Small and medium-sized enterprises, or SMEs, form the foundation of our global economy. They represent 90 percent of all businesses and employ more than 50 percent of the world’s workforce, according to the World Bank. Yet for many reasons, SMEs struggle to access the necessary capital to expand, modernize, and thrive. Recent global events, both economic and geopolitical, have exacerbated this concern.
The alternative lending marketplace can offer many solutions, including one intriguing to both investors and SMEs. Senior secured loans present options for businesses to acquire growth capital outside the traditional bank-lending process. Senior secured loans can help small businesses obtain the cash they need to hire more staff, open new locations, expand inventory, or simply make monthly payrolls.
Growth requires capital, which banks historically have been hesitant to provide to small businesses. In the 1990s, banks began reducing their risk exposure, prompted in part by the Basel Accords. And since the financial crisis of 2008-09, banks have been even more reluctant to lend to small businesses for a variety of reasons. Businesses might have low cash flow, inadequate credit or collateral, or customer-related concerns. Further, since the financial crisis, banks have faced more lending regulatory requirements and the increasing costs associated with them.
The COVID-19 pandemic has placed similar lending pressures on SMEs. Though banks had money to lend, they instituted a “lockdown on lending” and focused on their larger customers. The Russia-Ukraine war, unstable fuel prices, rising interest rates, and recession anxieties further stressed the lending environment. As a result, the World Bank reports, SMEs are undercapitalized by $5.2 trillion annually.
So who can help SMEs meet their financial needs to achieve their business goals? Alternative lenders, including business development companies (BDCs) such as Saratoga Investment Corp., support middle market businesses that banks might disregard. Alternative lenders offer timely, flexible access to capital through transparent means and easy-to-use options.
One of those options is the senior secured loan. Unsure how it works? Then here’s everything you need to know about senior secured loans.
What Are Senior Secured Loans?
Senior secured loans are financing options that investment companies, such as banks or BDCs, provide to companies that need capital to support operations or expansion efforts. Banks or other financial institutions often package these loans as financial products and sell them to investors, who value their attractive yield, comparatively low risk, and stability when interest rates rise. Why are senior secured loans potentially less risky investments than bonds? Because of the words “senior” and “secured.”
Senior debt represents the highest priority among a borrower’s repayment obligations. If a company goes out of business, it must repay senior debt first, followed by junior debt (such as bonds), and then stockholders.
Paddy Hirsch, an author and economic commentator, makes this comparison: Perhaps you’re buying an airline ticket. Where you buy that ticket (in first class, business class, or economy) determines when you’ll get off the plane. Those in first class disembark before those in economy. Senior debt represents the first class of creditors, while stockholders sit in economy class.
The secured component of the loan means the debt is collateralized with company assets or property. If the borrower goes bankrupt, those assets can be sold to repay creditors. Those two factors in combination make senior debt the first to be repaid in bankruptcy situations.
Senior secured loans usually carry floating interest rates and are short-term obligations. Here are a few examples.
In June 2022, a media company secured a five-year senior secured loan for $2.425 million to repay existing debt and fund growth. Also in June, a tech company specializing in Artificial Intelligence borrowed $50 million to refinance debt and generate working capital. In both cases, the companies invested (either in credit commitments or research and development) without feeling burdened by existing debt.
Many SMEs can benefit from using senior secured loans but might be unsure about them in practice. Here’s a look at the practical aspects of senior secured loans.
How Senior Secured Loans Are Structured
Senior secured loans generally are floating-rate, fixed-term loans that companies use to fund expansion or debt service. The floating rate usually is based on the London Interbank Offered Rate (LIBOR) or the U.S. Prime Rate plus a fixed spread.
Here’s an example. Say the lending agency establishes its fixed rate at 4 percent, and the LIBOR rate is 3 percent. The senior secured loan’s interest rate would be 7 percent. Because those rates float, however, interest on a senior secured loan might fluctuate quarterly or even monthly, depending on interest rate movements.
As noted earlier, senior secured loans typically are used for transactions where capital is needed. At scale, that might mean acquisitions and buyouts. For SMEs, funding growth is the primary concern.
Senior secured loans are term debts, usually lasting between three and eight years. And, as the word “secured’ indicates, they require collateral to obtain. The loans also might require the borrower to fulfill certain debt agreements, or covenants. These can include maintaining a specific credit profile or certain business activities.
SMEs considering a senior secured loan should examine their options, which can grow overwhelming. A reassuring lender will cover the pros and cons of each borrowing possibility, including senior secured loans, to determine which opportunity provides the most flexible options and highest benefits.
Benefits of a Senior Secured Loan
Investors and borrowers view the benefits of senior secured loans differently. For investors, senior debt can be attractive because income payments rise as interest rates rise. That can provide investors with a hedge against inflation. In addition, senior secured loans typically experience low default rates because collateral backs them.
For borrowers, senior secured loans can offer lower-cost and more flexible lending options. With the fluctuating rates, payments can decrease when interest rates fall — though conversely, payments increase when rates rise. Borrowers also can receive more favorable lending terms, depending on the creditor.
Senior secured loans are more accessible to SMEs and have an easy application process. These are some of the many reasons borrowers might contact a business development company about a senior secured loan.
Ultimately, however, these products are about investing in companies, countries, and communities. Companies of all sizes must grow to be successful. Those that don’t expand fall behind. Many companies view the prospect of growth as exciting and inevitable.
According to McKinsey, the world will witness a “once-in-a-lifetime wave” of capital spending on physical assets by 2027. McKinsey estimates the global capital investment surge to reach $130 trillion, much of which will be spent on infrastructure rebuilds and decarbonization projects.
A 2022 Guidant Financial survey of small-business owners found that 75 percent reported being happy and 65.3 percent were profitable. Yet they’re eager to be happier and more profitable: 51 percent want to hire more staff, 41 percent want to expand or remodel, and 40 percent want to invest in digital marketing.
Growth certainly can be difficult, particularly during inflationary periods that stress a company’s resources and ability to expand. However, choosing the status quo over growth can stress companies even more. By growing, companies identify ways to obtain new resources, provide better products and services, and reach more customers.
Growth is vital to a company’s “long-term survival.” Capital investment helps fund growth, and business development companies such as Saratoga Investment Corp. can help fund that investment.
Conclusion
Small and medium-sized businesses drive global employment, innovation, and economic development. But they need capital to advance responsible and sustainable growth plans. Moreover, they need capital to address unforeseen circumstances that arise during economic instability.
Banks traditionally have underserved the SME market, contributing to the global SME finance gap. Alternative lenders such as Saratoga Investment Corp. can help fill this gap, providing SMEs with compelling capital options to fund important projects.
A senior secured loan represents one of the many options alternative lenders can provide to growing companies that require reliable funding. Saratoga Investment Corp. has worked with SMEs in software, healthcare, education, industrial services, and many other industries to secure the capital they need to build a lasting future.
Interested in a senior secured loan or other financial product to launch your company’s future? Then review Saratoga’s investment profile to determine whether its services meet your company’s needs.