Why Corporate America's Lower-Middle Class is Irresistible to Lenders

The term "middle market" may not convey much sex appeal, at least at first blush, but companies that fit that description are proving to have a powerful allure for both the biggest U.S. banks and hipper, cutting-edge fintech firms.

What makes the companies, with revenues from $10 million to $1 billion a year, valuable customers isn't surface panache but revenue and hiring growth that are outpacing the U.S. economy, customer loyalty and the possibility of lucrative expansion, according to a new report by the financial consulting firm Deloitte

It's a market that has long been the domain of smaller, regional banks, which have the advantages of proximity and long-standing relationships. But that's changing as fintech lenders, like Kabbage, Lending Club and Bond Street offer rapid approvals through online applications that use computer algorithms to gauge credit-worthiness while traditional banks like JPMorgan Chase (JPM) and Bank of America  (BAC) offer enhanced digital services such as check deposits via smartphones and tablets.

"We've known this a long time in the industry: that you win on relationship, but you can lose a deal on price," Deron Weston, one of the report's authors, said in a telephone interview. Now, bankers can also lose a deal based on "the quality of your products and services: how innovative, how automated, how digital those products are."

Deloitte's findings are based on a fall telephone survey of 100 C-suite executives at firms with $10 million to $100 million in revenue, the lower end of the middle-market spectrum. That portion "is where we see the next wave of disruption happening, as marketplace lenders and other fintech firms" move in, the authors said in the report.

From April through June, average quarterly revenue for such businesses grew 6.6% from a year earlier, outpacing U.S. economic growth of 2.7% in the same period, the reported noted. Their payrolls widened 3.8%, compared with a 2.1% gain in the U.S. labor market.

"It is reasonable to expect this growth trajectory to continue," Deloitte said in the report. A separate study, in June, showed that nearly half of smaller middle-market firms expected to increase spending within the next year, about a third expected to borrow more money and 54% were like to buy another company.

When they need help with those ventures, they're likely to start with their primary bank, which for most is the one that provides their checking account, Deloitte said. Seven of the nine product such companies use most often are with that bank, and the relationships are what the firm called "sticky."

In other words, they last a long time. Companies stay with the banks that provide their checking accounts for an average of 17 years and with those where they borrow money for about 15 years, Deloitte found.

Wells Fargo (WFC) , which touts its position as the country's largest middle-market business lender, is well aware of the potential value in that. The San Francisco-based company expanded further in the market with its October agreement to buy a $32 billion portfolio from GE Capital that included all of the seller's secured loans and leases to middle-market firms in the U.S. and Canada.

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Such targeted growth makes sense because the customers, while loyal to their primary bank, will not only go elsewhere for services that bank doesn't provide but may consider switching to a bank that can provide all their service needs. Some 48% said they would ponder consolidating all their financial services with one bank.

While less costly loans, more rapid approval and digital technology that smaller banks typically don't have the capital to provide may lure customers away gradually, the shift accelerates for those whose growth is changing their banking needs.

Some businesses value specialist firms for services like investment banking and bond issues, Deloitte said. Other, riskier borrowers have lost access to banks because of heightened federal regulation, which opens a door for hedge funds and marketplace lenders.

About 12% of middle-market firms are more willing to working with non-bank companies than they were two years ago, and 15% described non-banks as a serious threat to traditional banks, Deloitte found.

"That's a new dynamic that's sweeping into the commercial space, and it's going to move faster than any of us think," Weston said in the interview. "The innovation or the new products and services that we're seeing in the retail space are going to expand in the commercial space. If the financial institution or the bank does not respond to that and match it, or have comparable or competitive products and services, then they are at risk of losing some of these long-term relationships."

Source: Deloitte

So-called marketplace lenders, which use online platforms to connect investors -- whether large or small -- with borrowers, have already benefited both from customer frustration with banks after the 2008 financial crisis and from the speed with which their technology-driven operations can provide loans, said David Haber, the co-founder of Bond Street.

The New York-based firm, which offers loans of $50,000 to $500,000, specializes in lending to small businesses and has benefited from greater public awareness of online platforms, thanks in part to companies like Lending Club going public. 

While requiring minimum yearly revenue of $200,000 from applicants, Bond Street has attracted much larger customers -- with an average revenue of $3 million a year -- partly because of its rapid approval process. The firm typically closes loans in two business days. 

"People still don't have great feelings toward banks, and they're very open to new relationships with new companies whose values they share," Haber said in an interview.

Indeed, in addition to the middle-market customers who said they would look to consolidate with one bank, roughly another 30% indicated that even if they stayed with their primary bank, they were open to trying services at other firms, Deloitte found.

That's an opening for big banks like JPMorgan Chase (JPM) , which has been working for several years to build its middle-market business. It's an area where the company sees "tremendous opportunities," Doug Petno, the head of commercial banking, told investors in late February.

The New York-based bank's middle-market customers, typically private companies with yearly sales of $20 million to $500 million, have more than doubled to 1,970 in the past five years as annual revenue increased more than six-fold to $351 million.

JPMorgan intends to grow further yet: It has a long-term revenue target of $1 billion from the sector and is already outflanking competitors in four of the five biggest U.S. metropolitan areas: New York, Chicago, Dallas and Houston.

Since 2009, the bank has moved into 30 new high-potential markets and is competing in all of the 25 biggest metro regions, including Charlotte, N.C.; Boston and San Diego, he noted.

"We're going to be patient and disciplined and build that over time, and build it for endurance," Petno said.

While banks have typically relied on better terms and lower rates to win customers, Deloitte's survey noted that many companies still want relationships with advisers who can recommend the best strategies and products.

"Good old-fashioned banking is still very important," said Val Srinivas, another of the report's authors.

Customers are "looking for expertise not only on their industry but also financial solutions for their financial needs," he said in an interview. "A lot of times they need to be educated about these solutions; they may not even be aware of the needs or the problems they have as they grow." 

Filling that niche may not be a priority for every marketplace lender, but it's something that Bond Street emphasizes, Haber said. 

"We don't aspire to be just a lender," he said. "We really want to be what we describe as their financial advocate, and to me, that means providing a lot more value than just the economics of our loan."

While providing the capital that enables customers to pay for their growth is an important piece of the relationship, Bond Street can also analyze the wealth of data it collects during the approval process and share those insights with customers to help them grow more successfully.

"The future is one where capital is available online," Haber said, "whether that's through another online lender or through Chase. If Chase is offering our customer the exact same loan at the exact same rate, we still want them picking Bond Street every day of the week. To me, that means we have to provide more value than just the capital."

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