Private Equity Chasing Returns in Small Business Lending

Between October 2007 and December 2008, the Federal Reserve dropped interest rates by 5.25%. In fourteen months. That is one of the fastest, steepest rate cuts in history.

And it broke things for a lot of people.

If you were retired and living off the interest from your savings, you were suddenly earning almost nothing. If you were a conservative investor who stayed in bonds and CDs, your returns basically vanished overnight. People who had done everything “right” were now drawing down their principal just to pay the bills.

So where does all that money go when it can’t sit in a savings account anymore? It goes looking for returns. And it found them in some unexpected places.

Wall Street Stopped Pretending

Green spends time in this chapter pulling apart what happened to Wall Street. And it’s not a pretty picture.

There was a time when investment banks actually had their clients’ interests in mind. Merrill Lynch was founded on the idea that regular people should be able to invest. The firm built its reputation on trust.

That version of Wall Street died a long time ago.

By the time the financial crisis hit, investment banks had shifted from advising clients to trading on their own accounts. Goldman Sachs employees were caught calling their clients “muppets.” The firms were betting against the same products they were selling. Nobody on the inside even pretended to care about the people on the other side of the trade.

Then came the flash crash of 2010, where the stock market dropped nearly 1,000 points in minutes because of automated trading algorithms. And then LinkedIn went public at a price-to-earnings ratio of 722. For context, Google was trading at 27 times earnings. LinkedIn was at 722.

If you were an ordinary investor watching all of this, the message was clear. The stock market isn’t really for you anymore. It’s a casino run by people with better computers and fewer ethics.

Angels Fill the Gap

So a bunch of investors decided to skip Wall Street entirely and put their money directly into companies they could understand. Angel investing.

The numbers are surprising. In 2010, there were roughly 250,000 active angel investors in the U.S. compared to about 900 venture capital funds. Angels did 61,900 deals that year, investing about $20 billion. Venture capital? Only 2,750 deals for about $22 billion.

That means angels were doing over 20 times the number of deals as VCs, for almost the same total amount of money. The typical angel investment was $25,000 to $50,000. Small enough to be meaningful for a startup. Small enough that losing it wouldn’t wipe out the investor.

This was a massive shift. The early-stage funding market was no longer controlled by a handful of Sand Hill Road firms. It was distributed across thousands of individuals making their own bets.

Venture Capital Lost Its Edge

Green makes an interesting argument here. Venture capital used to be the lifeblood of early-stage innovation. That’s not really true anymore.

VC firms got bigger. They raised larger funds. And with larger funds came larger deal sizes and lower risk tolerance. It doesn’t make sense to write a $25,000 check when you’re managing a billion-dollar fund. So VCs moved upstream. They started doing later-stage deals. Safer bets. Companies that already had traction.

That left a huge gap at the early stage. Angels filled it.

The target return for an angel investor is about 10x in five years. That works out to roughly a 60% annual ROI target. In practice, a well-managed angel portfolio actually returns somewhere between 20% and 30% per year. Which is still fantastic when savings accounts are paying 0.1%.

Investing in the Infrastructure of Lending

Here is where the story connects to small business lending.

Some of these angel investors weren’t just funding the next social media app or food delivery startup. They were funding companies that wanted to change how money moves. Specifically, they were investing in platforms that could automate the sorting and evaluation of funding requests. The whole point was to take the loan officer out of the equation.

Think about what that means. For decades, the bottleneck in small business lending was a human being sitting at a desk, reviewing applications one at a time. These new platforms could do it in seconds. Match borrowers with lenders automatically. Use data instead of gut feelings.

By the time Green wrote this book, over $100 billion had already flowed through these innovative lending channels since 2005. That’s not a niche experiment. That’s a real market.

The Numbers Were on Their Side

The trends all pointed in the same direction. Internet adoption was growing at 107%. Entrepreneurship was at its highest level since the mid-1990s. The median borrowing need for a small business was about $44,000.

That $44,000 number matters. It’s way below what most banks will bother with. But it’s exactly the sweet spot for an automated online lender. No branch. No loan officer. No three-week underwriting process. Just an application, an algorithm, and a funding decision.

The demand was there. The technology was there. The money was there. All three showed up at the same time.

The 72% APR Nobody Talks About

Now here is where Green drops a warning. And it’s an important one.

Merchant cash advances became one of the fastest-growing products in alternative lending. The pitch sounds reasonable. You get $100,000, and you pay back $136,000. The owner looks at that and thinks “okay, that’s 36% total. Not great, but I can live with it.”

But that’s not how it actually works.

The repayment comes out of your daily credit card revenue. Every single day, the lender takes a percentage of your sales. For a business with decent volume, that $136,000 gets paid back in about six months. Not a year. Six months.

When you do the math on an annualized basis, that 36% is actually 72% APR.

Green puts it bluntly. “Pigs get fat, hogs get slaughtered.” There’s nothing wrong with making money on lending. But charging 72% while making the borrower think they’re paying 36%? That’s the kind of thing that brings regulators knocking on your door.

Name Your Commission

It gets worse. Some merchant cash advance funders let their brokers “name your commission.” The broker could charge anywhere from 1% to 15% on top of the advance. That commission came out of what the borrower received.

Think about the incentive structure there. The broker’s job is supposed to be finding the best deal for the borrower. But the broker gets paid more by steering you toward the most expensive product. That’s not a misalignment of incentives. That’s a complete conflict of interest.

And for a small business owner who doesn’t know any of this, who is just grateful someone finally said yes to their funding request? They’re the easiest target in the room.

The Bottom Line

Chapter 5 tells two stories at once. The first is genuinely exciting. Billions of dollars in private capital rushing toward innovation in lending. Angels funding platforms that could serve the small businesses that banks wouldn’t touch. New technology making $44,000 loans economically viable for the first time.

The second story is darker. Some of the people in this new market were not interested in building a better system. They were interested in extracting as much money as possible from people who had no other options. 72% APR hidden behind friendly math. Broker commissions designed to reward exploitation.

Both stories are true at the same time. That’s what makes this chapter important. The private capital that flowed into small business lending created real opportunity. But it also created real danger for the people it was supposed to help.

This post is part of a series on The Banker’s Guide to New Small Business Finance by Charles H. Green, published by Wiley (2014). It covers Chapter 5: “Private Equity In Search of ROI.”

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