The Overseas Private Investment Corporation: Enterprise

A Survey of SME Finance and the Emerging Alternatives for Access to Capital

Jim Faith

Trade and Export Finance Online

Global California

December 3, 2014

© 2014 TEFO. All Rights Reserved

Agenda

• Section 1: An SME Snapshot View • Section 2: Current Bank Lending Environment • Section 3: Emerging Alternatives for SME Access to Capital • Section 4: Alternative Finance Outlook for 2015

SME Working Definition and Profile

• Less than 500 employees • Represent 99% of all American companies • Employ over 50 percent of private sector employees (about

120 million people) • Generate 65 percent of net new private sector jobs • Represent over half of U.S. non-farm GDP • Vast majority are sole proprietorships • Represent 98% of all U.S. exporters and 34% of U.S. export

revenue

Section 1: Snapshot

US Small Businesses by Number of Employees Section 1: Snapshot

Source: US Census Bureau, 2013

Top Five Exporting States by Number and Value Section 1: Snapshot

Rank State Number of Exporters

Exports ($Millions)

US 302,051 1,365,738

1 TX 40,737 279,491

2 CA 75,012 168,045

3 NY 41,028 86,523

4 LA 4,000 63,339

5 FL 61,848 61,344

Number of Exporters

Exports ($Millions)

295,241 477,502

37,921 85,527

71,921 66,693

38,675 51,640

3,378 22,028

58,976 42,051

US Census Bureau 2013 Preliminary Report

All Exporters SME Exporters

Top Five Export Destinations Section 1: Snapshot

Rank Country Value ($ Million)

1 Canada 301.6

2 Mexico 226.1

3 China 121.7

4 Japan 65.2

5 Germany 47.4

US Census Bureau 2013 Preliminary Report

Country Value ($ Million)

Mexico 23.9

Canada 18.9

China 16.3

Japan 12.7

South Korea 8.4

US Exports CA Exports

Top SME Exporters by Company Size

Source: US Census Bureau, 2013

Section 1: Snapshot

118K

33K 17K 14K

4K 7K 0

20,000 40,000 60,000 80,000

100,000 120,000 140,000

1-19 Employees

20-49 50-99 11-249 250-400 > 500

Top Exporters by Company Size

Exporters are Better Economic Performers

Exporters consistently out-perform non-exporters in: • Higher Sales • Higher Employment • Pay higher wages • Are more productive in terms of value added per worker • Use higher levels of capital per worker • Have higher skill intensities • Nearly 40% of exporters also import and 80% of importers export.

Section 1: Snapshot

Source: US International Trade Commission Report (2011)

Current Bank Lending Environment

• Post-recession Cyclical and Structural Effects • Regulatory Oversight: Dodd-Frank and Basel III • The Credit Gap and Emergence of Online Alternative Funding

Section 2: Environment

Greater Perceived Risk Means Tighter Lending • SME sales haven’t returned to pre-recession levels, which in turn,

means less demand for loan capital. • Traditional collateral, primarily real estate, lost value during the crisis

making some borrowers less creditworthy. • Banks have remained more risk averse in the recovery while focused

on integrating new regulatory oversight in their day-to-day operations. The resulting tighter lending criteria includes: • Greater focus on borrower’s personal profile, credit scores, income

and assets • Higher collateral requirements • Increasing equity requirements for new loans • Preference for liquid collateral, e.g. personal savings, CD’s, or

stock.


Banking Industry Consolidation • The Banking industry has been in a state of perpetual consolidation

since the mid-1980’s. Community Banks, the second leading source of SME bank loans, are being absorbed by larger banks. There are less than 7,000 today, down from over 14,000 in 1984.

• Smaller banks have traditionally relied on relationship banking which includes social context like the borrower’s character and local community history in lending decisions.

• Relationship banking is expensive and don’t translate well to the data-oriented criteria and automation used by larger banks.


Higher Transactional Costs • Lenders face greater risk because SME’s are inherently more sensitive to

economic volatility, have higher failure rates, and fewer assets to collateralize.

• Publically available information on SME business and financial performance is fragmented and costly to obtain.

• The fragmented market makes it difficult to develop general credit standards and to securitize and sell small business loans in the secondary market.

