltdown,
which are here to stay for several more years.



Copyright © 2009 Gregg Financial Services

By: Gregg Elberg

 

Banks and borrowers are hurting big time today. Of course
there are a few exceptions. But for the most part that fact is that it is not a
good time to be in banking or to need a loan. How can this be true when the US
Treasury has recently given billions of dollars to the banks and is encouraging
them to lend?

 

From the Banks’ point of view, every loan they make is
closely scrutinized by their regulators. While this is nothing new in concept,
the level of second guessing is extreme. There is a very good reason why. Over
100 banks have failed this year. The Bank insurance fund legally is mandated to
keep a reserve of 1.15% of all bank deposits; the reserve is down to .22%. This
is why the Federal Reserve is suggesting that all banks pay three years of
insurance premiums in advance, to bolster the federal insurance fund to protect our savings.

 

Banks are under great pressure to get rid of their Real
Estate Owned; this is a regulatory term for bad loans wherein the bank has
taken the real estate back one way or another. Recently in Marin County, CA a
supposedly “Top Rated Bank” was issued a cease and desist order by the Federal
Deposit Insurance Fund to either get rid of all of their REO over one million
dollars or get out of business by merger or otherwise. It is an open question
whether Tamalpais Bank will make it or not; two of their top people have
defected to a competitor.

 

Another Bank in the region, The Exchange Bank, had their
first loss in their 100 years of operation: over one hundred million dollars. Ouch!

 

A very successful real estate developer recently had a very
nasty surprise from their lender: reduce your loans by $1.5 million dollars or
we will not renew your $6.5 million dollar loan- and the loans were current. In
essence the banking crisis is pushing the developer towards bankruptcy, which
are at all time historic highs.

 

A hotel developer contacted Gregg Financial Services because
of cost overruns on a project in Wisconsin
the bank was holding back $2 million of agreed upon construction funds. They
need another $1.5 million dollars or the project will be in legal proceedings.

 

The residential market is getting worse because home prices
continue to fall across the country and foreclosures have not abated; moreover,
banks are making it harder than ever to get a loan to purchase a house if you
do not have all cash.

 

In the commercial real estate market prices are falling as
rents are falling and vacancies are growing. This is a trend that is
increasing.

 

If all of the above were not bad enough, by any objective
standard, many cities, many states and the USA
in particular are technically bankrupt because they do not have the current
cash to pay their bills. Firehouses and public services are closing as we fail
to curtail spending on wars in far away lands that are diverting the Nation’s resources
from regular American citizens.

 

The bottom line: All of these negative trends filter down to
the average American and their institutions; the prospects for 2010 are
probably much worse than we have today. This includes alternative financing such as purchase order
financing and accounts receivable financing because a weak economy generates
less purchasing power and less need for financing goods and services in the short run.

 

© 2009 Gregg Financial Services

 

By: Gregg Elberg

 

The signs are everywhere, but they are not the type of signs
you would hope to see if the economy is starting to recover. Take a look at the
main street in you town. Do you see more “Going out of Business”, “For Sale” or
“For Rent” signs that normal?

 

It is fair to say that in most areas such is the case. Does
this mean that it is easier to buy a building or a house? Unfortunately this is
not true because banks are very reluctant to lend to anyone except the very
best creditworthy people and companies. The old maxim seems to ring true: the
only people who can get a loan are those who do not really need a loan.

 

Does this mean it is an easy time for Banks? 85 have failed
this year and there will be more failures. Recently a local Bank was praised by
an independent rating service and one of the very best; this week they received
a cease and desist order from the Federal Deposit Insurance Corporation to eradicate
all lending losses over one million dollars within a very short period of time,
or merge with a stronger institution, or go out of business. Another one
hundred year old bank in the community suffered their first loss in their
history, and it was a whopper: one hundred million dollars.

 

Gregg Financial Services talked to a local realtor that
specializes in helping banks and Freddie Mac and Fannie Mae dispose of
foreclosed properties? Has the marked improved? Frankly his market is booming
with disaster: 28 foreclosed homes in escrow, 32 foreclosed homes in escrow,
and 35 foreclosed homes that he has given pricing estimates of value to get the
listings. It is almost nine million dollars worth of properties in escrow;
about $142,000 in value each.

 

In Marin County, CA
where I live we have witnessed three of the larges foreclosures in the history
of the county- all in a range of $50 to $75 million dollars. One local shopping
center is about 80% empty in the retail areas.

 

Two other banks in our area are dark because their parent
corporations have failed. Five auto dealerships have gone out of business. The
San Francisco Chronicle itself is facing bankruptcy. It predicts that the upper
end of the housing market will be the next area of concern and losses. Many
commercial real estate projects are in similar predicaments.

 

The bottom line: the mortgage meltdown is continuing and the
situation is getting worse.

 

© 2009 Gregg Financial Services

 

 

Asset-based Lending In The Current Market Place

 

By: Pauline Renaud

 

In the current financial environment, obtaining traditional
bank funding on favorable terms remains a challenge for most businesses.
Consequently, an increasing number of companies are looking at alternative
options, such as asset-based lending (ABL),
to secure financing. The renewed appetite for this form of lending is the
result of several factors, including the lower-risk profile it presents for
both lenders and borrowers, compared to other financing facilities. ABL
however has its own issues, such as valuation and monitoring, which need to be
managed early in order to limit potential risks. This is particularly
important, as ABL is expected to become the
mainstream and preferred source of lending for businesses going forward.



Driving forces behind ABL
activity



Most lending activities have been affected by the current crisis, including
asset-based lending. But unlike the majority of credit facilities, ABL
provides several benefits to both lenders and borrowers, and is therefore
faring better.

 

The increase in asset-based lending activity has been
particularly noticeable over the last two years, due to the lack of cash flow
financing during the crisis. In the meantime, new lenders have started
appearing on the ABL market as the
competition has thinned out. These different factors allow the ABL
market to cover a wide range of companies and sectors. “Given the spectrum
within the market, putting aside the exceptional times of last autumn and the
beginning of this year, asset-based lending is generally always active to one
degree or another. But the specific segments of the market that may be the most
active shift depending on larger economic forces,” asserts David W. Morse, a partner at Otterbourg, Steindler,
Houston & Rosen, P.C. “Obviously, there has been a significant
drop off in the large, sponsor-driven acquisition financings, particularly
those where the asset-based component was only a small part of a complex
capital structure involving other bank and capital market debt products.”



But other parts of the market have witnessed vibrant activity, as confirmed by Paul Beveridge, a managing director
of KBC Business Capital. “There is a generally lower level of demand
for some applications of ABL. However, there
is still a strong demand for refinancing and restructuring, as companies and
advisers are turning to ABL as an available
and committed source of finance – as opposed to on-demand overdraft financing,”
he says. The refinancing of corporate debt with asset-based loans has indeed
experienced an up-tick, particularly in the second quarter of this year, due to
the large number of companies struggling under heavy debt burdens.



Several experts have also noted that asset-based lending has been busy in the
area of ‘amend and extend’ for existing asset-based facilities, as part of a
broader restructuring of a business’s capital structure. Some exit financings
by companies seeking to emerge from bankruptcy protection, and
debtor-in-possession (DIP) financings for companies in Chapter 11, have also
become more common, given the large number of businesses collapsing. “In
addition, fewer companies are making a profit, and are therefore remaining
asset-based borrowers for much longer than in the past. Indeed, many borrowers
used to be profitable enough to be considered ‘bankable’ and transitioned to
conventional banking versus remaining asset-based lending borrowers. This is no
longer the case,” points out Donald F. Clarke, president of
Asset Based Lending Consultants, Inc.



Besides the current crisis, and the subsequent lack of financing, one of the
main drivers encouraging the recourse to ABL
has been its flexibility, availability and attractive pricing, compared to
other types of funding. But the credit crunch has also made banks more wary of
lending money, making them turn to ABL,
which is considered to be a safer credit facility, says William S. Veatch, a partner at Morrison & Foerster
LLP. “In the pre-recession era, there was a trend towards ‘covenant
light’ credit agreements and loose collateral arrangements, giving the borrower
complete control over its business. In the current recession, lenders are
reverting back to fully-secured, asset-based loans where the lender has
airtight protection vis-à-vis the collateral, and a significant voice in the
event that there are early warning signs of trouble in the borrower’s business.
The recession has necessitated a return by lenders to stricter credit
underwriting requirements,” he adds.



Seizing opportunities, avoiding pitfalls



Asset-based lending is particularly recommended in some sectors or for certain
types of companies, such as capital intensive businesses with assets that can
be leveraged to provide working capital. Companies with assets that
specifically encourage ABL funding are
concentrated in the manufacturing, retail and distribution sectors, but also in
the services industry. Types of assets usually include stocks or inventory,
plant and machinery, property, as well as brands and intellectual property,
given the fact there is a greater certainty regarding their valuation in terms
of recovery. But some experts insist most categories of assets can allow a
business to find credit in the form of an asset-based loan, as every company
has receivables.



