According to recent figures from the Federation of Small Businesses (FSB), business confidence has returned to positive territory for the first time in two years. Half of businesses surveyed, which range from SMEs to more established firms, plan to expand operations this year, while 32 per cent intend to increase the level of investment to support their growth strategies.
For companies looking to capitalise on this positive sentiment, many will likely need to raise capital via equity or debt to fund their expansion plans. For established businesses, issuing equity may not be the best option, however, as it dilutes shareholdings at a time when the business is most likely to be profitable and cash generative.
What is debt financing?
So how could debt funding help? The debt funding landscape has changed considerably in recent years and companies in growth mode are no longer dependent on the vagaries of traditional bank lending to fund short-medium term expansion. For companies looking to raise money quickly to adapt to changing markets or new opportunities, private debt has emerged as a highly flexible alternative and includes medium-term note (MTN) programmes, corporate bonds, direct lending and Peer2Peer (P2P) lending. But the landscape with many new products is complicated and businesses need to understand what they offer and which are most suitable for their requirements.
There is currently a substantial funding gap in the private debt market for established SMEs and mid-market companies, which we at LGB Corporate Finance have identified. We have introduced MTN programmes, traditionally used by larger companies, to address this. In the institutional debt markets MTNs can be used by banks and the finance subsidiaries of global companies to meet ad hoc funding needs.
Like a banking facility, MTN programmes have common documentation for repeated borrowing up to a programme limit; however the borrowing is conducted under the terms of a negotiable note instrument that is placed by LGB Corporate Finance with investors. In this way a programme can accommodate complex capital structures and the borrowing of large or small amounts. We have established more than 20 programmes and have demonstrated that they can also be very useful for SMEs.
Corporate bonds as an alternative
Corporate bonds are another private debt alternative for mid-market companies to consider. They have been in existence for a lot longer than MTN programmes and are a certificate of debt issued as a way of raising capital. The bonds usually pay an annual or bi-annual coupon, or interest rate, and the amount borrowed is returned at the end of the fixed term. Interest rates charged are often lower than those of the traditional lenders and give companies significantly greater freedom to operate as they do not impose restrictions that are often attached to bank loans.
Another direct lending financing option is to target funds, which invest pension and insurance money in SMEs and established businesses, and which are able to take long-term positions. The funds tend to offer a faster approval process than the banks, and have more flexible credit structures than P2P loans. However they have the opposite problem: the vast majority of credit funds cater to larger borrowers seeking event-based financing, such as acquisitions, making them unsuitable to many smaller growth businesses that need working capital or an injection of funds to support product development.
P2P also an option
P2P lending, (not to be confused with crowdfunding, which involves equity) mainly operates online and generally, with lower overheads than traditional financial lenders, is able to provide its service more cost-effectively. It is most suitable for companies at the smaller end of the SME market, which are able to meet the monthly financing repayments, however, it struggles to properly serve companies with funding requirements of more than £1 million, and is generally not suitable for companies with a complex capital structure.
While there are a range of options available to SMEs, each needs to be considered carefully for their individual merits and suitability for different business needs. MTN programmes provide flexibility and significant freedom to draw down on the capital in incremental amounts and these characteristics fit well with entrepreneurial businesses that may need to access capital at short notice to respond to the growing demand for their products and help the sector continue its strong contribution to the economy. Corporate bonds and direct lending funds can work well for larger companies; while earlier stage but profitable businesses should consider P2P lending as it is relatively inexpensive and the fundraising process can be more efficient than negotiating with several banks. So while there are a range of options, it’s important that the right choice of funding is selected.
Angus Grierson is managing director of LGB Corporate Finance