29 Jul Are Mid-Sized Businesses Higher Risk?
By Michael McAdams, President, Pasadena Private Lending
Historically, many statistical experts have put small-to medium-sized enterprises (or SMEs) into the middle of the classic statistical bell curve of risk. That is, SMEs are often placed in the medium-to-higher risk category, between low-frequency large corporate defaults and high frequency consumer defaults.
In this simplistic chart, the left tail of risk is for large corporate issuers who infrequently default because of their resources, experienced management teams, and accounting oversight as well as their customer’s continued acceptance of their products. The right tail of risk is for consumers who, as a group, may default with regularity, although exposures are typically small and highly diversified.
Statistics for both large corporates and consumers come from massive databases and provide analysts and traditional credit evaluators with extensive information on both large corporations and consumers, making it easier to assess key risk parameters.
Standard and Poor’s, Moody’s, Fitch Investor Services, Kroll Bond Rating Agency, DBRS/Morningstar and several other Nationally Recognized Statistical Rating Organizations (NSRSOs) collect and analyze corporate financial data. Likewise, a myriad of credit reporting agencies and credit card and mortgage grantors collect and publish data on consumers.
Clearly, while large corporate defaults are rare, many will recall the surprises of Enron, Health South, WorldCom, Lehman Brothers and FTX. Likewise, the sub-prime mortgage crises saw an unexpected concentration of consumer risk. And while those extreme events caused huge losses for many large corporate constituents including employees, governments, vendors, bond holders, other lenders, mortgage holders and owners, most corporate defaults see the companies reorganize with moderate economic losses spread over an array of creditor classes. Likewise, most consumer defaults in normal times result in modest losses to relatively few.
On the other hand, SMEs reside in the “so-called” fat part of the default probability curve, or the belly of the frequency distribution,” and so appear by sheer size to represent greater risks. While those millions of SMEs make up the vast number of US businesses, and logically, some significant number of annual defaults, the question remains exactly how many defaults do they experience? However, because their data is often unavailable except among private lenders and commercial banks, the exact figures are unclear. More problematically and more importantly, compared to the big companies and consumers, what is the severity of those defaults on lenders, vendors, employees, and owners? That is, ultimately, how risky are SMEs?
First let’s define risk in this context. Risk is not just the risk of default (or non-payment as expected) but also the risk and severity or magnitude of loss to any constituent after a restructure of a company and its capital structure as well as after a senior creditor has exercised their legal rights to sell company collateral and/or pursued collection from any/all other available means. That is, it is appropriate to consider the amount and timing of actual loss vs. any temporary non-payment issue.
In short, as noted in a presentation by KBRA Structure Credit Finance News in December 2022, SME companies typically have higher recoveries in default because they have less complex capital structures to restructure if necessary and the knowledge of the nuances of the business is significant by both managers and lenders, among other factors. Likewise, it is Pasadena Private Lending’s (PPL) experience, that compared to very small firms and consumers, SMEs traditionally are companies with committed owners, often with outside wealth to invest in a business if needed.
One of PPL’s Board Members, Arturo Cifuentes Ph.D., a former Columbia University Business School professor has however said that the academically robust case for SME risk still requires more data than to date has been available. This is because most SMEs are privately owned, do not issue public securities, do not seek NSRSO credit ratings, and typically operate under the radar of national business press. However, developing SME databases and analytical services like that of KBRA DLD and “next-gen” rating firms like WiserFunding (an updated AI-based reinterpretation of Professor Edward Altman’s seminal research into corporate risk) are focused on the space.
However, in best available numbers, reported SME defaults have tracked the direction of general economic defaults and tend to run “plus/minus 20%” of the general corporate default rate. That is, if the large corporate market has had a 3% default rate, than SMEs have had a 2.4-3.6% default rate in recent years. The difference has tended to come from industry concentration issues – i.e. energy or auto industry-specific issues – and it has worked both ways if SMEs had dedicated production to a key supplier or if their production was applicable to a wide variety of industries. Again, these are reported defaults and probably under-represent smaller companies that are less well tracked by outside services.
Unfortunately, banks and even private lenders continue to be unwilling to share portfolio data even when it is anonymized. However, several private lending software firms like AIO Axis recognize the benefits to their clients and are building means by which anonymous compilation of portfolio data could be shared with researchers, investors, and rating agencies. A large increase in data – and change – is on its way.
Until that time, we may not have either the quantity or quality of data to make complete comparisons to either large corporate borrowers or the mass of consumer borrowers. However, the experience of millions of corporate owners as the drivers of the US economy combined with PPL’s experience over the last 20+ years indicates that well-diligenced SMEs can be an optimal balance of risk and opportunity for all constituents.
I invite you to consider the possibilities by further exploring our website where we share our credit process and spotlight our team. And when the time is right, contacting us however best serves you.
Until then, stay well and financially nimble.