But ABL is not only being used solely by
struggling companies – it can also be a positive tool for taking advantage of
opportunities in the market. “In addition, companies experiencing strong growth
with limited capital investment look to asset-based lending to provide the
working capital they need to fuel expansion,” adds Mr Clarke. Some businesses
operating in specific sectors are pursuing this type of lending in particular,
as part of a broader investment strategy. “The recession has created
significant buying opportunities across all industries, for businesses to
complete strategic acquisitions of their competitors at an attractive price,”
explains Mr Veatch. “Asset-based loans can be an invaluable tool for completing
such an acquisition financing. Opportunities exist in all industries, including
the technology sector, where the assets consist largely of intangible
intellectual property rights.”

 

The other benefits of ABL
for borrowers include the fact that it provides a revolving line of credit
attached to asset values. In other words, the borrower can use the facility
only when needed and pay it back when money is available. “Also, ABL
represents a source of funding that will grow in line with sales. This can be
an advantage as the recession ends, due to the fact that ABLs are well placed
to support increased working capital needs, unlike other funders,” asserts Mr
Beveridge. The financial resources of the borrower will also be affected less
by a slowdown in business. For lenders, the ABL
borrower is usually a long-term client that provides steady revenues. It also
represents funding linked to collateral values, which can be monitored. The
lender gets information, on a regular basis, regarding the borrower’s
situation, and can therefore react quickly if issues arise, explains Mr Morse.
“The reporting and monitoring of the borrower and its assets provide the lender
with a basis for better understanding its risk and being proactive in dealing
with such risks.

 

 

The Factoring Business: How Times Have Changed

By Harold I. Dundish, Senior Vice President and Division Manager for IDB
Factors, a division of IDB Bank

The landscape of the factoring business has
evolved over the past several decades. What started as family-owned businesses
buying account receivables from mills and manufacturers has turned into a
multi-billion dollar business with the entrance of banks into the market in the
late 1960s and early 1970s.



When family-owned businesses controlled a good portion of the factoring market, lending rates and commission rates were
at reasonable levels and there were no fees because the profits generated were
very good. Soon enough, the banks wanted a piece of the factoring
pie. It was a good service offering for larger lenders to add to their
financial portfolio. But the playing field changed once the banks started
offering factoring as they reduced all rates, making
it more challenging for the other players.



However, the banks began to feel the risk of the factoring
business and wondered whether it was worth the reward. In the 1960s and 1970s,
bankruptcies were considered an embarrassment - unlike today where it is
just a normal course of business. Companies were also declined for credit or
were given terms of net 10 days at most when the factors requested financial
statements in cases involving pledged inventory. Any company with a deficit in
working capital was declined or restricted on credit extension.



Textile business booming



Although the banks encountered the risks of the factoring
business, there were still many opportunities as the textile and apparel
manufacturing businesses thrived in the United
States.



In the early 1970s, there was a constant change in the type of machinery
technology used to produce and improve fabrics, specifically in the southern
part of the country. Double knits were very popular and many businesses could
sell contracts for Bentley double-knit machines at big profits to other
manufacturers. Acetate yarn was also a highly desirable commodity at that time
as well, due to the popularity of sweaters.



"Factor vs. commercial corp."



Visits to customers were made more often because the customers were mostly
non-public companies, and many times, more credit was extended as a result of a
visit. Factors were called "factors" not "commercial
corporations" or "trade finance companies." The name has changed
over the years because "factoring" in other
industries is associated with troubled firms that need financing, and factors
wanted to develop other industries for their product, hence the reason for the
change.



Factoring evolves



Today the industry has witnessed significant changes. For the most part, the
textile and apparel industry has moved overseas, primarily due to the lower
labor costs of producing garments and textiles in the United
States. Only a small percentage of garments
are made in the United States.
Some of the domestic production is done to facilitate quick turnaround for a
retailer; while in other cases, some manufacturers have captured a very
specific niche in the marketplace that is still possible to produce in the
States from an economic perspective.



In the past, the mills that sold to the manufacturer were the dominant part of
the factor's client base.



Today the manufacturer/importer is the factor's primarily client base and the
client's customer is the retailer. Wholesale factored volume is small. Overall,
in excess of $80 billion is factored in the U.S. Factoring
volume is still primarily comprised of apparel firms because this has always
been a very acceptable form of financing in this industry.



The factoring industry has consolidated
substantially, with the larger factors acquiring many smaller factoring firms. GMAC CF and CIT
Group are two factoring firms that have acquired many
other competitors over the years. The same is true for the retail industry, as
many have gone out of business or were acquired by others.



There are now "re factors" who are factors that give their credit,
collection and check processing functions to a larger, full service factor.
This allows the re factor to concentrate on its client base and new business
development while giving up a portion of its commission income to the
full-service factor for providing these services.



The biggest concern among factors today is their customer base - the retailers.
In the 1990s, Venture Capital firms would acquire large retail operations and
turn the balance sheet upside down. With good cash flow, there was a free flow
of credit from factors. However, in light of today's current economic climate,
there are large credit exposures on the consolidated retail customer base. As a
result, factors are in some cases restricting credit to these customers. This
is different from the situation several years back when factors were not as
concerned about the customer base as long as customer bad debts were at
acceptable levels. Today, factors are charging a premium for certain higher
risk retail customer credit exposures.



Factors are in an economy that they have never before experienced. With some of
the most reputable old-line household name firms getting into serious financial
difficulty, everyone is extra careful and diligent as they navigate through
these turbulent times.



Harold I. Dundish is senior vice president and division manager for IDB
Factors, a division of IDB Bank

 

CIT'S HEALTH 'FACTORS' INTO APPAREL FIRM'S SUIT

By JAMES COVERT

 

Fearing that a potential CIT bankruptcy
might devastate its business, at least one apparel firm has sued to end its
relationship with the troubled commercial-lending giant, The Post has learned.

Scherr Inc. -- a Livingston, NJ-based maker of men's casual clothing --
charges that "CIT's disastrous
financial situation creates grounds for insecurity" as the manufacturer
looks to recover cash for merchandise delivered to retailers, according to a
lawsuit filed this week.

If the lawsuit prevails in court, legal sources say CIT
could be hit with a deluge of similar complaints from skittish fashion
companies looking to flee to rival "factoring"
firms, which provide the credit that keeps inventory flowing to stores.

CIT -- whose factoring
unit is a linchpin for the fashion industry, financing more than 60 percent of
apparel deliveries in the US
-- in recent weeks has rebuffed legions of clients looking to sever their
contracts, sources said.

In an effort to soothe worries about its shaky finances, CIT
said last week it's extending $1 billion in cash advances and credit to
manufacturers and retailers, having cut a $3 billion financing deal with its
largest bondholders.

The announcement quelled the unrest among many CIT
clients.

"It's mostly business as usual this week," according to one
industry source, noting that CIT is
"buying new receivables and allowing people to draw down on credit
lines."

Sources said CIT likewise has moved to
accommodate some clients by amending contracts to protect their accounts from a
possible bankruptcy filing -- by placing receivables into a kind of escrow
account, for example. Still, CIT warned this
week it still may resort to bankruptcy protection.

In its lawsuit, Scherr alleges that CIT's
factoring unit recently admitted that the "poor
financial condition" of its corporate parent made it
"impossible" to extend new loans.

The suit, filed in New York State Superior Court is slated for a hearing
tomorrow.

 

