The landscape of small business financing is changing. No longer do entrepreneurs have just two paths: venture capital or traditional bank loans to grow their businesses.
A new wave of private credit funds and other alternative lenders has emerged, providing small businesses with new ways to access capital.
The private credit market has grown; by mid-2024, it was valued at $1.34 trillion in the US. The growth of this private credit market has big implications for US small business financing.
What Is Private Credit?
Private credit (or private debt) is loans to businesses from nonbank lenders; think private debt funds, BDCs (Business Development Companies), and specialty finance companies.
As the Federal Reserve explains, it “generally refers to direct loans made to mid-market businesses by nonbank vehicles such as private debt funds and Business Development Companies (BDCs)”. In other words, investors like pensions and insurers lend directly to companies outside the public markets.
For small businesses, private credit is an alternative to traditional banks or SBA loans. Historically, a small business owner would use personal savings, credit cards, or a bank line of credit (in 2023, 44% of small businesses applied to big banks, 28% to small banks).
Now there are more options. Only 23% of businesses applied to online lenders, so banks still rule, but private funds and other forms of alternative lending are changing the mix.
In short, today’s small business financing landscape includes these new options. For small business financing needs, private credit funds and fintech lenders are now part of the mix alongside banks.
The Explosive Growth of Private Credit
To put it in perspective, consider the numbers. The Fed says private credit “has grown about 5x since 2009” and is around $1.34T by mid-2024. McKinsey says it’s around $2T by the end of 2023. What was once niche is now a multi-trillion-dollar industry.
Institutions are pouring money into private credit for yield, and businesses are going to it as banks tighten. Stricter post-crisis rules have made banks more cautious with smaller loans. A Brookings study found regional banks “lost a good chunk of their core business lending” to nonbanks.
In practice, much more capital is flowing through alternative lending channels. The impact is real: private credit supported around 1.6 million jobs and $224 billion in US GDP in 2022.
These numbers show that private credit funds and business credit funds are now major sources of capital for American companies, especially smaller ones.
The Bank Pullback and Downmarket Lending
Banks, hit by post-crisis rules, have largely ceded the small business market, leaving a financing gap for small firms.
Private credit providers moved in to fill that gap. Many funds and BDCs started lending to the smaller companies that banks had abandoned. In effect, alternative lenders are now serving Main Street through fintech platforms, BDCs, and business credit funds.
Benefits for Small Businesses
What does it mean to a small business? In a word: greater flexibility and speed. Private credit transactions are typically highly tailored.
Lenders might permit payment-in-kind interest, longer amortization, or fewer covenants than a bank would. For small companies requiring peculiar terms, private debt might be their only possible remedy.
With that flexibility, businesses can drive growth without debilitating restrictions.
Private lenders, however, borrow even more aggressively than that. Most allow for more leverage: a bank might cap a small-company loan at roughly 3.5× EBITDA, but a private fund will borrow up to 5× or even more.
Such increased ability to borrow gives a borrower the capacity to finance larger projects or acquisitions.
Speed is a further benefit. Private credit funds normally have capital available, so when a deal has been negotiated, money can come in several weeks rather than several months.
For a company that is running to do something about an opportunity, that can be a difference-maker.
Finally, borrowers get more hands-on help. With private money assembling portfolios of firms, they can potentially be partners.
A private lender was touted by one entrepreneur for providing strategic guidance, “they’ve allowed us to get a chance to talk about how we can improve,” he noted, something that no bank would ever do.
Such mentoring can be invaluable for smaller firms.
These mutual advantages go a long way to explain why most aspiring businesspeople consider these alternative sources of credit. The terms of finance can better suit their requirements, while a bank’s “no” can become a private funding source’s “let’s do it.”
Considerations and Risks
This broader credit market comes with caveats. Private debt tends to cost more than bank debt; loans have higher interest rates and fees to accommodate the extra risk.
Borrowers may issue equity warrants or agree to hard covenants. Due to these loans being private, their visibility is reduced, and it pays to do one’s homework thoroughly and compare deals with care.
There has been notice of growth, but none of alarm, from regulators to date. The Federal Reserve’s 2023 report rated the risk of instability as “limited.” Indeed, private-credit-fueled loans default less than similar bank loans in some data.
Still, policymakers call for caution; fast growth anywhere can seed trouble later on.
Even banks are getting in on it. Most of the large banks have developed their own private credit funds or strategic alliances.
Goldman Sachs, for example, plans to double its private credit portfolio from about $130B to $300B over five years, meaning that they think private lending is going to be part of the future/permanent landscape, not a phase.
Conclusion
Private credit funds and nontraditional lenders are revolutionizing small business finance in America. More small businesses need to be financed than ever before, and they can access it from more sources than before.
According to American Investment Council’s Drew Maloney, “small businesses need access to more capital, not less.” With this new trend comes no longer exclusivity for banks alone.
Industry and policy circles now specifically refer to the private credit market when advising on ways to enhance small business funding.
In fact, such a move to alternate funding has generated many new funds providing business credit and specialty lenders that are tailor-made to finance entrepreneurs.
Such innovations reflect that private funds can no longer be considered fringe players; they are integral to the funding landscape of U.S. small businesses.
The word to business owners is simple: get rejected by a bank? Shop other offers. Private credit and business credit funds bring tailored loans and quick funding, even offering insights banks can’t. And yes, shop rates and terms judiciously; not all deals suit all businesses. But with these sources, a small-business owner can potentially discover the growth capital to flourish.
Featured Image – Freepik
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