Brendan Ross on Direct Lending Investments, and the future of small business lending
The economic collapse accelerated the need for crowdfunding and peer-to-peer lending for startups, but established businesses needing capital to move to the next level were kept out of the party by the SEC.
Until Regulation A+ limits become a reality, established small businesses are in a bit of a netherworld when it comes to accessing capital.
Lower interest rates and bigger banks looking for bigger returns mean small business looking for smaller amounts to invest in some equipment, or a larger building, are constrained in their search. The smart money sees this as opportunity.
By nature, these established entities have a track record, a customer base and financial records that make it easier to assess viability.
Their management are more likely to have experience. An overall reputation has started to form. Some of that smart money comes from Direct Lending Investments, a private investment firm which specializes in lending money to established small businesses.
Their President Brendan Ross spent some time describing Direct Lending Investments and commenting on the direction the industry is headed in.
What criteria do you use to select the lenders you work with?
Most important is the lender’s management team, which must share my beliefs about the loans that are worth making and owning at this time: short term, high yield, low default risk based on a proven underwriting model, and responsible.
These need to be loans that businesses are happy to receive and fully able to pay back. The rest of my lender due diligence process centers around lending practices, including how they source borrowers, their underwriting process and expected default modeling, a full review of their legal documents, their track record, and their funding as an enterprise.
Choosing lenders is the most important thing I do. It’s also the most infrequent.
I’ve been in operation since late 2012, and I only have three lenders at present. We do not make mistakes during this process.
You do not favor loaning to startups. Why is that?
Every business to which I loan money has a plan for how that money is going to grow their business. Some of these plans will succeed and some will fail, but all borrowers need to have enough of an existing business to pay me back whether their growth ambitions succeed or not.
Startups do not have an existing business to fall back on, therefore lending to them is not conservative enough for me.
Debt is probably not the right choice for most brand new startups because debt requires immediate servicing. How is a new startup going to start repaying its loans?
There is a time and place for debt, but the very beginning probably isn’t it.
Small businesses are finding a harder time securing the credit to expand that many acknowledge is needed to help the economy recover. Why don’t government and traditional lenders realize this? Will they eventually? Will we see this change?
In that piece, the Fed notes that small business lending has been declining since 1995 for a large number of reasons (fig. 2).
The biggest problem is simple: America now has a lot of service businesses, and many of these businesses are great creditors for me because they have long and substantial operating histories. But what service businesses don’t have much of is collateral.
I don’t need a big pile of machinery to make a loan because I know that service business are a good credit risk. But bank regulators are simply not comfortable with providing banks with the ability to add leverage of 10 or 15 to 1 while making loans that are back by limited collateral. The idea that only borrowers with collateral are worthy of loans is just plain silly.
Look at the immense profits made on credit cards, all to borrowers who have more debt than assets. But the financial system just can’t get its head around lending to service businesses that aren’t swimming in collateral.
I don’t think this blind spot will correct any time soon. Alternative lenders, attracted by the profits available in this space, will have to fill the gap, and this will be slow going for a while because banks continue to exit small business lending.
What business sectors provide the lowest volatility and which ones are historically more risky?
Among my loans, I favor doctors, dentists, retail stores, restaurants, and hotels. These are brick-and-mortar businesses with a large number of small customers. If they have been around a while, they are likely to survive most of what is thrown at them.
You mention that in order to sufficiently spread out risk, investors need at least 400 loans at $25 each. Does the average investor have patience to seek out and maintain such a wide portfolio? Yes, you need a lot of diversification to avoid getting hammered by bad luck. This is part of why LendingClub and Prosper made small slices available: because they wanted to protect their corporate reputations by making it easy for investors to diversify. On the business lending side, it’s almost all whole loans. The loans I buy average $37,000, so the $10+ million you need for diversification is beyond the reach of most investors. Diversification is part of why people with less than $10 million come into my fund.
Do they have sufficient knowledge? Investors mostly don’t have the patience or knowledge to pick loans themselves, and they really shouldn’t worry about that.
They can follow three paths:
Use a LendingClub Prime account or Prosper QuickInvest: Both platforms will build a portfolio for you with little effort on your part.
Hire a statistician that is connected to an automated investing tool. Bryce Mason’s is the front-runner here. Bryce picks loans based on his models, and automated software can buy them directly into your account. More work, and more cutting edge, but if an investor is determined to do something to get an edge and can’t afford a fund, this is the best option.
Choose a Fund Manager. Unfortunately, professional management in this space is available only to accredited investors who can meet some fairly high minimums. My Fund, at $100K, has one of the lower minimums around. Still, this is probably the best path available assuming the manager has significant experience in and knowledge of this asset class.
Is 400 loans a lot for a sector with low volatility?
Many years ago, the LendingClub site had a tagline: “No one with 800 or more loans has ever lost money.” I’m not sure what happened to that tagline, but it was there for a reason: the benefits of diversification extend far beyond where most investors lose track of the complicated math involved.
What were some formative lessons you learned from your business career before Direct Lending Investments? I’ve been lucky to have such an incredibly broad range of experiences, and it seems like all of them help me today. When I graduated from Brown, I went straight into management consulting. I knew pretty quickly that I wanted to be a CEO, and I gathered a lot of experience — much of it in e-commerce — in the 10 years it took to get my first shot at company leadership, when I ran www.ReserveAmerica.com for Barry Diller. I ran other companies after that before deciding to change things up and tackle the money business with a private credit investment fund. I think my experience as a CEO of multiple real businesses has given me a unique perspective on small business lending.
Because I’ve raised money, borrowed money, written business plans, reacted to good and bad luck, hired people and fired people, I really understand all sides of the equation. I know what investors want from me, I know what I want from the lenders I work with, and I know what they want from the businesses they lend to.
Mostly I’ve learned that business is only rarely about naked competition. Businessmen and women succeed best when other people want to work with and for them. I try to be someone that others enjoy having in their corner.
How will the climate for Direct Lending Investments change as the economy recovers? Do the opportunities become more or less numerous? How are they different?
More numerous. Even as the economy improves, businesses continue to exit small business lending. So my opportunity set is growing as more businesses qualify for loans while fewer banks make them. Private credit is really in its infancy, and it is going to be huge.
Does the ACA in any way affect your investment strategy with doctors?
Yes, it does. ACA has really slowed down the process by which doctors get paid for their services, and you can see it in their cash flows. We want to be a part of the solution, but we have had to tighten lending requirements across the medical industry. Hopefully the system will work out these kinks, but for right now ACA is definitely impacting cash flows in the medical industry.