Survey Report l August 2009
By Dr. John K. Paglia
Associate P rofessor of Finance
PEPPERDINE PRIVATE CAPITAL MARKETS PROJECT SURVEY
Pepperdine University’s Graziadio School of Business and Management recognizes that private
businesses account for over half of the gross domestic product and employment base of this country and
are extremely important to our economic future. The school established the Pepperdine Private Capital
Markets Project, and launched an ongoing research survey, to help private business owners and capital
providers make optimal investment and financing decisions.
The Pepperdine private cost of capital survey (PCOC) is the first comprehensive and simultaneous
investigation of the behavior of the major private capital market segments. The survey deployed in
March/April 2009, specifically examined the behavior of senior lenders, asset‐based lenders (ABLs),
mezzanine funds, private equity groups, and venture capital firms. The Pepperdine PCOC survey
investigated, for each private capital market segment, the important benchmarks that must be met in
order to qualify for capital, how much capital is typically accessible, what the required returns are for
extending capital in today’s economic environment, and outlooks on demand for various capital types,
interest rates, and the economy in general.
Our findings indicate that required returns vary significantly by capital type and risk assumed, with senior
lenders expecting 6.5%, asset‐based lenders demanding 11%, mezzanine funds requiring 18%, private
equity groups expecting 25%, and venture capital funds requiring 42%. This relationship is depicted
below in the Pepperdine Private Capital Market Line.
Figure 1: Private Capital Market Required Rates of Return
The results from our survey follow by category.
PEPPERDINE PRIVATE CAPITAL MARKETS PROJECT | SURVEY REPORT – AUGUST 2009
© PEPPERDINE UNIVERSITY GRAZIADIO SCHOOL OF BUSINESS AND MANAGEMENT. All Rights Reserved. | 2
ACKNOWLEDGEMENTS
Pepperdine University
Linda Livingstone
David M. Smith
Michael Sims
Douglass Gore
Jasmine Olikh
Yokesh Sivakumar
Thomas Didia
Yutao Tang
Michael Roth
Robertson and Foley
Robert T. Slee
Ralph Adams
Michael McGregor
Eric Williams
Survey Design and Distribution
Tim Rhine
Barry Yelton
John Graham
Everett Walker
Jeff Nagle
Samir Desai
Greg Howath
Mark Walker
Eric Nath
Richard J. Crosby
Private Capital Markets Class Speakers
Rob Slee, Robertson & Foley
Tim Rhine, PointeBreak Solutions
Brad Triebsch, Central Valley Fund
Greg Howath, Caltius
Jan Hanssen, PEM Group
Gary W Clark, Tech Coast Angels
Robert Zielinski, Riordan, Lewis & Haden
M. Todd Stemler, Caltius Mezzanine
Kevin D. Cantrell, Riordan, Lewis & Haden
Vanita Spaulding, Ceteris
David Sack, Sack & Associates
Other Support
Nevena Orbach
Leonard Lanzi
John Dmohowski
Gray DeFevere
Sarah Esperanza
PEPPERDINE PRIVATE CAPITAL MARKETS PROJECT | SURVEY REPORT – AUGUST 2009
© PEPPERDINE UNIVERSITY GRAZIADIO SCHOOL OF BUSINESS AND MANAGEMENT. All Rights Reserved. | 3
TABLE OF CONTENTS
BANK SURVEY INFO ................................................................................................................................ 5
Profile of Respondents ........................................................................................................................ 5
Lending Characteristics....................................................................................................................... 5
Outlook on Business Lending Market and Economy ........................................................................... 10
ASSET‐BASED LENDER SURVEY INFO ...................................................................................................... 13
Profile of Respondents ...................................................................................................................... 13
Lending Characteristics..................................................................................................................... 14
Outlook on Lending Market and Economy ......................................................................................... 17
MEZZANINE SURVEY INFO ..................................................................................................................... 21
Profile of Respondents ...................................................................................................................... 21
Lending Characteristics..................................................................................................................... 22
Outlook on Lending Market and Economy ......................................................................................... 28
VENTURE CAPITAL SURVEY INFO ........................................................................................................... 31
Profile of Respondents ...................................................................................................................... 31
Investment Characteristics ................................................................................................................ 33
Outlook on Venture Capital Market and Economy ............................................................................. 43
PRIVATE EQUITY SURVEY INFO .............................................................................................................. 47
Profile of Respondents ...................................................................................................................... 47
Investment Characteristics ................................................................................................................ 49
Outlook on Private Equity Market and Economy ................................................................................ 57
INDEX OF FIGURES AND TABLES............................................................................................................. 59
PEPPERDINE PRIVATE CAPITAL MARKETS PROJECT | SURVEY REPORT – AUGUST 2009
© PEPPERDINE UNIVERSITY GRAZIADIO SCHOOL OF BUSINESS AND MANAGEMENT. All Rights Reserved. | 4
PEPPERDINE PRIVATE CAPITAL MARKETS PROJECT | SURVEY REPORT – AUGUST 2009
© PEPPERDINE UNIVERSITY GRAZIADIO SCHOOL OF BUSINESS AND MANAGEMENT. All Rights Reserved. | 5
BANK SURVEY INFO
Profile of Respondents
The following responses pertain to our bank survey administered in March/April 2009. Our results are
based upon 78 responses to this survey. The respondents are geographically dispersed throughout the
United States.
Of the banks surveyed, 46% identified themselves as community banks, 42% as commercial banks and
12% as business banks.
Figure 2: Bank Type
Eighty‐five percent (85%) of these banks said they participate in government loan programs (i.e., SBA).
Figure 3: Government Loan Program Participation
Lending Characteristics
Over the four months prior to the survey, lenders report that 67% of all cash flow‐based loans were
ultimately booked. Sixty‐one percent (61%) of all collateral based‐loans, excluding real estate, were
booked, while 58% of all commercial real estate loans offered were booked.
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The most common motivation for securing lending was refinancing (44%) followed by the purchase of
equipment or buildings (17%). Working capital was also frequently cited as a reason for securing a loan.
Figure 4: Motivations for Loans
The most important factor for deciding whether to extend a loan or not is the debt service ratio.
Respondents gave it a 27% weight. Fixed‐charge coverage and availability of personal guarantees were
also cited as being very important (11%). Funded debt to EBITDA and management strength are
important factors as well, being given a 10% weight in the decision to extend credit.
Figure 5: Weight of Factors Considered When Extending a Loan
Banks also report various threshold ratios as being important when determining how much credit to
lend. Among these are fixed‐charge coverage, funded debt to EBITDA, debt service, and debt to net
worth.
Table 1: Critical Ratios When Extending Credit
Indicator Median
Fixed‐Charge Coverage (Min) 1.2
Funded Debt to EBITDA (Max) 3.0
Debt Service (Max) 1.25
Debt to Net Worth (Max) 3.0
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When lending is based upon assets, fair market value is used most often for equipment, real estate, and
marketable securities when estimating the amount to lend. Sixty‐one percent (61%) use fair market
value for equipment, 91% for real estate, and 88% for marketable securities. For equipment, 24% report
using purchase price as the key factor for determining the loan‐to‐value ratio.
Figure 6: Collateral Valuation Standards
Banks report the standard advance rates (or loan‐to‐value ratio) for each of the following types of
assets. Although low‐quality and intermediate‐quality inventory report the same advance rates, a
greater number of banks (85%) report making intermediate‐quality inventory loans, whereas just 25%
report making low‐quality inventory loans.
Table 2: Standard Advance Rates
Collateral Median
Low‐Quality Inventory 25%
Intermediate‐Quality Inventory 25%
High‐Quality Inventory 50%
Equipment 75%
Real Estate 75%
Land 50%
Cash Flow 80%
Marketable Securities 70%
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On their current deals, 30% of those who answered said that the approximate all‐in interest rate,
including spreads over prime and LIBOR, is 6.0% to 6.5%. Fifteen percent (15%) said that the rate is 7.0%
to 7.5%, and 9.0% said that the rate is 6.5% to 7.0%.
Figure 7: Rates Charged on Loans
Sixty‐two percent (62%) of respondents report using variable rate loans while 38% use fixed rate. For
variable rate loans, 45% reference prime while 26% reference LIBOR. Of those referencing LIBOR, nearly
47% use a one‐month rate as a reference, while 33% reference the three‐month rate.
Figure 8: Loan Pricing Reference Rates
The median loan term on booked deals is 60 months for equipment loans, 180 months for real estate
and 12 months for working capital.
Table 3: Loan Terms
Type Term (median)
Equipment 60 months
Real Estate 180 months
Working Capital 12 months
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Various loan covenants were attached to the loans. Of these, 49% of the time a limit on the level of
indebtedness was applied. Forty‐one percent (41%) of the time, a restriction was placed on earnings. A
debt to EBITDA covenant was applied approximately 36% of the time.
Table 4: Covenants Attached
Answer Average Value
Limits on Level of Indebtedness 49%
Limits on Distributions 33%
Limits on Management Compensation 6%
Positive Earnings 41%
Fixed‐Charge Coverage 34%
Debt to EBITDA 36%
Banks report varying levels of restrictiveness for popular covenants. Specifically, the median debt‐tototal
