The Business Finance Market: A Survey


An ISR Business finance & investment study


This book provides a comprehensive survey of supply and demand, product innovation, pricing, and other matters in the business finance market.

It looks at the major factors affecting the competitiveness (growth, performance) of banks and other business finance suppliers. It examines the principal business finance products, new product developments, and marketing and distribution issues. Finally, it reviews key influences on businesses’ demands for particular types of finance.

The book will be useful to academics, commentators, and practitioners on both the supply and demand sides of the market – including executives in the business finance industry, industrial-commercial firms and their finance managers, and independent professional advisers and accountants.

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CONTENTS

1. The Business Finance Market: an Overview

Outline and summary of the main contents of the book*

2. Banks and the Supply of Business Finance

Banks versus other suppliers of business finance* How banks seek to compete and market their business finance products* Factors making for efficiency in business finance marketing* Banks’ costs and their reduction* Diversification and the development of venture capital and other non-conventional facilities by banks*

3. The Economic and Political-Legal Environment of Business Financing

Interest rates, economic growth and recession, inflation, taxation, legal regulation, and other wider environmental influences on business financing* International differences in the nature and importance of long-term debt and equity financing* Securitization in Britain and the United States*

4. The Financing Requirements of Different Types of Firm

The financing requirements of new businesses* Finance and the size, growth and performance, maturity, and riskiness of businesses* Finance and business cultures and personalities*

5. Business Financing Requirements in Different Industries

Agriculture* Residential property, construction, and civil engineering* Engineering* Chemicals* Pharmaceuticals* Food processing* Motor vehicles* Textiles* The main service industries, including banking and mortgage lending*

6. The Uses of Finance by Businesses

Start-ups* Management buy-outs and other acquisitions and mergers* Domestic and international trading* Assets acquisition and long-term business development (etc.)*

7. Factors Influencing Businesses’ Demands for Particular Types of Finance

Location, communications, and access* Advertising/marketing and bank-customer relationships* General features of business-economic and financial systems* The characteristics of businesses and the purposes for which finance is required* The economic costs/benefits of particular forms of finance*

8. The Demand for Overdrafts and other Short-Term Credit Facilities

Overdrafts* Wholesale money market facilities* Acceptance credit facilities and the discounting of bills of exchange* Company credit cards* Trade credit* Invoice discounting and factoring facilities*

9. The Demand for Medium-Term Loans and other Facilities

Medium-term bank loans* Hire purchase and leasing* Sale and leaseback and re-mortgaging facilities*

10. The Demand for Large-Scale Long-Term Finance

Large-scale long-term bank loans* The corporate bonds and distressed loans markets* Stock market and private equity/venture capital*

PRICE & SPECIFICATIONS


Print book

Third revised edition 2008. New impression 2011

ISBN 9780906321461

151 two-column pages

Hardback

Price £98.95 including free postal delivery

E-book

E-book price £16.15 (British pounds 16.15)

E-book ISBN 9780906321546


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Sample passages

Trade debts or delays in paying for goods and services received are effectively informal extensions of credit by the sellers to the customers. There is substantial linkage and substitution between factoring and invoice discounting, trade credit, and overdrafts as forms of business funding. As in the case of overdraft and trade credit facilities, the main function of factoring and invoice discounting is the provision of flexible working capital. However, in practice this often shades off into the direct or indirect financing of capital investment and business growth and development generally.

Factoring has grown rapidly in recent years.

Major attractions of factoring are the flexibility and benefits to cash flows and the speed with which individual factors are able to convert most of the new invoices into cash. In addition, factors often provide useful and staff saving associated services – such as debt collection, general credit management and protection and sales ledger administration.

In unquoted small and medium-sized businesses generally, the main methods of formal external financing are:

· overdrafts;

· bank loans;

· hire purchase and leasing;

· venture/private equity capital; and

· factoring.

As far as investment for growth is concerned, businesses require finance for a variety of specific purposes. They may want to acquire new plant and machinery and office equipment; to hire and train new staff; to built or refurbish premises; and/or to finance mergers and acquisitions.

Particularly in the case of big complex projects, mixed packages of different funding for different purposes are commonplace.

The sources of the finance for such projects also tend to vary. A combination of different kinds of finance often funds company management buyouts. Venture capitalists might supply equity and mezzanine finance and banks senior debt and overdraft facilities. On top of this, management buyout teams themselves might contribute equity finance.

