The passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act in July, 2010 was largely a knee-jerk reaction to the financial crisis. This sweeping piece of legislation has had, like many legislative initiatives, numerous unintended consequences. For example, many believe that Dodd-Frank is responsible for the precipitous decline of the small community bank, the life blood of small businesses across the country.
However, it is difficult to singularly lie this at the door-step of Dodd-Frank. In 1995, there were about 13,000 banks with assets under $100 million. By the time Dodd-Frank became law in 2010; this number had dropped to 2,265 and it continues to shrink. In the four years following the passage of Dodd-Frank, another 365 small banks have closed, merged or otherwise disappeared. The Minneapolis Federal Reserve projects another 317 small banks will be lost in 2015.
There are persuasive arguments on both sides of the question but, regardless of cause, the irrefutable fact remains; small community banks are dwindling and small businesses are suffering from the vacuum, unable to secure loans necessary to sustain and grow their businesses.
Blood in the Water
A vacuum, to a hedge fund, is like blood in the water to a shark. Small to medium sized businesses are finding it increasingly difficult to borrow from conventional lenders and hedge funds are rushing in to fill the void with asset-based loans to small companies.
Hedge funds can be incredibly creative in the way they structure a loan, particularly in the manner of securing their investment. Hedge funds, unlike their conventional banking counterparts, have collateralized loans to small companies in ways unimaginable to bankers.
For example, hedge funds may require that a company pledge its patents as collateral, a practice almost never seen in traditional banking. Other hedge funds have secured themselves through convertible bonds. This means the borrowing company agrees to relinquish future equity in exchange for the loan.
The Trend is Gaining Traction
Lending to small business is not uncharted territory for hedge funds but the unabated retreat of banks from small business lending is creating substantial demand. Also whetting hedge fund managers’ appetites for this type of investment are the potential returns. The research firm eVestment reports that hedge funds dedicated to lending experienced average returns of almost 12% in 2012, compared to average hedge fund returns of around 2% in the same year. This heady combination of high demand and large gains is not lost on hedge fund managers.
There is little evidence of a paradigm shift in the banking industry with regard to small business lending. As a result, hedge funds and other purveyors of alternative lending options will continue to erode the market once dominated by community banks and other traditional lenders.
We may never fully understand the reasons for the decline of the community bank but, it is heartening to see the vacuum being filled by hedge funds, private equity firms and others. More than one-half of American workers owe their jobs to small business and hedge funds are saving and creating those jobs by engaging this demand.