The Balance Of Small Business Investing

Last week, PYMNTS explored the rise of the family office, and how that entity may be perfectly positioned to become the next big thing in small business alternative finance. But according to Small Business Investor Alliance President Brett Palmer, we should not get ahead of ourselves.

While it is possible for family offices to invest in the small private equity vehicles that then lend to SMEs, it’s never going to become a common phenomenon. Instead, Palmer told PYMNTS what it takes for a small business investor to succeed, whether it’s a family office or not.

PYMNTS: There has been some discussion about how SMEs can benefit from direct investment from family offices. But you don’t necessarily agree that these will become a mainstream source of capital. Could you explain?

BP: There are a lot of family offices, and they certainly have a lot of capital. But they’re very difficult to access because, by their nature, they’re private. They don’t flaunt themselves. Where we look at it is from a small private equity perspective. More family offices are investing in small private equity vehicles that lend to or invest in SMEs. That model works really well for family offices to invest in because there are very good returns.

Small businesses of the world are still struggling to access capital, and they will continue to struggle with it. Small private equity funds are uniquely placed to help fill that gap.

There is an article published by the SBIA in 2012 that focuses on the pros of family office investment in vehicles that lend to SMEs. Today, in 2015, do you still hold an optimistic view of that model? 

BP: Absolutely. Small private equity makes a lot of sense for a lot of reasons There are a couple of things that make it particularly attractive to family offices. One, the economics – the returns are very good. It aligns with their interests. Two, it’s something they can understand. For a lot of the family offices, the original family money came from running businesses. They tend to be small or middle-market businesses. There are some that are very large, but they tend to be big businesses that were small and, at one point, grew into something larger, and were sold. What small private equity funds are doing is investing in those types of businesses that family offices can understand. They can have a good relationship regarding these investments. Private equity can be very attractive because it provides greater diversification and a greater level of expertise – a deeper dive – to help manage their investment.

From the other side of things, if a small business owner is seeking funding, is it possible for them to look for that financing directly from a family office?

BP: It’s really hard if you’re a small business trying to access family office money. It’s not easy to do. If you can do it, you generally will have done it early. The old saying for small businesses when you’re first starting out is the three Fs that are sources of starting capital: friends, family and fools. If you’ve got access to a family office, you’ve probably already tapped into it. Generally an angel investor will invest in small businesses as opposed to a formal family office, though sometimes the line between the two gets blurry. It certainly can be done, but it’s rare. Even private equity investment in small businesses is rare. Rarer still is for a family office to do it, but it does happen.

So contrary to some other commentary on this topic – that family offices may be the next big thing in small business lending – you don’t necessarily see this becoming a common trend. 

BP: No, it won’t be common. SMEs have always struggled with access to capital. It’s not a new phenomenon. As long as there’s been capital, there’s been small businesses struggling to access it. Especially since the financial crisis, it has been particularly acute, post-Dodd-Frank as far as conventional bank lending, which has gotten infinitely harder. Banks have really retreated from that space because of regulation, and that’s not going to get better anytime soon.

Access to capital is changing. For example, business development companies – those are publically traded private equity funds that invest in SMEs. They’ve tripled in size from about $25 billion in small business lending four or five years ago, to more than $80 billion today. In the next four-to-five years, they’re going to add another $100 billion of SME business investments to their portfolio. That is exponential growth that is filling the small business market that banks have abandoned. Small businesses are struggling to access capital, but new forms of capital are coming online. Some are expanding, like small business investment companies, which have filled a very significant gap. But they haven’t filled the whole gap – they never will be able to fill the whole gap. But family offices, angel investors and other forms of alternative financing have grown and will continue to grow for the foreseeable future, because Dodd-Frank has strangled the banking industry.

A lot of that is because SMEs are considered high-risk by the banks. What is it about small business investing that lets these alternative lenders take on that risk?

Small business is, in some ways, much higher risk. But if you’re specialized, it doesn’t have to be. It’s not like you can just buy a stock and walk away. You have to do a deeper dive, you have to understand not only the industry but you have to understand the people. The people matter in small businesses a lot. Where you can go into a big company and fire the CEO and CFO, if you fired the CEO and CFO and COO of a small business, I’m not sure there would be anybody left! They’re all the same person. You can’t just swap these people out. Small business lending requires a different set of skills as far as understanding the industry, understanding not only your capital but what the next round of capital will be and how you will exit.

But with that, there is much greater growth opportunity in small businesses. Much greater. That’s true in good times and in bad times. It’s must harder for a very large organization to grow than it is for a smaller one. SMEs have a greater opportunity, but it requires greater specialization in the small business space.