assets maximum is 3 times, while the minimum cash flow percentage is 125%. The minimum fixedcharge
coverage ratio is 1.2 times, and the maximum debt/EBITDA covenant is 2.75 times.
Table 5: Covenant Thresholds
Covenant Threshold (median)
Max Debt/Total Assets 3 times
Min Cash Flow Percentage 125%
Min Fixed‐Charge Coverage 1.2 times
Max Debt/EBITDA 2.75 times
Banks report that average returns over the prior five years of lending have ranged between 6.75% and
7.3% (medians). The highest returns have resulted from working‐capital lending, while real estate
lending has produced the lowest returns (6.75%).
Table 6: Historical Returns (5year)
Type Return
Real Estate 6.75%
Working Capital 7.30%
Equipment 7.00%
C&I 7.00%
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Banks also regularly charge various fees. The median closing fee is 1%, modification fee is 1%,
commitment fee is 1%, and prepayment penalties vary in accordance with time. In addition, unused line
fees are 0.25%. Other fees regularly charged include audit fees and attorney’s fees when relevant.
Outlook on Business Lending Market and Economy
Over the next 12 months, 45% of those surveyed believe that the prime interest rate will increase, while
52% believe those rates will stay the same. For LIBOR interest rates, 61% believe they will increase,
while 30% believe those rates will stay the same. Forty‐two percent (42%) believe that credit spreads
will increase, while 27% believe they will stay the same, and another 27% believe they will decrease.
Figure 9: Interest Rate Forecast (12month)
The majority of the banks (61%) said that they believe that the demand for loans in general will increase
over the next 12 months.
Figure 10: Demand for Loans Forecast (12month)
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Over the next 12 months, most lenders believe that lending in general will become more restrictive
(46%) or stay about the same (39%). Only 15% felt that lending will become less restrictive.
Figure 11: Lending Restrictiveness Forecast (12month)
Forty percent (40%) of those surveyed believe that the Gross Domestic Product (GDP) will stay the same
over the next 12 months. Of the 30% that believe the GDP will increase, 50% believe it will only increase
by 1% to 2%. Of the 30% that believe it will decrease, 60% believe it will only decrease by 1% to 2%.
Overall the median expectation is ‐1.6%.
Figure 12: GDP Outlook Forecast (12month)
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ASSETBASED
LENDER SURVEY INFO
Profile of Respondents
The following responses pertain to our asset‐based lender (ABL) survey administered in March/April
2009. Our results are based upon 69 responses to this survey. The respondents are geographically
dispersed throughout the United States.
Of those surveyed, only 32% said they were regulated by the Federal Deposit Insurance Corporation
(FDIC).
Figure 13: FDIC Regulation
Asset‐based lenders generally segment themselves in the various tier types. Approximately 35% of ABLs
in the survey are Tier 1, meaning they generally lend amounts greater than $10 million. Approximately
28% classify themselves as Tier 2, as they lend between $3 and $10 million. The final group (37%) serves
the smaller market.
Figure 14: ABL Tier Type Distribution
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Lending Characteristics
Of those active in offering asset‐based loans over the prior four months, the median number of
operating asset‐based loans offered was 6. The conversion rate on these was approximately 33%. For
real estate loans, the median number booked was 1 based upon 5 offered.
Table 7: Offered and Booked Loans (median)
Offered Booked Hit Rate
Operating Asset 6 2 33%
Real Estate 5 1 20%
Refinancing topped the list for borrowers’ motivation for obtaining an asset‐based loan (53%) over the
past four months. Acquisitions were cited as the next most frequent motivation (22%) followed by
financing growth (12%).
Figure 15: Loan Motivations
The following standards were cited when deciding whether to lend or not. They included fixed‐charge
coverage (minimum of 1.0), funded debt to EBITDA (maximum of 4.25 times) and debt service ratio
(minimum 1.2 times).
Table 8: Critical Ratios When Extending Credit
Indicator Median
Fixed‐Charge Coverage (min) 1.0
Funded Debt to EBITDA (max) 4.25
Debt Service Ratio (min) 1.2
When their firm calculates the standard advance rate (or loan‐to‐value ratio) for a particular real estate
asset, 60% of those surveyed said they estimate the loan‐to‐value ratio by using fair market value. For
accounts receivable, 52.5% said they use face value. Approximately 69.7% said they use a method other
than those listed below when estimating the loan‐to‐value ratio for equipment, while 38.9% claim
“other” as the primary determinant of value of inventory. A large component of this category is likely
associated with orderly and distressed liquidation values.
Table 9: Methods Used to Value Assets
Purchase Book FMV Face Other
Equipment 0.0% 12.1% 18.2% 0.0% 69.7%
Inventory 5.6% 13.9% 22.2% 19.4% 38.9%
A/R 7.5% 10.0% 10.0% 52.5% 20.0%
Real Estate 5.7% 0.0% 60.0% 0.0% 34.3%
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Figure 16: Methods Used to Value Assets
Advance rates vary by type of collateral. The median of accounts receivables advance rates is 85%, while
marketable securities follow closely behind at 80%. The median advance rate response for low‐quality
inventory is 22.5%.
Table 10: Lending Advance Rates (median)
Accounts Receivable 85.0%
Inventory – Low quality 22.5%
Inventory ‐ Intermediate quality 35.0%
Inventory – High quality 55.0%
Equipment 67.5%
Real Estate 65.0%
Land 50.0%
Firm's Cash Flow 65.0%
Marketable Securities 80.0%
Eighty percent (80%) of the time, loans are variable rate. Forty‐six percent (46%) of the time, loans are
priced by referencing prime, while 48% of the time the reference rate is LIBOR. Interest rate spreads
vary dramatically by lender ranging from prime plus 0.5% to prime plus 16%. LIBOR spreads, used more
frequently by larger organizations and based upon a 3‐month rate most often, range from LIBOR plus
3.5% to LIBOR plus 6%. The medians are as follows:
Table 11: Median Rate Spreads
Index Spread (%)
Prime Spread 3.50%
LIBOR Spread 3.75%
The loan terms varied significantly by asset type. Equipment loans ranged from 24 to 72 months, real
estate loans ranged from 12 to 240 months, and working‐capital loans ranged from 12 to 60 months.
The medians are reported below:
Table 12: Loan Term by Collateral
Type Months
Equipment 60
Real Estate 60
Working Capital 36
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The most common financial covenant is the limit on distributions (85.3%), followed by limits on level of
indebtedness (78.8%) and fixed‐charge ratio (75.9%). The median fixed‐charge ratio threshold was 1.1
times and the median debt‐to‐EBITDA ratio was 4.5 times.
Table 13: Covenant Frequency
Covenant Frequency
Limits on Level of Indebtedness 78.8%
Limits on Distributions 85.3%
Limits on Management Compensation 42.3%
Positive Earnings (pretax income/sales) 48.0%
Fixed Charge 75.9%
Debt to EBITDA 52.2%
Fees are also very common on asset‐based loans. Closing fees ranged from 0.5% to 4% of the loan
amount, modification fees from 0.1% to 3%, commitment fees from 0.5% to 1.5%, collateral monitoring
fees from 0.1% to 12%, unused‐line fees from 0.25% to 1%, audit fees from $750 per person per day to
$1,000 per person per day, and attorneys’ fees generally at cost. Other fees cited include insurance,
annual fee, and due diligence fees.
As for all‐in rates, they varied significantly by type of asset and size. The highest rates were charged on
working‐capital assets, followed by equipment loans. The rate ranges are reported below.
Table 14: Rate Ranges (current)
Asset Rates
Real Estate 4.75‐18%
Working Capital 5.00‐36%
Equipment 5.25‐19%
C&I 5.25‐14%
For business loans being booked currently, 39% of those surveyed said that 7.5%‐15.0% is the all‐in rate
that the borrower will pay for the loan (expressed on an annualized basis), while another 39% said those
same rates are 0‐7.5%, and 22% said the rates were greater than 15%. The median rate reported is
11.0%.
Figure 17: AllIn
Rates Being Booked Currently
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The median realized returns for booked deals over the past five years range from 8% to 18%. Workingcapital
returns were cited as being the largest (18%), followed by equipment loans (12%).
Table 15: Realized Rates of Return
Loan Type Rate
Real Estate 8%
Working Capital 18%
Equipment 12%
C&I 8%
Of those surveyed, 53% report that they do not use a risk‐adjusted return on capital (RAROC) model to
assess performance.
Figure 18: RAROC Usage
Outlook on Lending Market and Economy
The majority of asset‐based lenders believe that interest rates for asset‐based loans will increase over
the next 12 months. Of those surveyed, 62% believe the prime rate will increase, 65% believe LIBOR will
increase, and 56% believe credit spreads will increase.
Figure 19: Interest Rates Forecast (12month)
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Almost all those surveyed (97%) believe that the demand for asset‐based loans in general will increase
over the next 12 months.
Figure 20: Demand for AssetBased
Loans Forecast (12month)
Fifty‐six percent (56%) believe that asset‐based lending in general will stay the same, and 35% believe it
will become more restrictive.
Figure 21: Lending Restrictiveness Forecast (12month)
Sixty‐two percent (62%) of the respondents believe that the Gross Domestic Product for the United
States will decrease over the next 12 months.
Figure 22: GDP Forecast (12month)
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Of the 12% who believe the GDP will increase, 75% believe it will only increase by 1‐2%.
Figure 23: Distribution of GDP Forecast (increase)
Of the 62% who believe the GDP will decrease, 48% believe it will only decrease by 1‐2%, but 33%
believe it will decrease by 2‐5%.
Figure 24: Distribution of GDP Forecast (decrease)
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MEZZANINE SURVEY INFO
Profile of Respondents
The following responses pertain to our mezzanine capital survey administered in March/April 2009. Our
results are based upon 39 responses to this survey. The respondents are geographically dispersed
throughout the United States.
Of those surveyed, 68% identified their firm as a small business investment company (SBIC).
Figure 25: SBIC Classification
Fifty percent (50%) of the respondents reported that the typical size of their investment in any one
company is $5M‐$10M, and 36% say the typical size is $1M‐$5M.
Figure 26: Typical Investment Sizes
Mezzanine capital providers indicate that 48.4% of their deals are sponsored, which means they join a
