Small businesses suffering from an overly conservative lending market may find are now looking to hedge funds for asset-backed loans, according to a report by www.businessweek.com.

Banks, rattled by the $400 billion loss in bad investments over the past year, have largely cut off lending to small businesses throughout the U.S, forcing entrepreneurs to explore unconventional financing methods. Hedge funds providing asset-backed loans - commercial loans secured by the business’s inventories, equipment, accounts receivables, real estate or other collateral – have become a popular source of credit.

Since the 4th quarter of 2007 lending from 300 asset-based lenders has dropped substantially. Unlike larger corporations, small businesses don’t have large reserves to float the business through tough times. Asset-backed loans from hedge funds generally cost 2 to 3 percentage points higher than the prime rate, require asset appraisal, and may involve physical inspections. Fortunately, the processing time is only a 2 to 3 weeks.

Lately, we have seen more and more banks hesitate to lend to certain industries such as Gas Stations, restaurants, small retail establishments. The turnaround time for processing loans has increased for two reasons: 1. Bank underwriters are reviewing deals more thoroughly. 2. Rate cuts have increased the volume of loan requests. Also, lenders are now requiring businesses to transfer their banking to the Institution as a hidden prerequisite for financing.

Given current market conditions, we expect to see longer processing times and more documentation requirements from lenders. For the next two months small businesses should focus on controlling expenses and building a solid banking relationship. In this market knowing a business banker is more important than knowing a good business bank. On a lighter side,we expect to see the benefits of the economic stimulus and interest rates cuts trickle down to small businesses as soon as banks reorganize and strengthen their balance sheets.

The Fed cut interest rates March 17 by 75 basis points. The repeated rate reduction drove down prime lending rates to 5.25 percent. As predicted over the past two months, there’s a large possibility of more rate cuts in the future.

The impending recession and rising inflation make this an opportune time for small businesses to borrow money and acquire assets at a low price. The combination of higher inflation and low interest rates will lead to larger margins overall as wage inflation costs decrease.

Also, in this market environment small business owners can expect competition to wane, providing valuable growth opportunities. At the same time, businesses can keep fixed costs low to lower their leverage and increase their revenue streams to improve visibility.

Vendor financing may seem like the obvious answer. It requires little paperwork, time commitment and avoids the hassle of interacting with institutional lenders. However, vendor financing is a much more expensive way of buying equipment than taking a loan product from a traditional bank.

For example, generally franchises tie-up with a select group of equipment financing institutions to offer their franchisees equipment purchasing opportunities. Interest rates on these products can range up to 200 to 400 basis points higher than on a financial product from a traditional bank.

Even gas companies offering prospective gas station owners acquisition financing deals can hike interest rates up to 400 basis points. Not to mention, they’ll lend at a 15-year term and build in a surcharge on fuel sales while a conventional banking product is generally spread over a 25- to 30-year term with no additional fees on fuel sales.

Small business owners need to weigh the 200 to 400 basis point cost savings and the 5 to 7 year longer payback period against the initial hassle and time commitment of gathering documents.

Over the past couple of months, the Federal Reserve’s interest rate cuts have dominated business and financial publications worldwide. Following a 50 basis point cut in September, October’s 25 basis point cut has raised expectations of more rates cuts to come. According to a recent article in the Financial Times, analysts predict that the Fed rate will drop to 3.5 percent over next year.

What does this mean for securing loans to expand your small business or buy another? What kind of financial product should you choose - a floating rate or fixed rate? How should you deal with prepayment penalties?

If you’re looking for long term funding (more than 10 years), secure a floating rate. Business lending is based on the prime rate, which directly correlates with the fed rate. With the economy expected to soften in 2008, prepare for a sluggish cash flow. A rate cut will give you the opportunity to convert to a fixed rate in next six to nine months when interest rates bottom out.

The majority of small business owners do not like floating products, because future cash flow becomes unpredictable. In spite of a short term higher sticker rate, it‘s an opportune time to utilize floating rate products and save money over the term of the loan.

There are instances when small business owners cannot fully avail this opportunity. For example, small business owners with SBA loans cannot refinance to a fixed rate for the next three years due to prepayment penalties. Still, the small and medium enterprises will benefit from lower interest rates because the floating rate (linked to prime) is expected to drop over the next year.

Interest rate trends beyond the next year to two years remain uncertain. The increasing shortage of commodities, especially oil, will increase cost-based inflation. This type of inflation is much more difficult for central banks to manage than demand-based inflation. The growing demand in emerging markets like India and China will also keep an upward pressure on inflation, restricting the central bank’s flexibility to lower interest rates. Rates may even rise.

But every cloud has a silver lining. The increasing demand in markets like India and China may open new markets for small businesses owners. The strategies for that impeding opportunity will be topic of my next blog… Until then, enjoy the lower cost of capital.