Such complementarities in funding mean that increases in demand for one kind of funding often result in increased demand for other, related kinds…” (pages 18-19)

Many large banks are significantly involved in the supply of venture capital through subsidiaries.

In general, securities or stocks and shares might count as venture capital. Individual business finance packages also often bundle together equity injections, term loans, and overdraft facilities. Long-term loans might carry equity conversion options in the event of the investment financial returns being considerable and/or the size and risk of debt too great.

The total amount of finance supplied to industry and commerce by independent venture capital firms is very small compared to that supplied by mainstream bank lenders and stock market equity investors.

Like other financiers, venture capitalists themselves have to raise funds. To get capital, they have to perform well and offer satisfactory rates of return to their investors.

Supplies of outside finance into the venture capital industry are relatively volatile. With the onset of economic recession, the amount invested by pension funds in independent venture capital companies might reduce by between one third and one half in a single year.

Venture capital suppliers that are the subsidiaries of large banks or insurance companies potentially have access to large amounts of long-term funding from their parent companies. They might also be able to take a longer-term view of their investments. However, these subsidiaries still have to perform financially in their own right. They will want to avoid certain kinds of investment in favour of others and to dispose of their equity holdings once they achieve their target levels of profitability (etc.).

Irrespective of the ownership/management and resources of firms, formal venture capital in general is usually more difficult and expensive to obtain than conventional bank loans and overdrafts. It is common for venture capitalists to demand returns of 20 to 50% per annum on their investments. The minimum sums available for investment are often much too big for small businesses. For their part, venture capitalists themselves have to be satisfied that client businesses have good performance and growth prospects and will make necessary changes (etc.) before they will supply investment finance…” (pages 35-36)

Around the world, securitization is still overwhelmingly concentrated in the larger corporate sector of the business finance market.

It is mainly larger firms that issue shares and float their own IOUs as commercial paper or bonds (etc.). Smaller firms continue to rely mainly on banks and themselves for finance rather than the securities market.

The securitization of existing commercial loans – i.e., their packaging and sale as securities – has also mainly covered larger corporate loans, credit cards, motor finance, and mortgage loans. Most small business loans are not fixed-rate, long-term, standardized products that can be readily commodotized and sold to other institutions.

Non-bank organizations such as finance companies may at least potentially have the capacity to develop the necessary systems. However, no significant organized secondary market in securitized small business loans yet exists. The fact that neither banks nor non-bank competitors have been able to make large numbers of small business loans without holding on to them has helped protect the competitive position and shares of banks in the business finance market.

Banks also continue to have other advantages vis-à-vis their competitors.

They have long experience and substantial in-house expertize in making business loans. They also have access to comparatively diverse funding sources – and on a scale and flexibility necessary to keep valued business customers on their books.

They are often local and convenient to use.

Finally, they provide current accounts and wide range of useful ancillary business financial products and services – and are often in a good position to diversify further through their general relationships with large, diverse customer bases… (pages 60-61)

About one in three new businesses fail. The higher risk involved in putting money into new business ventures manifests itself in generally higher charges for outside funding.

Business financing risks tend to be lower the higher the values of assets backing loans as security. They also tend to be lower the bigger the profits, the longer the length of trading records, and the smaller the existing borrowing levels of firms.

Risk of failure tends to decline with age, higher growth, and increase in size (turnover, number of employees) of firms.

A study of the growth and performance of small- and medium-sized firms in London found that only 58% of an original sample was still in business a decade later. The chances of survival significantly increased the older and bigger the firms were. Whereas just over one-half of firms established within the past 10 years had failed, nearly two-thirds of those established more than two decades ago were still trading successfully. Further, while more than half of the businesses that employed less than 10 people had failed only one-third of those that employed 20 or more had failed.

In themselves, business age and size do not reduce the risk of business failure. There may be a significant statistical association between the age, size, and riskiness of firms. Nonetheless, numerous other, substantive factors lie behind business growth/performance and survival.

Amongst other things, positive commitments to growth on the part of management and strong growing markets often help business longevity, scale, and survival. However, in some cases achieving good profits may require that firms develop and sell fewer, higher quality, higher priced products and services for niche markets – not engage in across-the-board expansion.

No matter how fast growing and successful in selling firms might be currently, they may fail to make   improvements in their technology and products, not differentiate their products enough from those of competitors, or have customer bases that are too narrow (etc.). As a result, they may stop growing or under-perform in the future.

