Lean Into the Scary: Assessing the Funding Source Market for Factors in 2023

While we often focus on how factors can provide financing to their clients, factors themselves need funding. In 2023, with the overall economic environment in a state of flux, costs and availability are a moving target. Jeff Whaley, CFO of Haversine Funding, spoke with Commercial Factor to outline how factors can shore up their funding sources to compete in an increasingly chaotic landscape.

How has a rising rate environment affected the cost and availability of funds for factors in 2023?

Jeff Whaley: The rising rate environment has certainly constrained the availability of funds for factors and made the funding that is available more expensive. This new and evolving environment, combined with the recent round of bank failures, has made banks increasingly hesitant to invest in this space and will likely continue to do so over the remainder of the year. Base rates (SOFR and Prime) have increased dramatically over the last nine months, and the spread required above those base rates has widened as banks and other funding sources perceive an environment of increased risk. In some cases, the cost of capital to factors has almost doubled over the course of the last year through these rate increases, combined with having to identify new, higher cost sources of financing to further support senior credit lines where banks have tightened credit.

Do you expect costs to increase or decrease this year? Why?

Whaley: There are a couple of ways to look at this question. With regard to funding costs, yes, they will more than likely continue to increase this year, as the Federal Reserve has indicated increased hawkishness to head off continued inflation. The recent round of bank failures will probably temper the rate at which the Fed raises rates, but rates are still looking to head up this year.

With regard to operating costs, I expect that labor and operating costs will also continue to increase but could potentially moderate somewhat near the end of the year as the increased interest rates inevitably start to slow down economic activity. In order to reduce costs, factors should look to identify lower cost solutions to maintain their margins. Those solutions could be outsourcing or automating labor-intensive processes. Further, smaller factors will need to leverage employee flexibility to cover multiple roles.

Similarly, how do you expect availability to trend through 2023? Why?

Whaley: I expect that availability will become more constrained, as increasing yields will create more competing uses for funds. Additionally, banks curtailing risk will likely result in constraint of availability throughout 2023.

For factors concerned about an impending recession, how can they work with their funding sources to ensure they have consistent access to capital to fund their businesses?

Whaley: The first key for any factor concerned about ensuring consistent access to capital is communication. Factors must be aggressive in communicating with funding sources about potential growth or challenges in their respective businesses. This communication should be direct and as precise as possible regarding potential needs for funding. Additionally, factors should be willing to “cast a wide net” with regards to obtaining funding, educating themselves on the various types of financing available in addition to their structures, timing and funding requirements. These options could be to replace their bank lines but could more plausibly be used to bolster those credit lines for growth or to offset more restricted eligibility requirements. Banks are not likely to be as reliable a source of funding over the next 12 to 24 months since they likely will be operating with increased scrutiny of their respective liquidity positions.

What has the competitive environment been like for funding sources this year?

Whaley: The competitive environment has been intense as interest rates have increased. Over the past few years, alternative lending and factoring offered a yield that far exceeded the yields available with more conventional debt products. As market yields have increased, alternative lending yields have exceeded those of more conventional debt securities by an increasingly slim margin. Given that set of circumstances, competition for funding sources has become much more acute. We have seen new entrants focused on non-bank lender finance as a result of these constraints. Haversine was formed to fill a gap in the market dedicated to helping the small to mid-sized factors grow. We’ve continued to increase our client base, expanding to working with larger finance platforms. Additionally, we are seeing a few bank lenders that still want to carve out a niche for themselves in lender finance, but in those cases, they are doing so within a tighter framework, creating needs for subordinated debt and other junior capital products.

How would you describe deal activity in 2023 and do you expect it to improve or get worse the rest of the year? Why?

Whaley: Deal activity began to pick up in the fourth quarter of 2022, and that increased rate of activity has persisted into 2023. With that said, between credit quality and conservative underwriting, there is a lot more deal flow but not as many closed and funded transactions. We expect the volume of deals to only improve through the end of the year as more businesses increasingly look to non-bank sources for financing.

Has there been any change over the last few years in how or from who factors seek funding? If so, what is behind this trend?

Whaley: Yes. Historically factors would primarily receive financing from regional banks or a bank lender finance group combined with equity and capital support from their personal finances, fundraising or even large subordinated (mezzanine) debt tranches with minimums of at least $10 million (but likely larger as a minimum requirement). In that environment, there was a gap in funding sources providing capital that falls between equity and senior debt in the capital stack. If you were a startup or small shop, it would take you longer to build your platform, as you needed to raise money, give up equity or find participation partners to meet your growing funding needs. To respond to this gap in funding sources, new groups have come to market with unitranche solutions at a higher cost of capital, or, like with us, offering both senior and subordinated debt starting at $1 million and going up to $25 million.

What is your overall outlook for the factoring industry in 2023?

Whaley: Is chaos an acceptable answer? The outlook for 2023 is very difficult to predict because the data we are seeing in the overall economy and, more specifically, within the alternative finance industry, seems to point in disparate directions. On one hand, we see a lot of volatility in the market, which would indicate real headwinds for factors and their clients. Generally, though, it seems collections are still on solid footing and unemployment remains remarkably low.

If history is any guide, times of volatility generally point towards consolidation, as volatility will inevitably lead some players to exit the market. By the same token, we expect new players will enter the factoring industry seeking opportunities as banks become more restrained in their lending to small and medium-sized companies. Cases could be made equally convincingly that 2023 could either be the start of a process of consolidation within the factoring industry or a genesis of new non-bank players entering the spaces vacated by banks.

A lot of how you perceive the next 12 months may depend on where you sit in the factoring industry. Does your company have a solid and diverse set of capital sources? What industry concentrations does your portfolio have? What is your firm’s appetite for risk? A firm’s answer to these questions will probably dictate how they fare over 2023 in unpredictable ways.

It’s probably wise to steal a phrase from our president at Haversine, Gen Merrit-Parikh: “Lean into the scary.”