private equity group in the deal. Just 27.6% of deals are non‐sponsored.
Figure 27: Frequency of Sponsored Deals
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Lending Characteristics
Approximately thirty percent (30.24%) of those who answered said that their booked deals are with
straight interest, while 55% said that their deals include interest plus free warrants.
Figure 28: Deal Structure
Eighty‐six percent (86%) reported that their division or firm receives most of its compensation from
coupon payments.
Figure 29: Compensation Distribution
Mezzanine capital providers issued a wide range of proposal letters over the past four months. The
largest concentration issued was in the 2 to 5 category (45%) while 16% issued fewer than two. The
median reported was four.
Figure 30: Proposal Letters Issued
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Forty‐five percent (45%) said that their firm has booked one or fewer mezzanine loans over the last four
months while 23% indicated booking more than three loans. The median number booked was 2, which
indicates a median hit rate of approximately 50%.
Figure 31: Bookings
Over the last four months, 33% said that refinancing was the motivation for the borrower to secure
mezzanine capital while 23% indicated acquisition purposes, and 22% report financing growth as the
primary reason.
Figure 32: Motivations for Funding
Management strength (35%), business risk (26%) and financial risk (25%) were reported to be the most
important factors when determining whether to extend credit or not.
Figure 33: Important Factors When Extending Credit
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Of the factors important to consider when deciding whether to extend a loan or not, total debt to
EBITDA (45%) was weighted as being the most important factor followed by fixed‐charge coverage (31%)
and senior debt to EBITDA (16%).
Figure 34: Important Financial Factors
On a pre‐funding basis, when regarding financial risk, survey respondents report that the median
threshold for total debt to EBITDA is 3.75 while the maximum senior debt‐to‐EBITDA ratio is 2.5. The
minimum fixed‐charge coverage ratio is 1.2 (median).
Table 16: PreFunding
Financial Thresholds
Parameter Median
Total Debt to EBITDA (max) 3.75
Senior Debt to EBITDA (max) 2.5
Fixed‐Charge Coverage (min) 1.2
Regarding business risk, when deciding to extend a loan or not, historical operating performance was
determined to be the most important factor (23.4%) followed by customer concentrations (19.7%) and
future prospects of company (17.2%).
Figure 35: Business Risk Factors
When determining whether to provide capital, mezzanine providers identify $10,000,000 in sales
(median) as the minimum size company for consideration, providing it is exhibiting a minimum sales
growth rate of 5%.
Table 17: Size and Growth Requirements
Parameter Threshold
Minimum Firm Size $10,000,000
Minimum Sales Growth Rate 5%
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When determining the maximum amount of capital to extend, mezzanine capital providers cite the
following important thresholds. In particular the most frequently cited ratio of capital‐to‐cash flow
metric is 4.0 times while the maximum allocated to senior debt is 2.5 times. Capital providers also cite a
minimum fixed‐charge coverage ratio of 1.2 times.
Table 18: Financial Ratio Thresholds
Parameter Median Ratio
Maximum Multiple of Recast EBITDA 4.0
Maximum Multiple of Operating Cash Flow 4.0
Maximum Total Debt to EBITDA 4.0
Maximum Senior Debt to EBITDA 2.5
Minimum Fixed‐Charge Coverage 1.2
Approximately 47.8% of respondents report charging a coupon interest rate of 12‐13% while 43.4%
report charging a rate that exceeds 13% on capital extended. The median rate reported in the survey
was 13%.
Table 19: Coupon Rate Distribution
Coupon Percent
10‐11% 8.8%
12‐13% 47.8%
14‐15% 21.7%
16‐17% 21.7%
The most frequent loan term reported is 60 months. Approximately 64% of all survey respondents
report extending capital for a 60‐month term. Just 18% of respondents report shorter loan terms than
60 months and the same frequency is reported for terms greater than 60 months.
Figure 36: Loan Length Distribution
Mezzanine capital providers monitor firms in a variety of ways. While all survey respondents report
requiring board observation rights and required audited financials, just 38% take a seat as a board
member. Nearly 96% report requiring monthly financial statements and perform regular covenant
testing to ensure compliance.
Table 20: Monitoring Activity Frequency
Board
Mem
Board Observation
Rights
Mentoring
Key Mgr
Required Audited
Financials
Monthly
financials
Regular
Covenant Test
Yes 38.1% 100.0% 66.7% 100.0% 95.8% 95.8%
No 61.9% 0.0% 33.3% 0.0% 4.2% 4.2%
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Figure 37: Monitoring Activity Frequency
Loan covenants are utilized to restrict certain behaviors and accelerate the loan in the event of default.
Over 90% of respondents cite regular use of covenants related to maximum debt (95.8%), dividends and
distributions (100%), change in control (95.7%), fixed‐charge coverage ratio limits (95.8%), and limits on
the levels of debt relative to EBITDA (100%). Other covenants regularly used include limits on
management compensation (73.9%), positive earnings requirements (69.6%), and limits on capital
expenditures (87.5%). In addition, the median fixed‐charge coverage ratio covenant reported is 1.18,
while the median total debt to EBITDA trigger is 4.0 times.
Table 21: Covenant Frequency
Max
Debt
Divs &
Dist’ns
Mgmt
Comp
Change
Control
Positive
Earnings
FCC
Ratio
Debt /
EBITDA
Max
CAPEX
Yes 95.8% 100.0% 73.9% 95.7% 69.6% 95.8% 100.0% 87.5%
No 4.2% 0.0% 26.1% 4.3% 30.4% 4.2% 0.0% 12.5%
Figure 38: Covenant Frequency
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Mezzanine capital providers frequently structure deals that are subject to fees. Approximately 90% of
respondents indicate charging some sort of a closing fee. The average closing fee is 1.91% while the
median number reported is 2%. Approximately 32% also report charging a commitment fee.
Prepayment fees are also standard. Year 1 prepayment fees average 5.11% while the median reported is
5%. Year 2 prepayment fees average 3.84% while the median is 4%.
Table 22: Fees Types and Amounts
Commit
Fee
Closing
Fee
Prepay
Fee (yr 1)
Prepay
Fee (yr 2)
Prepay
Fee (yr 3)
Prepay
Fee (yr 4)
Prepay
Fee (yr 5)
Avg 0.44% 1.91% 5.11% 3.84% 2.47% 1.32% 0.42%
Min 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
Max 2.25% 3.50% 15.00% 10.00% 7.00% 6.00% 1.00%
Various rights are frequently contracted with capital recipients. In particular, in the vast majority of
situations, tag‐along rights, drag‐along rights, piggyback registration, anti‐dilution rights, put rights, and
registration rights are included in deals.
Table 23: Frequencies of Various Rights
Tag‐Along
Rights
Drag‐Along
Rights
Piggyback
Registration
Anti‐dilution
Rights
Put Rights Registration
Rights
Yes 87.0% 87.0% 91.3% 91.3% 87.0% 95.7%
No 13.0% 13.0% 8.7% 8.7% 13.0% 4.3%
Current deals are being priced with a hurdle rate of 18% (median) or 17.9% average. The range in rate is
from 10 to 24%. The reported 5‐year average historical return on mezzanine capital funds is 20.6% with
a range from 8 to 47%.
Table 24: Current Hurdle Rate and Historical Returns
Hurdle Rate on New Deals 5‐yr Average Return
Median 18.0% 19.0%
Average 17.9% 20.6%
For those firms indicating a deviation between their hurdle and actual realized rates of return, the top
reason cited is “early exit” followed by “change in exit multiple” and other economic influences. Nearly
14% indicated that historical returns and hurdle rates were equivalent.
Table 25: Reasons for Deviations from Hurdle Rates
Change in Exit
Multiple
Early Exit Late Exit Economic Other N/A
(matched rates)
Average 24.2% 28.3% 3.6% 23.6% 6.6% 13.6%
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Outlook on Lending Market and Economy
Over the next 12 months, 64% of those surveyed believe that interest rates (all‐in) for mezzanine loans
will increase. None of the survey participants believe rates will decrease.
Figure 39: Mezzanine Rate Forecast (12month)
Eighty‐six percent (86%) believe that the demand for mezzanine loans will increase over the next 12
months.
Figure 40: Demand for Mezzanine Loan Forecast (12month)
Sixty‐four percent (64%) believe that mezzanine lending will become more restrictive over the next 12
months.
Figure 41: Restrictiveness Forecast (12month)
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Of the survey respondents, 57.1% believe GDP will decline, while just 19.0% believe it will increase over
the next 12 months. The average estimate is for ‐0.8%.
Table 26: GDP Forecast (12month)
Negative 57.1%
Zero 23.8%
Positive 19.0%
Average of Estimates ‐0.8%
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VENTURE CAPITAL SURVEY INFO
Profile of Respondents
The following responses pertain to our venture capital survey administered in March/April 2009. Our
results are based upon 185 responses to this survey. The respondents are geographically dispersed
throughout the United States.
Of those surveyed, 31% said that their organization has two funds, and 30% said it has one fund.
Figure 42: Number of Funds
The most frequent category for the number of investments as they pertain to the current fund is 5‐10
(30%). Twenty‐nine percent (29%) indicate holdings between 2 and 5 investments, while 24% report
between 10 and 20. The median number of investments is 4.
Figure 43: Number of Investments in Current Fund
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The venture capital firms surveyed invest approximately 24% of their investment capital in the area of
software, followed by medical devices (13.4%), biotech (10.3%), clean technology (9.3%), and Internet
specific (9.1%).
Figure 44: Investment by Business Type
Geographically, California is home to approximately 40.2% of current portfolio companies.
Massachusetts is domicile to 7.6%, New York 5.3%, and Texas 4.9%.
Figure 45: Location of Portfolio Companies
Twenty‐one percent (21.3%) of respondents indicate the current fund time horizon of fewer than 3
years, while 22.6% report a time horizon of greater than 7 years. The most heavily weighted response,
however, was five years (25.5%).
Figure 46: Current Fund Time Horizon
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Nearly 43% of survey respondents indicate that their fund was formed 2‐3 years ago. Eight percent (8%)
of survey participants report launching their fund this year.
Figure 47: Inception of Fund Date
Investment Characteristics
Venture capital investing encompasses companies of various sizes. The smallest companies are classified