Finally, the wider industrial-economic environment is a major influence over which individual firms have little or no control. Thus, the survival rates of businesses in some industries (e.g. printing, pharmaceuticals, or electronics) may be significantly and persistently higher than in others (e.g. clothing or toys).

As said, apart from affecting the costs, risk also affects the main sources of business capital. In particular, the riskier the venture concerned the greater the reliance on equity finance is likely to be…” (page 73)

Banks that do have to raise outside finance are advantaged in raising funds by having access to central bank lender of last resort facilities and other official guarantees/protections against failure.

Meanwhile, the major high street banks and building societies have access to retail savings deposits through large branch networks as well as wholesale funds to convert into loans and other financial products and services. They can switch from one market to another to obtain the best rates for finance – even though building societies and other mutual institutions (unlike banks) are legally limited in the amounts of funds they can raise from wholesale sources.

If wholesale funding is comparatively cheap and plentiful, heavy dependence by building societies on personal savings to finance mortgage loans (etc.) will significantly raise their costs relative to those of competitors. Having to maintain expensive branch networks, pay more for retail savings funds, and depend heavily on one major source of finance can significantly reduce flexibility and capacity to grow and diversify.   However, the comparative costs/benefits of raising money from different market sources vary over time.

Supply and demand essentially determine the price or interest rate paid on savings deposits. Other factors being equal, the larger the supply of savings the lower will be the interest rate paid to depositors. Higher interest rates on deposits will tend to increase the supply of savings. So will levels of economic growth, employment, and real disposable incomes insofar as increased surplus personal capital does not channel into other investment outlets (e.g. house purchasing, share buying, or personal pensions and insurance).

Other factors being equal, net reductions in the supply of savings will result in institutions paying higher interest rates to savers. Increased demand for loans from deposit taking institutions will likely lead to an increase in interest rates for borrowers.

There can be substantial benefits from wholesale funding if money market rates are consistently lower than those paid to personal savers. However, wholesale fund costs fluctuate more than do personal savings rates. World economic activity affects the overall demand for industrial-commercial investment finance. Other influences on prices (interest rates) in the international wholesale money market are government monetary economic policies, official borrowing requirements, and inflation trends; foreign currency exchange rates; and the overall supply of funds to the market.

Global money flows relate to international interest rate differentials…” ( page 94)

In principle, there is a clear difference between financing short-term trading and financing fixed assets/longer-term business development. However, the two often overlap in practice. Firms often use ongoing core elements of overdraft finance as a means of long-term business financing. They also use factoring finance for business acquisition and general structural development purposes. Meanwhile, some corporate bonds are flexible enough to serve both long- and short-term finance and investment purposes.

Companies are more likely to resort to short-term financing from banks or the commercial paper market if interest rates are high – and if economies are in recession and markets are uncertain. There are other circumstances when businesses are strongly disinclined to lock themselves into significant long-term debt obligations.

However, high ratios of short-term to long-term debt (substantially more than 1:1 for long periods) can negatively affect business project financing and long-term fixed investment and development generally.

Inability to calculate borrowing costs will impair financial planning. This often occurs when short-term, floating rate loans are financing long-term fixed investments. In addition, overdrafts repayable on demand are inherently less certain and more risky than conventional structured loans.

Typically, term loans are not only longer but also larger than overdrafts. Nonetheless, the sheer scale of the funding regularly required by industry and commerce for development purposes – plus the risks involved – often rules out reliance on conventional bank loans altogether. For banks, funding large scale fixed investments and business development out of short-term retail deposits can be highly risky.

In practice, business development funding comes from a broad range of retail and non-retail debt, equity capital, and hybrid market sources.

If loan risks are higher, the interest rates charged will tend to be higher. However, if the risks are very high, then equity finance – repaid out of profits – will often be a much more suitable form of capital.

Public issues of shares and loan stock have for centuries been typical of situations where the amounts of capital required are very large and/or the allocations are for very long periods…” (pages 108-109)

Mezzanine finance is an intermediate/hybrid form of funding different from straightforward public share and loan stock issues, traditional venture capital, or bank term loans.

Unlisted firms wanting funding for comparatively high-risk projects often use mezzanine finance. So do firms who are unable or unwilling to pay the high prices for venture capital – and businesses lacking sufficient security or asset bases for large-scale long-term bank borrowing. The user firms are also usually independent indigenous companies. Home-based parent companies are more likely to finance their foreign subsidiaries directly.

