What’s the Deal with Private Lending?

For operating businesses across the US, the demand for capital to produce and distribute goods, pay employees, develop new revenue streams, and purchase property, equipment, and raw goods is coming more often from private lending sources. But is that ultimately a net positive, or does it create additional risks for the economy and the borrowers who are taking the money?

In this article, we’ll look at the origins of private lending, the ways private loans are structured and vetted, and some expert opinions on how this might impact risk in the longer term.

What is private lending?

Private lending is a financial relationship between a lender and borrower where the lender is not a bank, credit union, or other traditional lender. Private lenders may be high-net-worth individuals lending their own or borrowed money, or they can be an organization that lends money on behalf of a group of individuals.

Lenders are generally accredited investors or groups that pool money from accredited investors. To become accredited, an individual must have over $1m in assets, earn $200,000 annually ($300,000 married, filing jointly), or become part of a “family office” that manages $5m in assets or more.

Accredited lenders are able to invest in assets that are seen as more risky than those offered in the highly regulated public market. These small, mid-sized, and fast-growing companies (such as venture-backed endeavors that are not yet ready for a public offering) offer strong returns and often innovative ideas and products not seen in larger companies. They give investors the opportunity to invest in what’s possible, not what’s proven.

Private lenders often offer funds with an array of lending criteria much broader than those of traditional banks and credit unions, known for maintaining a strict “black box” approach to lending – you submit your application to the institution, it goes into the “black box,” and out comes an approval or denial. The borrower doesn’t really know if the institution shies away from construction contractors, developers, staffing, or manufacturing. All they find out is if they are approved or not.

In private markets, because of the variety of terms available, finding capital becomes a job based on search and negotiation techniques. Some businesses are on such a consistent pursuit of capital that they hire someone just for that role. Others outsource the work to a loan brokerage where teams maintain relationships with a network of lenders and are ready to pursue new lenders to resolve their client’s capital demands.

What Business Endeavors do Private Lenders Fund?

Private lenders fund businesses across the full gamut of legal industries. It can be helpful to identify some of the niche lending categories common in private lending. Some common uses of funds include:

• Equipment Loans: Businesses rely on quality technologies, tools and equipment to get their work done, improve efficiency, provide real-time data on performance, and ship and deliver finished products and services. Private lenders are available in every category from film and video equipment to databases, server systems, land-moving equipment, and smart manufacturing.
• Commercial Real Estate: The commercial real-estate market is growing and changing. Office buildings and malls are offering new ways to work, from co-working to maker spaces that increase people’s access to innovations in prototyping and manufacturing. Shopping centers continue to adapt to customer demands and evolving consumer trends.
• Second Home and Investment Real Estate: While primary homes are scheduled under residential lending, a second home, vacation home, or property you intend to rent in the short-stay market like airbnb or Sublet, these properties qualify as “investment real estate” and are commonly financed by a private lender.
• Bridge and Gap Loans: Real Estate often uses bridge financing when an investor is seeking to move more quickly on a property than they can when using traditional financing alone. The bridge loan allows the borrower to take possession quickly while they work through permanent financing for the property on a one to three-year timeline.
• Startup Funding: One of the most challenging periods for entrepreneurs in terms of access to capital is during their first three years. Traditional lenders look for at least two years, and often three years of business records. Entrepreneurs either don’t get financing at all, or they don’t get enough funding for their runway. By opening up a full array of financing instruments, they can discover new ways to approach securing contracts and accessing funds that allow them to grow.
• Multifamily Housing Loans: To qualify as a multifamily housing unit, a property needs to have five or more units in a single structure. Multiplexes, apartment buildings, school-to-housing or office-to-housing retrofits, and residential towers are all within the realm of multifamily housing. Loans are often built around the “class” of property based on the amenities and rental rates available for the property.
• Mergers and Acquisition Funding: Many business owners use business acquisitions as an important part of their growth strategy. They seek to acquire the operations of a competitor in their region, a similar business in another region, an operation up or down the value chain, or a related business in a slightly different category. By leveraging synergies, a merger and acquisition strategy can provide the opportunity for a business to expand its customer base, reduce costs, and improve service.
• Cash Flow Funding: Every business owner has to plan ways to resolve a prospect’s hesitancy to ‘buy now.’ A pain point they can quickly remove is the requirement for immediate payment. If a manufacturer supplies a retailer goods, the retailer wants some time to sell those goods in order to generate the cash to pay their invoice. Seasonal businesses need funds before the season starts in order to prepare for work. Cash flow financing provides access to capital so business managers can decide when and how they are going to access funds to make payroll, buy supplies, service clients, and conduct business.
• Development and Redevelopment: Land acquisition, subdivisions, permitting, utilities, these are some of the steps required before construction can begin. Some developers buy land and make it construction-ready, while others take projects from start to finish. Still others purchase delapadated properties and make them usable again. In any development scenario, there is a lot of risk. Financing is often dependent upon quality contractors and staged development. For most loans, scheduled inspections on stated project milestones are a requirement to protect lenders and developers alike.
• International Borrowers: International business owners often want to establish a foothold in the United States. They’ll set up a business entity, but because it qualifies as a new venture, even if they have existing customers here, they qualify as a new business. Add to that the difficulty with financing across governmental lines – a US lender can’t leverage assets or enforce regulations in another country. Financing international business operators falls to private lenders. Some lenders have a presence internationally and are able to work across divisions, while others use alternative strategies to establish value for lending.