as Stage 1 while the largest are classified as Stage 6. Respondents indicate the most frequent investment
stage to which capital is deployed is Stage 4 (28.3%), followed by Stage 1 (22.5%).
Table 27: Investment by Stage of Company
Stage Average
Stage 1: No product revenues to date and limited expense history, typically an
incomplete management team with an idea, plan, and possibly some initial product
development.
22.5%
Stage 2: Still no product revenue but substantive expense history, as product
development is underway and challenges are thought to be understood.
17.0%
Stage 3: Significant progress in product development; key development milestones
met and development is near completion, but generally no product revenue.
17.8%
Stage 4: Additional key development milestones met and some product revenue,
but still operating at a loss.
28.3%
Stage 5: Product revenue and operating profitability or breakeven/positive cash
flows.
10.9%
Stage 6: Established financial history of profitable operations or generation of
positive cash flows.
3.5%
TOTAL 100.0%
PEPPERDINE PRIVATE CAPITAL MARKETS PROJECT | SURVEY REPORT – AUGUST 2009
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Fifty‐one percent (51%) report a minimum equity investment per deal of less than $1 million. Seventyone
percent (71%) indicate a minimum investment of $2 million or less. Twenty‐nine percent (29%) do
not invest in deals smaller than $2 million.
Figure 48: Minimum Investment Amounts
According to the fund charters, 21% of funds restrict investment concentrations greater than 9%, while
53% restrict concentrations greater than 14%. Just 11% allow concentrations greater than 25%.
Figure 49: Investment Concentration Limits
Venture capitalists are known for taking minority positions in companies. Over eighty‐six percent
(86.3%) are non‐control transactions. Of these, our analysis reveals that nearly 67% of the transactions
are between 10% and 30% equity ownership.
Figure 50: Percentage of Equity Purchased
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Most of the investment dollars are made in preferred stock (88.8%) of the investee company. Just 4.6%
of investment dollars are invested in common stock.
Figure 51: Investment Security Types
The majority of companies that are targets of venture capital are C‐corporations (80.1%). S‐corporations
account for approximately 9.6% of investments.
Figure 52: Investment by Business Entity
Venture capital firms use a variety of investment analysis techniques to evaluate investments. Of these,
96% report using a market analysis, while 78% use a multiple analysis. Sixty‐seven percent (67%)
indicate they use a gut feel, which is used more frequently than a discounted cash‐flow analysis (DCF).
Table 28: Frequency of Investment Analysis Techniques
Analysis Percent
DCF 43%
Multiple Analysis 78%
Option Analysis 10%
Simulation Analysis 22%
Gut Feel 67%
Market Analysis 96%
Other 43%
PEPPERDINE PRIVATE CAPITAL MARKETS PROJECT | SURVEY REPORT – AUGUST 2009
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The relevancy and minimum acceptable 5‐year growth rate of EBITDA varies with stage of company.
Approximately 25.8% indicate the EBITDA growth rate over the next five years is not applicable to the
investment‐making process for stage 1 investments, whereas just 6.3% report its lack of relevance for
Stage 6 companies. For Stage 1 companies, the most frequently cited expected EBITDA growth rate
category is “greater than 80%,” whereas Stage 6 companies are expected to grow at 30‐40% in the most
frequently chosen category.
Table 29: Expected EBITDA Growth by Stage
Growth Stage 1 Stage 2 Stage 3 Stage 4 Stage 5 Stage 6
Less than 20% 21.4% 21.4% 16.7% 19.0% 9.5% 11.9%
20‐30% 10.0% 2.5% 15.0% 25.0% 30.0% 17.5%
30‐40% 4.3% 12.8% 10.6% 14.9% 31.9% 25.5%
40‐50% 10.9% 4.3% 13.0% 37.0% 23.9% 10.9%
50‐60% 11.4% 20.0% 25.7% 20.0% 17.1% 5.7%
60‐70% 21.7% 8.7% 34.8% 17.4% 8.7% 8.7%
70‐80% 0.0% 62.5% 12.5% 12.5% 12.5% 0.0%
Greater than 80% 40.7% 22.2% 18.5% 11.1% 3.7% 3.7%
N/A 25.8% 22.6% 20.1% 17.6% 7.5% 6.3%
Figure 53: Expected EBITDA Growth by Stage
The same pattern applies to sales growth rates. As investments are directed towards larger companies,
the revenue growth rate expectation, over a 5‐year period, declines significantly.
Table 30: Expected Sales Growth by Stage
Growth Stage 1 Stage 2 Stage 3 Stage 4 Stage 5 Stage 6
Less than 20% 9.5% 7.6% 3.4% 2.2% 4.4% 14.3%
20‐30% 4.8% 6.3% 10.3% 15.7% 29.4% 20.4%
30‐40% 6.0% 10.1% 16.1% 30.3% 32.4% 28.6%
40‐50% 15.5% 13.9% 20.7% 16.9% 11.8% 10.2%
50‐60% 9.5% 5.1% 9.2% 13.5% 5.9% 10.2%
60‐70% 3.6% 5.1% 9.2% 4.5% 4.4% 0.0%
70‐80% 3.6% 6.3% 4.6% 3.4% 0.0% 0.0%
Greater than 80% 21.4% 20.3% 12.6% 5.6% 2.9% 4.1%
N/A 26.2% 25.3% 13.8% 7.9% 8.8% 12.2%
PEPPERDINE PRIVATE CAPITAL MARKETS PROJECT | SURVEY REPORT – AUGUST 2009
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Figure 54: Expected Sales Growth by Stage
In order to close one deal, the following activities are conducted. The median numbers are reported.
Table 31: Steps to Close One Deal
Activity Number
Business Plans Received 100
Meetings with Principals 20
Term Sheets Issued 2
Letters of Intent Signed 1
Forty‐four percent (44%) of participants report the time to close a deal after the letter of intent is signed
is 1 to 2 months while 34% report the process taking between 2 and 4 months.
Figure 55: Time to Close
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Firms occasionally will assign an outside manager to oversee the company in which funds are invested.
Board members are assigned in approximately 51% of the cases while CEOs are assigned in
approximately 27% of the deals.
Figure 56: Frequency of Assigning Outside Managers
During the due diligence process, occasionally outside experts are hired to help in certain areas. Sixteen
percent report that outside experts are never hired while 53% indicate that experts are hired between
0% and 20% of the time.
Figure 57: Frequency of Assigning Outside Due Diligence Experts
Regarding exit plans, venture capitalists report selling to a public company (49.9%) as the most likely
course of action for a liquidity event. Nearly 24.6% indicate their plans to sell to a private company while
16.8% are planning for an initial public offering (IPO).
Figure 58: Exit Plans
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Deal flow comes from a variety of sources. The largest category is entrepreneurs themselves (26.6%)
followed by members (25.9%) and word of mouth (13.5%).
Figure 59: Deal Flow Sources
Target sales prices to total venture investment (TVI) ratios decline as investee companies are larger and
exhibit greater levels of profitability and operating history. Approximately 58% of survey participants
expect greater than 9 times TVI for Stage 1 investments, while nearly 80% of venture capitalists expect
returns of less than 4 times on Stage 6 investments. Stage 1 investors expect an average 8.2 ratio of
sales price to TVI, while Stage 6 investors expect 3.9 times.
Table 32: Expected Sales Multiples
Multiple Stage 1 Stage 2 Stage 3 Stage 4 Stage 5 Stage 6
1‐2 Times 2.0% 2.1% 1.0% 4.8% 12.0% 21.8%
3‐4 Times 8.0% 13.8% 21.9% 42.9% 59.0% 58.2%
5‐6 Times 16.0% 21.3% 38.1% 34.3% 16.9% 9.1%
7‐8 Times 16.0% 22.3% 15.2% 7.6% 4.8% 3.6%
9‐10 Times 28.0% 22.3% 13.3% 4.8% 2.4% 1.8%
More than 10 Times 30.0% 18.1% 10.5% 5.7% 4.8% 5.5%
Average 8.2 7.4 6.4 5.1 4.3 3.9
Figure 60: Sales to TVI Ratios Expected by Stage
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Participants also report that the time of expected exit event for a Stage 1 company is 6.2 years while a
Stage 6 company’s holding period is 3.8 years.
Table 33: Expected Liquidation Event Timeline
Time to Exit Stage 1 Stage 2 Stage 3 Stage 4 Stage 5 Stage 6
0‐1 Year 1.1% 0.0% 0.0% 0.0% 1.4% 4.4%
1‐2 Years 1.1% 0.0% 3.3% 3.4% 9.9% 15.6%
2‐3 Years 2.3% 7.2% 6.7% 12.4% 15.5% 15.6%
3‐4 Years 3.4% 8.4% 14.4% 21.3% 15.5% 15.6%
4‐5 Years 13.8% 19.3% 27.8% 21.3% 32.4% 33.3%
5‐6 Years 23.0% 18.1% 15.6% 21.3% 16.9% 4.4%
6‐7 Years 19.5% 18.1% 15.6% 10.1% 1.4% 4.4%
7‐8 Years 19.5% 19.3% 12.2% 3.4% 4.2% 2.2%
Greater than 8 Years 16.1% 9.6% 4.4% 6.7% 2.8% 4.4%
Average 6.2 5.8 5.1 4.7 4.1 3.8
Figure 61: Expected Time to Exit by Stage
The implied returns based upon expectations of sales multiples along with estimates of liquidity event
time frames indicate expected returns of between 40.5% and 43.5%.
Table 34: Implied Rates of Return
Stage 1 Stage 2 Stage 3 Stage 4 Stage 5 Stage 6
Returns 40.5% 41.3% 43.5% 41.1% 42.3% 43.3%
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For those venture capital funds that had a fund prior to the current fund (approximately 64%), actual
results indicate sales prices to TVI ratios that are less than those expected on current funds. The most
frequent response for all stages is 3‐4 times. And survey participants indicated that between 3.3% and
20.6% of investments, depending on stage, did not sell or were worthless.
Table 35: PriorFund
Sales Multiples
Multiple Stage 1 Stage 2 Stage 3 Stage 4 Stage 5 Stage 6
Did Not Sell/Worthless 10.4% 3.3% 4.3% 4.1% 10.6% 20.6%
0‐1 Times 4.5% 8.2% 4.3% 4.1% 4.3% 8.8%
1‐2 Times 10.4% 18.0% 20.3% 32.9% 29.8% 20.6%
3‐4 Times 29.9% 44.3% 52.2% 42.5% 40.4% 47.1%
5‐6 Times 22.4% 14.8% 7.2% 11.0% 12.8% 2.9%
7‐8 Times 7.5% 3.3% 5.8% 1.4% 0.0% 0.0%
9‐10 Times 0.0% 4.9% 1.4% 1.4% 0.0% 0.0%
More than 10 Times 14.9% 3.3% 4.3% 2.7% 2.1% 0.0%
Average 4.6 3.7 3.6 3.1 2.8 2.2
Figure 62: PriorFund
Sales Multiples
For past funds, survey participants report varying times to exit for the different stages of company life
cycle. As expected, Stage 6 companies allowed for an earlier exit (3.5 years) than Stage 1 companies (6.2
years).
Table 36: PriorFund
Time to Liquidation
Time to Exit Stage 1 Stage 2 Stage 3 Stage 4 Stage 5 Stage 6
0‐1 Year 0.0% 1.4% 1.2% 0.0% 0.0% 0.0%
1‐2 Years 0.0% 0.0% 1.2% 1.3% 1.9% 18.2%
2‐3 Years 3.9% 4.2% 7.3% 6.3% 25.9% 18.2%
3‐4 Years 6.6% 6.9% 13.4% 26.6% 22.2% 21.2%
4‐5 Years 10.5% 13.9% 24.4% 24.1% 27.8% 27.3%
5‐6 Years 17.1% 25.0% 22.0% 22.8% 18.5% 15.2%
6‐7 Years 25.0% 26.4% 19.5% 8.9% 3.7% 0.0%
7‐8 Years 26.3% 16.7% 7.3% 6.3% 0.0% 0.0%
Greater than 8 Years 10.5% 5.6% 3.7% 3.8% 0.0% 0.0%
Average 6.2 5.8 5.1 4.8 4.0 3.5
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Figure 63: PriorFund
Time to Exit by Stage
As shown below, implied actual returns on the most recently closed fund range from 24.4% to 29.8%,
which is significantly less than the returns expected on the current fund. Very little variability exists
between the stages.
Table 37: PriorFund
Implied Returns
Stage 1 Stage 2 Stage 3 Stage 4 Stage 5 Stage 6
Returns 27.6% 25.5% 28.3% 26.7% 29.8% 24.4%
Survey participants report that their hurdle rates or cost of capital varies significantly. Nearly 61% of
