Every time I get together with my fellow peers, the conversation always turns to our hyper-competitive market.  This was the main topic again at the recent SFNet Independent Finance and Factoring Roundtable.

It seems that in all but a couple of years (during the credit crisis), there has been much angst about competition from banks and other funding sources. Banks are leveraging SBA programs to aggressively re-enter the commercial and industrial lending arena. What is different this time is the entrance of new competitors that are looking for ways to generate decent yields in this low-interest-rate environment. This is seen in the amount of private equity money flowing into traditional commercial finance firms as well as the flood of new “digitally enhanced” lenders.

This flood of competition has resulted in pressure on loan pricing, structure, and credit standards. Banks are very attractive to borrowers because of the low pricing they offer and the ability to deliver non-credit services. The enthusiasm of the private equity market for commercial finance business has created a new dynamic. These funds are under continuous pressure to generate favorable returns. This translates into pressure to grow, which is the primary means of generating value.

The biggest buzz at this conference and many others recently, is the rapid appearance of a new group of lenders. This segment is so new, and so dynamic, that it has burned through a number of names during the past two years. What was once referred to as “merchant cash advance” broadened to “ACH advance,” and then adopted the non-descriptive moniker of “alternative finance.” Apparently, they were not enthusiastic about that description either and are now promoting their craft as “digitally enhanced lending.”

Whatever we call them, they represent a tidal wave of funds that are rapidly flowing into our space. Their lending strategy is completely based on software and algorithms that evaluate their borrower’s deposit account activity and the ability to debit the account to underwrite the loan. This model is extremely high on the risk reward scale. It was mentioned that the rate of default runs near 25%, and the level of loan losses is near 10%. The enticement is extremely high returns. The level of returns was not shared; however, they are obviously high enough to attract institutional money despite the extremely high loss levels I just mentioned.

Why would anyone borrow money at such a high interest rate and also allow someone to continually debit their operating account to ensure repayment? In a word, SPEED. In this age of instant gratification, these digitally enhanced lenders offer an immediate solution. They promise to fund in just 24 to 48 hours. Borrowers that are fearful of missing a critical payment or a window of opportunity will jump at the chance to grab cash quickly. Whether or not they are aware of the cost and operating risk they are assuming has not deterred them from taking the bait.

Why is this tidal wave occurring? A recent conference of digitally enhanced practitioners drew 2,500 professionals, including former U.S. Secretary of the Treasury Larry Summers, who stated that he would “not be surprised if within ten years” digitally enhanced lenders “generate 75 percent of non-subsidized small business loans.”

Ironically, despite the increasingly competitive landscape, there are many investors eager for acquisitions in the commercial finance space. Banks and private equity investors are very aggressive, and valuations remain strong. It was noted that banks will pay a higher premium; however, they will thoroughly disrupt the business. Private equity investors will pay less and are more inclined to allow the business to operate as it previously had. The strategy for the seller, therefore, is dependent on whether they are interested in maintaining the business in a similar form, or whether to optimize their payout.

These factors create a very dynamic environment. This new wave of competition is not going away.  Future success will be dependent upon these factors and others (1) efficiency (2) speed and (3) risk management. Risk management is not risk avoidance. The forecast calls for greater risk taking in the future. The key is to have a game plan for acceptable risk and effectively managing the risks we are willing to take.

For those who do not have the energy or stomach to compete, this is a good time to consider selling. I anticipate a consolidation in our industry.