• This state of operational and information disconnect has yet to be resolved and contributes to the higher transaction costs associated with small business lending.

• Consequently, transaction costs to process a $100,000 loan are comparable to a $1 million loan, but with less profit for lenders.


High Search Costs • The current environment includes high search costs in which it’s difficult

for qualified borrowers to find willing lenders, and lenders to find creditworthy borrowers. • A Federal Reserve study states SMEs can spend up to 25 hours on

paperwork for bank loans, and often apply to multiple banks. • Even successful applicants can wait several weeks before the funds are

available.


Regulatory Oversight • Bank management has been focused on the implementation of Dodd-

Frank reforms and Basel III requirements in their processing and day-to-day operations.

• This regulatory overhang has been an ongoing issue during the recovery, has contributed to the lack of available funds for lending and a case can be made that there has been a disproportionately negative effect on SME lending in particular.


Stalemate and the SME Credit Gap

• In summary, Banks say there’s a lack of demand and they’re not finding qualified borrowers. Small business owners say that, despite being creditworthy, banks remain unwilling to lend to them

• Transaction costs to process a $100,000 loan are comparable to a $1 million loan, but with less profit to the lender; and yet these smaller loan amounts are generally needed most by startups and SMEs.

• The unstoppable force (small business need for capital) has met the immovable object (bank lending) resulting in the creation of an SME credit gap.

• And that gap is being filled by technology solutions and the emergence of online alternative finance.


Types of Alternative Finance • Non-bank Direct Lenders • Marketplace Lenders • P2P Lending and Crowdfunding • Supply Chain Finance • Accounts Receivable Marketplace • Merchant Cash Advance • Equipment Leasing • Corporate Venture Capital • Angel Investment • Venture Capital • Public and Private Equity

Section 3: Alternative Finance

Non-bank Balance Sheet Lenders

• Balance Sheet lenders make loans and keep them on their own balance sheet instead of packaging and selling off as securities. If the borrower defaults, balance sheet lenders take the borrowers' assets to cover the unpaid debt.

• Typical terms are less than 9 months and the proceeds are used for working capital.

• Repayment is made by a fixed amount or percent of sales deducted daily from the borrower’s bank account over a period of months.

• Interest rates can range from 30% to 120% on an average loan size of $40,000. • Preliminary market data: $5 billion in loans since 2007 • Biz2Credit • OnDeck • Can Capital

Section 3: Section 3: Alternative Finance

Marketplace Lending • Online marketplace lending allows borrowers to comparison shop for a

range of loan products from a variety of lenders. • Lenders can include commercial, community and regional banks and

the SBA as well as other alternative lenders. • Mitigates the high search costs for borrowers (~25 hours). • Revenue generated from fees paid by the borrower if they get funded.

Or the loan package is sold to a lender. • Interest rates and loan terms are independent of the platform and

determined by the lender. • Boefly • Fundera • Lendio


P2P Lending and Crowdfunding • Peer-to-peer/Person-to-Person and Crowdfunding platforms enable individuals,

businesses, institutional investors and investment banks to lend to consumers and businesses for specific projects.

• Platform revenue comes from origination fees deducted from the loans disbursed to borrowers and servicing fees deducted from principal and interest payments paid to the lender.

• Value proposition: Lower interest rates for borrowers; attractive rates of return for investors; and a simple, web-based platform with lower operating costs than banks.

• Platform provides investors with the ability to distribute risk among multiple borrowers. • Interest rates can range from 8% to 25% for loans up to $250,000 over three years. • Preliminary market data: $4 billion in loans to date • Lending Club • Prosper.com • Funding Circle


Outlook for 2015 • Bank lending to SMEs has improved, but has not and likely will not

return to pre-crisis levels. In June 2013, bank portfolio loan balances of $1 million or less was

$288 billion – down $47 billion from June 2008. • Online alternative finance is currently generating about $10 billion in

outstanding loan capital and these alternatives will continue strong growth in 2015. The outstanding portfolio balance of online alternative lenders is doubling every year.

• By contrast, outstanding loan capital held by the banking sector is declining an average of 3% annually.