those surveyed report that their cost of capital is between 20% and 40%. The median cost of capital
reported is 33%.
Figure 64: SelfReported
Hurdle Rates
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Venture capital fund frequently rely on fund management fees to cover operating expenses. The vast
majority (79%) of venture capital funds report charging a fund management fee between 1.5% and 2%
of assets.
Figure 65: Fund Management Fees
Seventy percent (70%) of survey respondents report charging exactly 20% for a carried‐interest fee after
the investment is paid.
Figure 66: CarriedInterest
Fee
Outlook on Venture Capital Market and Economy
The vast majority (76%) of venture capitalists believe the demand for venture capital will increase over
the next 12 months.
Figure 67: Demand for Venture Capital Forecast (12month)
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Sixty‐two percent (62%) of survey participants believe that venture capital investing in general will
become more restrictive, and 30% report it staying about the same over the next 12 months.
Figure 68: Venture Capital Restrictiveness Forecast (12month)
Forty‐six percent (46%) of survey respondents indicated that they intend to make two or fewer
investments over the next 12 months in their current fund. Fifty‐four percent (54%) report the intention
to make three or more investments.
Figure 69: Expected Number of Investments Next 12 Months
Nearly 63% of survey respondents indicate that the Unites States Gross Domestic Product will decline
over the next 12 months, while 23.3% report an expected increase. The median estimate of GDP change
is ‐1.60%.
Figure 70: GDP Forecast (12month)
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Fifty‐nine percent (59%) of respondents indicate plans to raise funds over the next year.
Figure 71: Fundraising Outlook (12month)
For those planning a fundraising campaign, 43% report that they plan to raise more than $100 million in
capital followed by 29% indicating plans to raise between $50 and $100 million.
Figure 72: Fundraising Amount Forecast
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PRIVATE EQUITY SURVEY INFO
Profile of Respondents
The following responses pertain to our private equity (PE) survey administered in March/April 2009. Our
results are based upon 256 responses to this survey. The respondents are geographically dispersed
throughout the United States.
Of those surveyed, 88% said they are funded whereas 12% indicate they are fundless funds.
Figure 73: Distribution of Funding Classification
Approximately 72.2% report that committed capital is greater than $100 million. Roughly 15.4% indicate
committed capital between $20 and $100 million.
Figure 74: Committed Capital
Survey participants report having 51.8% of their funds left to deploy, which equates to an average of
$295.9 million per fund ($100 million median).
Table 38: Capital Left to Deploy
Percent Amount ($M)
Average 51.8% $295.89
Median 50.0% $100.00
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Responses indicate that the most frequent number of portfolio companies in which the respondents
have an investment in the current fund is 5 to 10 (31.3%). Approximately 26% of respondents report
having between 2 and 5 portfolio companies in their current fund, while 22.5% report between 10 and
20.
Figure 75: Number of Portfolio Companies
A schedule of the remaining time horizon for the current fund is below. Just 7.5% of respondents report
a remaining time horizon of 1 year. Approximately 45% of private equity funds report a remaining time
horizon of 3 years or less.
Figure 76: Remaining Time Horizon on Current Fund
Approximately 50.3% report that the current fund’s investment charter has 6 or more remaining years.
Figure 77: Remainder of Investment Charter for Current Fund
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Investment Characteristics
Approximately 31% of participants report making just one investment over the prior 12 months whereas
11.5% report making 6 or more. Approximately 70% of PE firms made three or fewer.
Figure 78: Number of Investments Made in Last 12 Months
Private equity groups invest in a variety of businesses. Among those, service businesses top the list at
25.5% while manufacturing garnered 21.1% of responses.
Figure 79: Types of Businesses in Which Capital Is Deployed
Minimum investment amounts per deal vary by fund. Approximately 8% of funds report a minimum
investment amount per deal within the range of $50 ‐ $100 million. Just 7.5% of funds will consider an
investment amount of $1 million or less, while approximately 40% of funds will consider investments
smaller than $5 million. Approximately 59% of participants will consider investments greater than $20
million.
Table 39: Range of Investment Sizes
Range Minimum Maximum
Less than $1 Million 7.5% 2.2%
$1‐2 Million 9.7% 1.5%
$2‐5 Million 23.1% 6.7%
$5‐10 Million 20.9% 10.4%
$10‐20 Million 16.4% 20.9%
$20‐50 Million 14.2% 23.1%
$50‐100 Million 8.2% 16.4%
More than $100 Million 0.0% 18.7%
Total 100.0% 100.0%
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Most frequently C‐corporations are the recipient of PE investment dollars (42.2%) followed by LLCs
(34.1%) and S‐corporations (14.2%).
Figure 80: Investments by Business Entity Type
Most often, investments are made in common stock (45.1%) followed by preferred stock (39.1%) and
subordinated debt (15.9%).
Figure 81: Investments by Security Type
Survey respondents indicate that although the majority of transactions are control (69%), approximately
29% are strictly minority positions.
Figure 82: Investments by Level of Control
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Private equity firms report that the target equity ratio as a percentage of all invested capital in the
overall capital structure is most commonly between 20 and 50%. The calculated median is 41%.
Figure 83: Target Equity Ratio
Several investment analysis techniques are used to evaluate potential investments. Ninety‐eight percent
(98%) of those surveyed said they use IRR, 57% use DCF, 95% use multiple analysis, only 20% use option
analysis, 45% use simulation analysis, and 83% assume the Year 5 exit multiple is the same as the entry
multiple when evaluating a potential investment.
Table 40: Investment Analysis Techniques
Type Percent
IRR 97.8%
DCF 56.8%
Multiple Analysis 94.6%
Option Analysis 19.7%
Simulation Analysis 44.7%
Year 5 Exit Multiple Is Same as Entry Multiple 82.8%
Other 45.0%
Private equity firms report for investment candidates that the minimum revenue growth expected over
the next five years is 5% to 10% annually according to 26% of those surveyed, 10% to 15% according to
18% of the people who answered, and 15% to 20% according to 15%.
Figure 84: Minimum Revenue Growth
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Investment candidacy also requires a certain amount of growth in earnings before interest, taxes,
depreciation, and amortization (EBITDA). Eighteen percent (18%) said that the minimum EBITDA growth
expected over the next five years is 15% to 20% and another 18% said 5% to 10%, while 17% reported
10% to 15% growth expected.
Figure 85: Minimum EBITDA Growth
On the last closed fund, 35% of respondents report having actual rates of return of between 20% and
30% while 18.8% report returns between 10% and 20%. Overall, approximately 75% of private equity
funds earned greater than 20% on the last closed fund. The median reported was 31.9%.
Figure 86: Actual Rates of Return on Last Fund
Seventy‐seven percent (77%) of those surveyed said that many or a large percentage of deals carried the
average return.
Table 41: Investment Contribution Distribution
Answer Percent
One or a Small Percentage of Deals Carried the Average Return 23.0%
Many or a Large Percentage of Deals Carried the Average Return 77.0%
Total 100.0%
PEPPERDINE PRIVATE CAPITAL MARKETS PROJECT | SURVEY REPORT – AUGUST 2009
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We collected results on the current fund with and without portfolio companies included. If portfolio
companies are included at fair value, the results indicate that approximately 78% of respondents are
earning returns of between 0% and 30%, with the largest classification being in the 0% to 10% range. If
we exclude portfolio companies, then the 0% to 10% classification is consistent suggesting a large
number of PE groups are underperforming both expectations and prior performance. The median return
excluding portfolio companies is 10% while the median return when including them is 14%.
Figure 87: Current Returns Excluding Portfolio Companies
Figure 88: Current Returns Including Portfolio Companies
For those funds reporting deviations between actual returns and hurdle rates on the current fund,
economic conditions were cited most frequently as a reason for the deviation (43.3%). Management
was given a weight of 20% followed by domestic competition changes (5.2%).
Figure 89: Sources of Return Deviations
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Hurdle rates are important when evaluating new investments. Approximately 63.5% said that the hurdle
rate for the current fund for new investments is 20% to 30%. The median hurdle rate reported was 25%.
Figure 90: HurdleRate
Distribution
Survey participants report that exit plans often involve selling to another PE group (34.3%) or selling to a
public company (34.7%). Just 9.2% plan on an initial public offering as a liquidity event.
Figure 91: Investment Exit Plans
Private equity firms spend a significant amount of time evaluating potential investments. In order to
close one deal, survey participants report reviewing 80 business plans, conducting 15 meetings with
principals, issuing 5 term sheets, and getting 2 letters of intent signed.
Table 42: Deal Flow Funnel
Median
Response
Business Plans Reviewed 80
Meetings with Principals Conducted 15
Term Sheets Issued 5
Letters of Intent Signed 2
PEPPERDINE PRIVATE CAPITAL MARKETS PROJECT | SURVEY REPORT – AUGUST 2009
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Approximately 46% report reviewing up to 50 business plans while 23.4% review between 50 and 100.
Just 17.1% reviewed more than 200 plans.
Figure 92: Number of Business Plans Reviewed to Close One Deal
After negotiations take place, according to 55% of those who answered, it currently takes 2 to 4 months
to close a deal after the letter of intent (LOI) is signed.
Figure 93: Time to Close a Deal After LOI Signed
Deal flow is extremely important to private equity groups. They report that 26.7% of their companies for
consideration come from direct marketing to owners. Another 23.6% comes from lawyers, CPAs,
financial advisors, etc. Business networking meetings account for 19.6%.
Figure 94: Sources of Deal Flow
PEPPERDINE PRIVATE CAPITAL MARKETS PROJECT | SURVEY REPORT – AU

