Lender to Lender Finance: Everything You Need to Know About Alternative Lender Relationships

In this article, we’ll break down what specialty lending companies seeking capital need to know about what differentiates banking relationships with alternative lender relationships by answering five questions.

• What is lender to lender finance and who are the key players?

• Why can it be difficult for specialty lending companies to secure bank financing?

• How is traditional bank and alternative lender activity evolving and what’s the impact?

• What are the unique advantages of partnering with an alternative lender?

• What should specialty lending companies consider when evaluating alternative lender partners?

What is lender to lender finance and who are the key players?

Lender to lender finance is a funding arrangement where one financial institution provides capital to another financial institution. This type of lending occurs when specialty lending companies require financing to manage liquidity needs, optimize capital utilization or facilitate short-term funding requirements. Lender to lender finance plays an important role in maintaining the stability of the financial system by ensuring that financial institutions have access to the necessary funds to meet their obligations and manage their day-to-day operations efficiently.

For the purposes of this article, we’ll define the key players that provide capital as traditional banks and alternative lenders, and specialty lending companies as the institutions that secure capital. Because traditional banks, ranging from community to larger regional FDIC-insured institutions, offer a broad range of products and services, they will typically have one group dedicated to lender to lender finance. These groups within larger institutions might help balance the bank’s liquidity positions or earn interest on excess reserves. Alternative lenders, such as private credit funds that raise money from investors and subsequently deploy capital, tend to maintain a niche on lender to lender finance, with focus on generating risk-adjusted returns for their investors.

The types of specialty lending companies that secure capital from these funding sources are wide ranging, from factors and other asset-based lenders to auto finance companies and merchant cash advance lenders.

Why can it be difficult for specialty lending companies to secure bank financing?

For specialty lending companies, partnering with traditional banks can offer a variety of advantages, including access to larger funding amounts, more competitive rates due to a lower cost of capital for banks and longer loan terms. However, it’s important to note that it can be difficult to qualify for traditional bank financing due to stringent eligibility criteria, even for some of the strongest performing specialty lending companies.

Traditional banks have historically demonstrated a reluctance to extend loans to startups, defined as businesses with less than two years in operation, as well as enterprises operating in specific high-risk asset classes or those with unconventional revenue models. This cautious approach often leaves many specialty lending companies, which focus on distinct industries or collateralized assets, in a challenging position when seeking funding support. In addition, stringent covenants and demanding financial performance metrics enforced by traditional banks throughout the loan tenure can create hurdles for specialty lending companies with unique operational structures or limited operational histories.

The path to securing traditional bank financing for specialty lending companies includes various obstacles. These challenges are further compounded by evolving market dynamics that are leading to more rigid lending practices.

How is traditional bank and alternative lender activity evolving and what’s the impact?

Since 2008, activity within the lender to lender finance sector has included both traditional banks and alternative lenders. However, there has been a noticeable shift away from the previous dominance of a few major banks in the space.

According to the 2024 Small Business Credit Survey conducted by the Federal Reserve, the disparity in the percentage of financing sources applied to by small businesses has been narrowing since 2020. In 2020, 79% of business financing applications were directed towards traditional banks, with only 29% going to alternative lenders. By 2023, these figures shifted to 72% and 37% respectively, indicating a trend towards a more balanced distribution of business financing applications between traditional banks and alternative lenders.

Percentage of Business Financing Applications by Credit Source Since 2020

Source: 2024 Small Business Credit Survey. Graph combines responses for Traditional Banks (Large Banks and Small Banks) as well as responses for Alternative Lenders (Online Lenders and Finance Companies). For applicable survey years, the application rate excludes demand for pandemic-related assistance programs (i.e., the Paycheck Protection Program). Respondents that submitted more than one application could select multiple funding source options.

The market gap shrinking stems from a convergence of dynamics reshaping the entire financial services industry.

Market Dynamic 1: Industry Consolidation

Increased merger and acquisition activity across traditional banking institutions has created opportunities for alternative lenders to grow their portfolios. As certain lending sectors and asset classes are being left behind by larger institutions that have shifted their focus to mainstream markets, more alternative lenders have either entered the space or have started to capture these underserved segments of the market.

