As we enter a tightening interest cycle, Private Lending is evolving as an option for business and property borrowers. What is Private Lending and when is it relevant?
What is Private Lending?
Private lenders are specialist finance providers who operate outside traditional banking policies and guidelines. Private lending has a long history in foreign markets and, in recent times, is becoming more relevant than ever as a global trend.
While there is a long tradition of "Solicitors' Mortgages", the private lending sector gained traction in the early 2000s across the USA and Europe. A tough credit market at the time meant that the combination of necessity and opportunity drove a surge in non-bank lenders. When markets settled, large banks stayed focused on corporations as their desired clients. The SME segment was left open to other funding options, including the "Private" sector.
However, this trend was slower to develop in Australia. Rising interest rates are one driver, but another is tightening credit policy from major and second-tier lenders across property conditions, including funding for development.
The Business of Private Lending
To better understanding the purpose of private lending, in essence, it fulfills a financing need for borrowers that fall outside the traditional metrics of credit assessment. (Refer to our article on the Five C's of Credit.)
Private lenders (or Privates) commonly service two key categories: Property or Business.
Property
Major and second-tier banks have steadily reduced their appetite for lending for property development. Banks are often lending at lower thresholds, based on a lower percentage of Gross Realisable Valuation (GRV) or Total Development Costs (TDC). They may also seek 100% coverage of debt - including evidence of 10% non-refundable deposits held.
These parameters mean developers have to contribute additional equity or generate more pre-sales. A private funding option can see a development starting faster than waiting to meet traditional credit criteria. Private funders will typically require less pre-sales and offer a higher percentage of GRV/TDC.
Business
The business lending environment is more complex. On one hand, banks and non-banks have been innovative in supporting funding for short-term needs or loans to circa $2M that meet prescribed criteria.
However, many customers with good character and capital bases are turning to private lenders when financing cannot be obtained from traditional lenders. Usually, this is due to the customer's "capacity" to service debt not mitigated enough by other stronger C's, such as collateral. Private lenders will more commonly focus on "the second way out" and ultimately preserve their capital.
What are the potential benefits?
Time to Fund
As a general rule, the private market is more nimble, and can make decisions quickly. This can deliver quicker access to funds and better speed to market for the customer.
For a property developer, this speed can result in significant savings in the overall cost of delivering a project, despite higher financing costs. For a business customer, it can secure much-needed inventory or facilitate a rapid-expansion period.
Policy & Covenants
The Private market will typically deliver a less stringent credit process. This is reflected in more flexible policy at the outset and less restrictive post-settlement covenants placed on the borrower(s). For many borrowers the time saved in the pre and post financing process is well worth the cost premium.
What are the potential risks?
Hidden Costs
It is critical to understand the terms of the agreement and this is where it is important to pause and look for good advice. Considerations include: What is the cost of discharging the loan early? For example, there can be as much as six months of interest penalty. What other financial penalties are included that may not seem "standard practice"? We give an example of "headline" fees below which can be an unexpected cost that leaves borrowers exposed.
Always check the loan contract thoroughly, and seek professional advice as appropriate.
Time Flies
Given that the profile of private lending attaches more risk, private's will typically offer much shorter loan terms. To avoid significant penalties for overstaying your welcome, start with the end in mind and have an exit strategy. Plan for this well before the term of the debt expires.
Lack of Flexibility
For those used to loan features such as redraw, offset accounts, progressively drawn loans etc., you may be disappointed. Privates will typically deliver loans without additional functionality, so you need to be clear about how and when funds are going to be used or repaid (if that is allowable).
Are there additional costs?
Clarity in Pricing
"Not all is as it seems" is a very apt quote to describe many private lending options. Comparing like for like, even for more experienced borrowers, can be challenging.
For example, how is interest calculated? Is there a line fee (charged based on the limit of the loan, not the balance). How often are fees applied?
While it is difficult to make sweeping statements on lending costs, the following is a guide for commercial purpose borrowing that compares a "reputable" Private option to a Major option.
| Item | Major | Private | Comments |
| Base Interest Rate | 5.75% - 7.0% | 8.75% - 10.0% | Interest Charged on Loan Balance |
| Line Fee | 1.25% - 0.0% | 1.25% | Interest Charged on Loan Limit |
| Application Fee | 0.50% | 1.50% - 2.0% | Be wary of Privates gauging upfront |
| Legal Fees | $1,500 | $2,000 - $4,500 | Privates have a less structured approach |
There are many examples at either side of these ranges. The purpose here is to provide a frame of reference when weighing up the costs and benefits.
In essence, apply common sense to your situation. Sometimes borrower's choices are restricted by their circumstances in which case, they need to make best use of what is offered in the market.
The Future of Private Lending
At this stage the market for private lending is relatively immature. As demand increases, the size of portfolios establish and trends emerge, lenders will better understand the risks and positioning they want to take in the market.
When we inevitably emerge at the other side of the current interest rate cycle, we hope to see this positioning solidify with more diversity in private funding options available to satisfy customer needs.
Accessing Private Lending
Due to the complex nature of private lending, it is best to seek professional advice when assessing which private lender is best for your circumstance.
A good professional adviser will have built professional relationships with reputable private lenders. Talk to your finance broker, accountant or lawyer to arrange a referral.
The team at MCP Financial Services has specialised expertise in supporting your business and personal finance requirements.
Disclaimer
The information in this article is general information only. It is not intended to be a recommendation or constitutes advice.