Typically, mezzanine finance cost more than bank loans but less than venture capital. It is similar to corporate loan stock with floating rates of interest, regular timetables for repayments of principal and (tax-deductible) interest charges. Mezzanine finance is subordinate in security terms to normal bank loans but second charges over business assets usually support it.

Mezzanine lenders often have the right to enter into the equity of the companies they finance on favourable terms – via warrants or other options. However, the finance does not typically convert into equity for a long time (say, 8-10 years). In the meantime, senior debt will have priority over the revenues of failing companies.

Mezzanine lenders receive interest only on their loans. In terms of risk, such finance is effectively little different from equity. However, whereas equity holders can expect an immediate and higher return if companies flourish this does not apply to mezzanine lenders. Thus, in practice, both parties might be better off investing in/issuing equity from the start.

Elements of mezzanine finance are sometimes included in capital packages alongside bank loans and venture capital. Such mixed packages tend to be dearer than pure secured debt but cheaper than pure risk capital. However, it is important for firms to ensure that they use the right form of finance for the right purposes, at the right time, and at the right price. Using mezzanine debt for (e.g.) relatively low-risk/short-term bridging finance or similar purposes will be an expensive option.

Nonetheless, mezzanine finance has expanded over the years alongside venture capital/private equity and new hybrid finance forms generally…” (page 122)

Some companies want comprehensive factoring facilities. They have ongoing requirements for speeding up and smoothing out cash flows through quicker and effective processing of invoices (debtor chasing, the making of regular advance payments by factors). They can also use the associated services supplied by factors: customer credit rating and other business-and financial information, sales ledger administration, and general credit management (etc.).

However, many firms do not require full factoring facilities. All they require will be a basic invoice discounting service – to speed cash flows and obtain decisions and advances quickly, without much formality, and without the customers being aware of the discounting of their invoices.

For many businesses, the interest and other charges to clients for such services would heavily outweigh the benefits. Client businesses that have relatively small numbers or narrow spreads of debtors pose higher risks for factoring companies. Thus, the sizes of initial advances are likely to be smaller and the charges higher.

Factors looking after sales ledgers might speed up bill payments. However, some businesses do not want separation from direct contact with their customers. Amongst other things, they may not want to lose useful feedback from customers about technical requirements and product suitability (etc.).

Some client firms perform their own debt administration. They may not want regular credit protection, but only cash advances on a “with recourse” basis – i.e., the factor to seek recovery of debts only in the event of defaults. Factors may impose fairly rigorous and costly administrative terms and conditions for such special services. The client business might have to allow regular inspection of its ledgers, supply aged sales/debtor analyses, profit-and-loss and other operating statements, and generally reconcile its and the factor’s ledger control accounts. In practice, the administrative costs and hassle of such arrangements will often outweigh the benefits… (pages 127-128)

Businesses that sell and then lease back capital assets will still obtain the benefits from using those assets but turn the ownership into cash. Firms might invest this cash to better purpose is elsewhere or use it as a substitute for taking on additional debt (etc.).

However, the cash sums realized should be large enough and not fall substantially below book values. Further reducing the financial economic benefits will be the costs of the rental payments that firms now have to make to the financial intermediaries now owning the assets in order to continue to use them. The ex-owners will also lose any future gains from selling the assets concerned. Finally, they will no longer be able to use the assets as security for loans.

Mortgaging and re-mortgaging properties is similar to selling and leasing back assets.

Here in the early stages, combined capital and interest repayment costs tend to be higher than leaseback rental payments. However, rental payments tend to rise over time. In addition, ordinary rent payers lose ownership of their former assets. Thus, they will no longer be able to use them as security for further borrowing – or benefit from any future capital gains from asset price increases…” (page 133)

Annually, there are numerous successful private equity-financed takeovers of under-performing companies with lowly valued assets and depressed share prices. Usually, the new owners and management teams will want to turn the businesses around as quickly and cost-effectively as possible. Corporate takeovers (acquisitions, mergers) sometimes provoke opposition from local-national politicians, trade unions, and incumbent managements. However, buying under-performing companies and reorganizing them under new managements is a long tried and tested means of saving and turning businesses into growing profitable concerns.

The strategy does not always succeed. Nonetheless, the research evidence is that venture capital/private equity funded buyouts do tend to increase business growth, performance, and employment…” (page 149)