Market Dynamic 2: Technology Enhancements

Simultaneously, technology enhancements driven by the digital banking era accelerated by events like COVID have set the stage for a more competitive market where flexibility and adaptability are critical for lending success. Alternative lenders have had the opportunity to scale operational efficiencies by leveraging technology enhancements at a faster rate compared to traditional banks that move slowly as it relates to adopting new lending technologies.

Market Dynamic 3: Evolving Regulations

In the aftermath of the 2023 regional banking crisis, banks have heightened their already stringent requirements, adding an additional layer of complexity to securing capital. The crisis catalyzed a significant tightening of credit standards, making access to funding even more challenging for specialty lending companies seeking financial support. As banks recalibrate their lending strategies, there is a noticeable shift towards prioritizing revenue streams to other areas, such as deposits and treasury management that do not require extensive capital deployment.

These market dynamics have opened the door for alternative lenders to step in and offer tailored financial solutions designed to address the specific needs of underserved niche markets. While these trends have reinforced the position of alternative lenders as reliable providers of capital, it has also led to increased competition as a growing number of players enter the space vying for deal flow and market share.

With a crowded landscape filled with noise and marked by highly competitive pricing, the importance of specialty lending companies making informed decisions amidst the plethora of options available becomes increasingly more important.

What are the unique advantages of partnering with an alternative lender?

Understanding the distinct advantages associated with alternative lenders is crucial in selecting the right partner for specialty lending companies in order to meet their specific financial needs and preferences effectively. From a high-level, what sets alternative lenders apart from traditional banks is their overall adaptability, an area that is seemingly becoming more important in today’s competitive lending landscape.

Unique Advantage 1: Flexible Processes

The flexibility exhibited by alternative lenders is a direct response to the traditional banking sector’s increasing focus on mainstream markets, leaving niche segments underserved.

As most traditional banks retreat to familiar asset classes, like real estate or equipment financing, they continue to shy away from investments in other niches, such as factoring, merchant cash advances or small-ticket consumer finance. This shift towards a standardized approach within specific asset classes can pose challenges for unique specialty lending companies in need of tailored solutions to accommodate their distinct requirements.

Conversely, alternative lenders adopt a more expansive strategy when it comes to targeting a diverse range of asset classes. Unlike banks, which are focusing their efforts around well-known sectors, alternative lenders embrace a broader strategy that encompasses niche overlooked markets. Being inherently more agile and responsive, alternative lenders typically operate on a smaller scale and exhibit faster decision-making. Therefore, many of these lenders have not made significant investments in a “one size fits all” process, such as hiring subject-matter experts, adapting underwriting procedures or implementing specific loan servicing systems. This more generalist and nimble approach allows alternative lenders to swiftly adapt and craft versatile frameworks that cater to a wider array of specialty lending company clients, filling the void left by traditional banking practices.

Unique Advantage 2: Expedited Underwriting

Alternative lenders offer a notable advantage in the speed of underwriting compared to traditional banks. This is primarily the result of differences in regulatory constraints.

Banks, known for their meticulous and stringent underwriting practices, often move slowly in evaluating and approving transactions. The regulatory requirements imposed on banks contribute to this slower pace as they must adhere to strict guidelines and compliance standards which inevitably makes underwriting and funding timelines longer. In addition, banks will require coordinating all legal, diligence and closing engagements with various third-parties which can lead to further setbacks, as well as costly fees being assessed.

In contrast, alternative lenders operate in a more agile and flexible environment which does not include the same level of regulatory scrutiny that banks face. This allows alternative lenders to swiftly underwrite deals, make quick lending decisions and provide expedited access to capital that empowers specialty lenders to sustain rapid growth momentum. For example, if a specialty lending company needs to move quickly on finding additional capital to support the growth of its clients within its portfolio, an alternative lender can usually complete underwriting in a matter of weeks, instead of months through a bank. As a result, by partnering with alternative lenders, specialty lending companies are less likely to have to deal with headaches related to capital constraints that may surface during the underwriting period.

Unique Advantage 3: Custom Loan Structures

Traditional banks, by nature, exhibit a more risk-averse approach compared to alternative lenders. This inherent difference leads to a unique advantage in customizing capital structures to suit the specific needs of specialty lending companies. Tailored funding solutions offered by alternative lenders span a spectrum of products, ranging from senior lines to subordinated debt or participation capital, and provide a more personalized financing experience for specialty lending companies.

