Currently there is a significant disparity between small privately held businesses' strong need for credit, which is unmet, and lender's enthusiastic willingness to give credit to large companies, few of which are seeking credit.

According to research from the Pepperdine Private Capital Markets Project conducted in December 2011, 59% of 253 investment bankers surveyed said that the number of quality companies with less than $5 million in earnings before income, taxes, depreciation and amortization who are worthy of investment exceeds the amount of capital available to support their growth.

At the same time, 58% of respondents to the investment banker survey said the amount of capital available exceeds the number of quality companies with $100 million EBITDA that meet investment criteria.

This sentiment is echoed by private equity firms — 63% of the 288 private equity respondents said that the number of companies with $5 million EBITDA that are investment worthy exceeds the capital available. Of private equity respondents, 58% said that the capital available exceeds the number of companies with over $100 million EBITDA who are worthy of investment.

This "lender's paradox" will continue to be a drag on the lending industry and the overall economy unless there are measures in place to address the problem. Capital markets are expansive and today's small businesses should not have to pull out their hair and resort to credit cards or friends and family as a sole source of funding. A number of ideas could be employed to helping close the gap between credit demand and supply, here are three:

  • Banks can take a leading role in educating private businesses about simple financial terms. The very best bank websites have clear descriptions of business credit solutions. However, there are few agreed upon definitions for terms and many instances of obvious omissions. Even the Small Business Administration's "Glossary of Terms" omits "microfinance," "venture capital" and "factoring. (Note: Many of the user contributed blogs hosted by the SBA do offer information on these subjects, but these are buried on the site, difficult to find and should be covered by the SBA itself).
  • Capital providers can help small business owners understand the criteria that are needed to attain financing from different sources. In many instances, loans are negotiated separately and privately and there is no record of information. If capital providers share this information with business owners — who gets capital investments and who doesn't — lenders can streamline the process for those who are seeking capital by eliminating the sources that clearly do not meet their business requirements.
  • Similarly, banks would be well served by sharing more information about loan thresholds. Previous Pepperdine research, from October 2011, showed that about 35% of private businesses attempted to get a bank loan in the previous year and a mere 50% were successful.  Most small businesses have little understanding of important benchmarks. This results in a dead weight loss for the economy as these businesses (most, in fact) waste time pursuing loans for which they have no chance to qualifying. Private companies are faced with a cash crunch and lenders are missing opportunities to make higher yield loans. Why not publish, at least on a quarterly basis, the minimum thresholds for qualification for various important financial ratios and metrics (i.e., fixed charge coverage ratio) for approvals and declines?

Ideas like these aim to boost both lenders and private business. The timing to make these incremental improvements could come at the time when banks are positioned to benefit significantly.
Though not out of the woods yet, the banking industry is continuing to recover. According to a February 29 report from the FDIC, "commercial banks and savings institutions insured by the Federal Deposit Insurance Corporation (FDIC) reported an aggregate profit of $26.3 billion in the fourth quarter of 2011, a $4.9 billion improvement from the $21.4 billion in net income the industry reported in the fourth quarter of 2010. This is the 10th consecutive quarter that earnings have registered a year-over-year increase." The number of troubled banks also declined during the quarter. The profits are the result of banks reducing the reserves they set aside to offset bad loans. Once the housing market achieves stability, banks will have greater flexibility to allocate capital that was previously tied up covering home loan losses.

When the banks have capital flexibility we will also see an increased ability for small business to attain capital and execute growth strategies. To get there, some new techniques would help lenders, private business and the overall economy.

John K. Paglia is associate professor of finance, director of the Pepperdine University Graziadio School of Business and Management and director of the Pepperdine Private Capital Markets Project.