By Dianna Ransom

Despite lining up a last-minute, $3 billion reprieve from its bondholders
over the weekend, CIT
Group isn't in the clear yet. To counter its losses, CIT aims to attract
more funds through deposits to its bank in Utah.
However, the company first needs approval from the Federal Reserve and the
Federal Deposit Insurance Corp. to transfer more of its assets to the bank. And
more broadly, the firm must find a long-term solution to the increasingly
expensive business of finding capital to make loans.

Even if CIT manages to stave off filing
for bankruptcy protection, small-business owners would be wise to familiarize
themselves with credit alternatives — especially these days, says David S.
Waddell, the CEO of investment strategy firm Waddell & Associates in
Memphis, Tenn. Owners are now finding that their longtime deposit relationships
arent proving as useful, as many lenders restrict loan and credit terms to keep
more cash on hand, he says. (According to the Federal Reserve's most recent
Senior Loan Officer Opinion Survey in April, 75% of domestic banks said they
tightened credit for small firms — up from 70% in the Fed's January survey.) In
addition, credit card companies like American
Express and Advanta
are either tightening their terms or cutting small businesses off entirely.

"Hopefully, recent events and those within the last year gave
entrepreneurs inspiration to locate alternative forms of capital," says
Waddell. But if aligning back-up (or primary) financing sources hasn't been a
top priority at your firm, it's not too late.

Here are five small-business funding alternatives to consider:

Government-backed loans

In March, the Small Business Administration began guaranteeing as much as
90% of some loans. Now, preferred SBA lenders such as Bank
of America and KeyBank
may be more willing to extend you an SBA-backed loan, says Brian Hamilton, CEO
of Sageworks, a Raleigh, N.C.,
financial research firm, and a former SBA consultant. Since President Obama
signed the American Recovery and Reinvestment Act (ARRA) into law in
mid-February, the weekly loan dollar volume has risen more than 40% in the 7(a)
and 504 programs, compared to the weekly average before passage, according to
John J. Miller, a SBA spokesman.

Passage of the ARRA, also permitted the SBA to temporarily waive a fee that
it charges to banks, which is passed on to borrowers, says Martha Seidenwand,
KeyBank's SBA program and operations manager in Cleveland. (Special SBA
programs including the American Recovery Capital (ARC) program and the floor
plan financing program, might also prove helpful.)

Community banks and credit unions

Having dodged the brunt of the mortgage bullet, community banks and credit
unions may be in a better position to lend to small businesses, Hamilton
says. A number of community banks are issuing additional loans to small
businesses as the outlook for the lending environment improves. In addition,
credit unions may soon take on more small-business loans as larger lenders
tighten their terms.

Peer-to-Peer networks

After a nine-month registration period with the Securities and Exchange
Commission, the San Francisco-based peer-to-peer lending network Prosper is
back in the business of brokering loans. At Prosper, borrowers list how much
they need and details about their business, while strangers can make loans with
as little as $25. Virgin Money specializes in structuring business loans
between friends, family members and associates. Lending Club will connect only
credit-worthy borrowers with lenders.

Microlenders

In need of a small cash infusion? Enter: New York-based microlenders Accion USA
and Count Me In. Because these organizations rely on donations from charitable
organizations and individuals, they're more willing to lend to entrepreneurs
just starting up or to those with checkered credit histories. Although
microloans generally carry higher interest rates than bank loans, Accion
recently lowered its rates from between 11% and 18% to between 8% and 15%. The
SBA also provides microloans and offers rates between 8% and 13%.

Asset-based lenders

Don't let the near-collapse of CIT, one
of the nation's largest factoring firms, fool you. There are troves of other
asset-based lenders willing either to purchase your accounts receivables for
80% to 90% on the dollar or to lend against them. LSQ Funding, an Orlando,
Fla., factoring firm, for example, works
exclusively with small to midsized businesses across the U.S.,
and New York's FGI
Finance purchases international receivables. For those who like competition,
the New Orleans-based Receivables Exchange allows credit-worthy businesses to
auction off their receivables to the highest bidder.