For lenders to thrive in the current demanding capital landscape, understanding the pulse of the market and the factors driving it is of utmost importance.
In today’s financial market, capital is a precious commodity. The current dynamic between borrowers and lenders is undergoing a seismic shift. The shortage of discretionary capital has led to an increased premium for capital demands. In other words, there’s a lack of available funds that can be freely used, so there is an extra cost associated with meeting capital requirements. This shift affects how deals and loans are being done. LTVs, interest rates, and deal flows are creating challenges and opportunities that echo throughout the financial landscape.
Private lenders must have a layered capital stack with multiple sources of funding to be successful beyond 2023. This is because institutional capital sources are volatile and susceptible to market changes. Lenders with their own capital, warehouse and leverage lines, relationships with existing correspondence or syndication partners, family offices, and institutional investors will be the most viable and stable lenders in the space.
In 2023, institutional capital sources were once again unreliable. These sources are often driven by Wall Street dynamics, interest rate changes, and economic changes. Additionally, the decision-makers at intuitional capital sources often lack the experience and depth to understand private lending. They also lack the tools and technology to scale their risk management assessment.
One notable exception is a new trend with a couple of lenders who know how to underwrite and fund loans and who are backed by fully or recently sold-to committed institutional funds. These lenders have displayed exceptional underwriting and risk management skills, direct ownership with a favorable cost of capital, and trust in their leadership.
What are some recommendations for diversifying capital and creating multiple capital stack resources? Consider these:
Funds and loans on balance sheet in the form of funds, private placement, and syndication.
Family office backing
Warehouse and leverage lines
Strip returns as a fund source of its own
Specialty institutional funds like insurance company investments, pensions, and endowments
Traditional institutional lines
IMPACT ON LVTS
The current market conditions have triggered a distinctive ripple effect on LVTs, a fundamental metric in lending that determines the ratio between the loan amount and the appraised value of the asset. With capital becoming scarcer, lenders are exercising caution, leading to a more conservative approach in determining LVTs. This conservative approach is evident in various sectors, from real estate to small business loans. Lower LTVs act as a safety net for lenders, reducing their exposure to risk in an uncertain market. Consequently, borrowers face the uphill task of bridging the gap between the loan amount they require and the reduced valuation of their collateral.
INTEREST RATES DRIVE BORROWING COSTS
Simultaneously, the landscape of interest rates has undergone a significant transformation. The scarcity of available discretionary funds, coupled with the situation with Treasurys and the bond markets, has triggered a surge in interest rates, creating a costlier borrowing environment.
In response to this shift, lenders have adjusted their rates upward to balance the risk and maintain profitability. The increased rates are deterrent for borrowers, compelling them to reconsider their financial and investment strategies. Businesses and individuals now face the challenge of evaluating the sustainability of borrowing at these escalated rates.
This market scenario has woven itself into deal flow dynamics. Transactions that would have swiftly materialized in a more liquid market now face extended timelines and increased scrutiny. Deals that previously met funding criteria with ease are now subjected to rigorous evaluations, creating a bottleneck in the flow of transactions. This scenario affects various industries, from real estate acquisitions to startup funding, constraining opportunities and altering the pace of business development.
FINANCIAL PLANNING IS CRITICAL
Amid these shifting dynamics, borrowers find themselves in a position where strategic financial planning is imperative. As the gap between desired loan amounts and the reduced valuation of collateral widens, borrowers must explore innovative ways to secure the financing they need. This may involve seeking out alternative assets that lenders find attractive or working on enhancing the appeal of their existing collateral.
Additionally, as the lending landscape has become more competitive, it's essential for borrowers to sharpen their negotiation skills. Understanding the nuances of different lending sources, from traditional banks to private equity firms, can help borrowers identity the best fit for their financial needs.
In conclusion, current market conditions, characterized by the scarcity of discretionary capital, have necessitated a change in thinking in the lending landscape. The impact on LVTs, interest rates, and deal flow is palpable, challenging both borrowers and lenders to adapt and innovate. By exploring diverse sources of capital, adopting nimble strategies, and maintaining transparency, lender can navigate this turbulent landscape.
By Alex Kaddah, Sam Kaddah and Kendra Rommel
Private Lender, The Official Magazine of AAPL
Winter 2024 (Q1), p. 30-32