In the traditional banking realm, senior revolvers are commonly issued at conservative advance rates, typically hovering between 60-75%, coupled with competitive pricing and extended terms, usually spanning 5-7 years. While this standardized approach fits the bill for many specialty lending companies eligible for bank financing, alternative lenders bring a different dimension to the table. Alternative lenders can provide the remaining leverage and offer higher advance rates, sometimes reaching up to 95%. For instance, if a specialty lending company holds $100 million in assets across its portfolio, a bank may extend a senior line of credit up to $60 million (or 60% of the value of the assets), leaving room for an alternative lender to provide subordinated debt up to $38 million (or 95% of the remaining value of the assets). Subordinated debt involves higher risk for alternative lenders, and is therefore more costly for specialty lender borrowers. However, the weighted average cost of capital tends to be lower due to the lower amount of equity needed. This type of flexible structure enables specialty lending companies to leverage assets effectively while limiting equity injection.

The lender to lender finance space is continuing to evolve with more innovation around custom loan structures. Certain private credit funds now offer larger facilities without the hassle of dealing with multiple lenders. Additionally, the emergence of insurance company affiliates within credit funds introduces the option for more affordable term loan debt, reducing the dependency of alternative lenders needing traditional bank funding and enhancing the longevity of credit arrangements.

What should specialty lending companies consider when evaluating alternative lender partners?

In lender to lender finance, alternative lenders have emerged as valuable partners for specialty lending companies as the market faces retreating banks. While the surge of alternative lending options has empowered many specialty lending companies with flexible capital, it has also intensified the competition. To harness the unique advantages offered by alternative lenders, it requires a detailed evaluation of potential funding collaborators. Here are three key areas to consider for specialty lending companies that are conducting due diligence on prospective alternative lending partners.

Key Consideration 1: Overall Customer Experience

The level of the customer experience hinges significantly on diving into the array of asset classes encompassed by alternative lenders. Conducting meticulous research, which involves requesting case studies within comparable asset classes and evaluating the alternative lender’s proficiency in handling similar assets, can pave the way for a seamless customer journey. Uncovering the fact that an alternative lender has a track record of effective underwriting practices and adept loan servicing for similar specialty lending companies can serve as a testament to their ability to craft bespoke lending experiences tailored to specific business models. This validation process not only creates confidence in the alternative lender’s capabilities but also ensures a smoother and more personalized long-term relationship.

Key Consideration 2: Required Funding Timelines

For specialty lending companies to ensure sustainable growth, it’s critical to avoid constraints imposed by funding challenges. Specialty lending companies must have a firm understanding of the pace at which their portfolio is expanding and anticipate any prospective deals that require immediate funding. With these insights, specialty lending companies can proactively communicate their precise funding needs to potential funding sources during the assessment phase, setting clear and realistic expectations among all stakeholders involved. By aligning funding requirements with growth projections and deal pipelines, specialty lenders can navigate the funding landscape more effectively, ensuring a seamless and timely financing process that supports their business objectives.

Key Consideration 3: Strategic Debt Structures

While traditional banks may offer larger amounts of funding and extended terms in comparison to alternative lenders, specialty lending firms oftentimes require additional funding avenues. For specialty lending companies seeking a diverse range of debt structures and higher advance rates equipped with lower equity contributions, alternative lenders present an attractive option. It’s essential for them to have a comprehensive understanding of the debt options offered by potential alternative lending partners and to ensure strategic alignment with business goals and funding requirements when considering alternative lending partnerships. By strategically evaluating these areas, specialty lending companies can make informed decisions that best suit their financial needs and growth aspirations.

Specialty lending companies will certainly prioritize these various considerations differently, recognizing the nuanced impacts of customer experience, funding timelines and debt structures on their growth trajectories. Strategically aligning with an alternative lending partner that caters to their distinct requirements can ensure specialty lending companies are able to effectively manage liquidity needs and optimize capital utilization. More importantly, it will enable them to fortify their market positions and unlock new opportunities for innovation and success in the evolving financial ecosystem.