Section 4: Outlook for 2015

Some Perspective on Alternative Finance Section 4: Outlook for 2015

700

175 140 90 75

25 10 0

100 200 300 400 500 600 700 800

Bank Loans Business Credit Card

Equipment Leasing

SBA Factoring MCA Online Alternatives

Total SME Debt Capital Outstanding as of 2013 ($ Billions)

Source: Mills, Karen and Brayden McCarthy. “State of Small Business Lending: Credit Access During the Recovery and How Technology May Change the Game.” Harvard Business School. July 2014.

SME Exporters • There are reasons for optimism – a 2013 NSBA/SBEA survey shows

that 60% of non-exporters are interested in exporting and 52% of current exporters report increased export sales since 2010.

• A 2012 Boston Consulting Group report forecasts that by 2020, declining energy costs and increasingly competitive wages will give America as large as a 25 percent export cost advantage over major exporting competitors like Japan and Germany.

• The BCG report estimates that the US will experience a manufacturing renaissance and re-shoring starting in 2015, and could add 2-3 million jobs and $100 billion in annual GDP.


Online Marketplaces • Strong growth will continue in 2105. Currently Online platform

providers generally use proprietary technologies to evaluate risk and creditworthiness. There will be increasing efforts in: • Partnerships with third party agencies for data validation. • Development of securitization and secondary market due to

institutional demand. • There are credible estimates for a potential market size of $870 Billion.

This figure comes from a comparison to banks, credit cards companies and other lending institutions that generate over $870B/year in fees and interest over $3.2T in lending activity.

• Specialized segments will continue to grow in many areas of business and consumer lending. Segments like real estate, mortgage appraisal, education and healthcare etc. will continue to evolve.


Marketplace Investors • Institutional debt and equity investors will continue to seek the

relatively high rates of return. Traditional bank loans yield 5% to 7%, while many platforms are generating yields ranging from 30% to 120% of the loan value.

• These higher yields are particularly attractive in the current, and historic, environment of the Federal Reserve’s Quantitative Easing that has kept yields low.


SME Banking • Bank lending will likely never return to the pre-2008 environment. However

banks currently own the asset marketplace lenders want the most - millions of SME customers.

• The Bank and Credit Card industry response to online alternatives will be interesting to watch. Some are already participating by: • Using their capital to fund loans on marketplace platforms • Taking a position in the platforms and offering as a value-added service. • Assisting in the development of secondary market for trading and liquidity.

• A 2013 KPMG banking survey reports that banks have generally accounted for the new regulatory oversight and are now placing a renewed emphasis on a customer-centric business model and improvements to customer’s technology experience, which in turn, will drive major investments over the next few years.


Big Data • There will continue to be strong growth in the use of Big Data and

development of scoring algorithms which integrate social data from, for example, blogs, product and business reviews and tweets. Online platforms generally recognize that integrating new sources of data is their competitive advantage.

• The key predictive goal is to establish a correlation with repayment. The more predictive the loan pool, the stronger the underwriting .

• A marketplace lender uses its own data in a feedback loop that increases the accuracy of its model. • Loan performance data feeds back into the model, further increasing the

accuracy. • As the accuracy increases, the lender can offer lower rates to borrowers. • As rates decrease, more borrowers come to the platform, driving more

data into the model.


Regulatory Oversight • Marketplace lenders fall between the cracks for federal regulators because

they’re not banking entities. Currently no single federal entity has broad authority to regulate the emerging industry.

• The majority of oversight happens at the state level, with a patchwork of regulations within state lines.

• The P2P platforms are a hybrid of lending (the domain of regulators at the state and federal level) and registered securities (the domain of the SEC).

• A key innovation of P2P lending is that lenders on the platform are not lending money to borrowers in the legal or regulatory sense; rather the lenders are investors in securities issued by the lending platforms linked directly to specific loans originated by an underlying bank.

• These and other regulatory issues will be developed in 2015.


Regulatory Oversight • Key regulatory and policy issues to resolve:

• Define the appropriate level of regulation? • Transparency and Disclosure between all parties in a transaction. • Standardized Oversight and Monitoring by Federal and State

regulators. • Borrower financial awareness, literacy and education.


Thank You

Jim Faith

Trade and Export Finance Online

http://tefo.com

[email protected]

831-227-0595

© 2014 TEFO. All Rights Reserved

Documents

The Overseas Private Investment Corporation: Enterprise