Where did private lending come from?

Private lending is probably the oldest type of financing on the planet. The first central bank wasn’t established until the 1690’s AD in England, but records of borrowing and repayment date back much further. In Mesopotamia, farmers would borrow grain and repay their debt with crops they grew.

In the 20th century, private lending played second fiddle to banks and credit unions where business lending was concerned, but as regulatory constraints tightened, especially after the housing crisis of 2008, private lending has gone mainstream. Rates are competitive, and lenders conduct themselves much like banks, but often with a niche industry focus based on expertise developed by the lender or lending group.

Banks are now required to behave quite conservatively in the market, but creativity and innovation are anything but conservative. Processes for making product and service innovation a core part of business development have spread and become common. Wealthy individuals have also seen the returns provided by banks shrink as rates have remained moderate to low for extended periods.

Private lenders have sought ways to get their money into higher-risk, more innovative sectors for a variety of reasons—to participate in innovative business culture and see improved returns over banks. Today, there are more avenues to business capital than ever before, but the skills and tenacity to find the right money for a borrower can be hard to find.

How big are private lending markets?

The private lending market has seen some of the highest growth in the financial system, totaling nearly $2 trillion in 2023. That is a tenfold increase over its size in 2009. It is clear that private lending isn’t going anywhere, and that for most businesses, their financing will draw from both traditional and private sectors.

Compared with a commercial banking market of 1.4 trillion, commercial banking is doing quite well. Some in traditional lending have questioned how commercial lending will perform in more challenging markets, while others suggest we’ve seen performance for 30 years and during that time it has demonstrated consistent performance.

How are private loans different from traditional loans?

Private commercial loans differ from traditional commercial loans primarily in terms of their sources, flexibility, and accessibility. Traditional commercial loans are typically offered by banks and credit unions, involving a formal application process that adheres to strict underwriting guidelines. These loans often come with fixed interest rates and repayment terms that meet regulatory standards.

In contrast, private commercial loans are provided by private lenders or investor groups, offering greater flexibility in terms of terms and conditions. Private lenders can customize loan packages to suit specific business needs, often providing faster approval processes with less stringent credit requirements. This makes private commercial loans an attractive option for businesses that may not qualify for traditional financing due to less conventional business models or short credit histories.

Why do businesses take private loans?

Businesses might opt for private loans for several reasons. One primary reason is the faster approval process, which is essential for companies needing quick access to capital to seize time-sensitive opportunities or manage unexpected expenses. Some private loans can close in as few as 24 hours while others can take one week to a few weeks to close. A conventional commercial real estate loan can take up to 45 days to close, and when SBA loan application reviews become backed up, or when there are added criteria that must be evaluated, they can be delayed further.

Because private loans offer more flexible terms and conditions compared to traditional loans businesses (and often their loan brokers) can negotiate repayment schedules and interest rates that align with their specific cash flow situations.

The accessibility of private loans allows businesses to acquire necessary funding even when they do not conform to traditional lending standards, supporting growth and operational needs.

What kinds of businesses apply for private loans?

Private loans are particularly appealing to startups and small businesses that might lack the traditional credit history or collateral required by conventional lenders. These businesses often need capital to launch or expand operations rapidly and cannot afford the lengthy approval processes associated with traditional banks.

Businesses in niche markets or those operating with unique or experimental business models may turn to private loans, as their non-traditional approaches might make typical lenders hesitant. Rapid growth is another indicator a business will have better success with broker-sourced private loans. Companies experiencing rapid growth or seasonal fluctuations in revenue may choose private loans for their flexible repayment options, which can be tailored to match their variable cash flows.

But what about venture capital? Venture capital is well suited to business ideas that can grow from a seed to a $1 billion valuation on a timeline of about 6 years, but for what we describe as “Operating Businesses,” those that provide a solid service or create quality, established products, venture capital is absolutely not the right choice.

Massive amounts of capital were sucked out of the venture markets in 2015, the year of the “Death of the Unicorns.” The reality is that many of these companies that reached $1 bn valuations between 2018 and 2021 never became profitable. The Operating Businesses that we work with place a premium on profitability over capital access – each dollar funded must go to profit-generating activities for the simple reason that failure to repay the loan would result in foreclosure. Harvard Business Review indicates that taking venture capital is like taking a loan with an interest rate of 300%.

The difference between private loan financing and venture capital funding comes down to the difference between responsibility and hubris.

Overall, private loans provide a flexible financial tool to enterprises that operate outside the standard banking lending criteria, yet require capital to sustain and grow their operations.

Are private loans more risky than other financing types?

Risk in private lending has to be evaluated on two sides: the risk to the lender and the risk to the borrower. Because banks pool the assets of many depositors, the individual depositor’s risk is limited as compared to direct loans, where the lender can be a single wealthy individual or an investment group which is still relatively smaller than a bank.

Private lenders often closely vet the borrower’s business plan, physical assets, cash flow, and contracts in an effort to validate the borrower’s capacity to do what they say. On the other hand, the borrower may agree to a floating rate, a higher interest rate, leverage against an asset such as real estate, a shorter term, or a variable rate loan, all factors that may increase the borrower’s risk to mitigate the risk of the lender.

Across multiple assessments of the past 30 years, private lending has not demonstrated significantly greater risk than traditional loans or corporate bonds. For borrowers, private loans help them access capital without giving up equity, and for lenders, direct loans provide competitive returns without the red tape and intermediaries associated with traditional lending markets.

How Businesses Access Private Loans

Accessing private loans can be a strategic move for businesses seeking flexibility and speed in their financing options. One of the most effective ways to navigate the private loan landscape is by leveraging the expertise of a skilled loan broker. Loan brokers act as intermediaries who understand the diverse private lending market and are equipped to match businesses with lenders that align with their unique needs and circumstances.

Our knowledgeable loan brokers assess the specific financial requirements and goals established for your business, such as funds needed, use of funds, repayment preferences, and any potential financial constraints that should be taken into consideration. We then identify potential lenders whose terms and conditions are a good fit. We engage lenders in a conversation to refine and target detailed terms until we have a match. This targeted approach saves time and ensures that we connect you with lenders that are predisposed to accommodate your needs.

Our expertise in negotiating loan terms is a primary part of our service to you. We bring the insight and experience to advocate on behalf of the business, securing favorable terms such as competitive interest rates, appropriate collateral requirements, and flexible repayment schedules. We help you not only access the funding you need but also the conditions that support the financial health and objectives of your organization.

Are you looking for the right capital but haven’t found it? Contact our team so we can find and structure a deal that aligns with your operational demands and financial strategy, empowering you to pursue your vision and growth strategy.