Against an otherwise difficult investing backdrop, the rewards of investing "local" outweigh the risks. Small business investments offer a unique opportunity to generate attractive returns that are less correlated to public stock and bond markets.
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The Current Investing Environment

I read a comment recently from a prominent investor describing the current investing environment as a "haunted house market" where a new scary event lurks around every corner. I'm with him.

The past few years have seen a strong recovery in real estate, and stock and bond markets have had a great run. For investors, there's been a lot to celebrate.

But there's also plenty of reason for caution. After years of artificially low interest rates, thanks to the world's central bankers, most asset classes are priced for perfection, and dividend and bond yields are at historic lows. The Fed now looks set to raise interest rates in 2015, and increasing challenges in the Eurozone and geopolitical risk in the Middle East and the Crimea are creating more uncertainty. Oil prices have dropped by half, which is good, but this introduces volatility into a huge part of the economy. Meanwhile, emerging markets are in turmoil.

It's worth asking: do the world's central bankers really know what they're doing? Even professional investors find this to be a brutal market to navigate. It feels like a perilous time for the preservation of capital.

What's an astute investor to do? Many historically looked to hedge funds, venture capital and private equity to find diversification and returns that are less correlated to stock and bond markets, but recent results have been mixed. According to BarclayHedge, the average hedge fund returned 3.46 percent net of fees last year, compared with a total return of 13.7 percent for the S&P 500; private equity and venture capital firms have more capital than they can put to work.

Meanwhile, on Main Street USA., the economic recovery has been more of a slow burn. Recent data suggests that business formation began to tick up in 2015, but surveys show that a combination of government regulation and lack of access to capital makes this a challenging time to build a small business. This is significant for the American economy, considering that smaller enterprises (generally defined as having fewer than 500 employees but mostly having a handful or less) tend to represent about half of US GDP and a similar share of all US employment, and generate almost two-thirds of all new jobs.

The Case for Investing in Small Businesses

In this perilous time for global financial markets, sophisticated investors should be putting their capital into U.S. small businesses. Why? Because demand for capital remains significant in an era when even the smallest companies operate across borders. It's more tangible to invest in something "local," where capital investment provides a critical fulcrum for entrepreneurial risk-taking and innovation. The returns are attractive: on average, gross interest rates on small business loans range from 10 to 17.5 percent. And this is a huge market -- according to the Small Business Administration (SBA), the outstanding loan balance to small businesses at the end of 2013 was $580 billion.

It's also a market that's in the early phase of undergoing monumental change.

First, while Europe, emerging markets and parts of Asia struggle, the US economy is continuing to heal. According to the National Federation of Independent Businesses (NFIB), small business optimism recently hit its highest reading since October 2006. While many businesses still cite the Affordable Care Act and taxes as key dampeners, small businesses are adopting an expansionary mindset, and demand is growing.

Second, new regulation and Basel III capital rules are changing bank behavior. The cost to lend to small businesses has risen, so appetite to lend has contracted, limiting the supply of capital. Plus, consolidation among banks has left fewer, larger lenders. The result, according to a just-released Federal Reserve Bank report, is that more than 50 percent of small businesses say that they are unable to get the capital they apply for.

Third, technology enhancements and the advent of big data are in the early stages of revolutionizing how credit risk can be evaluated and distributed. A variety of tech-driven platforms have begun to disintermediate the bank lending market, directly matching those with capital with those who need it. This "democratization" of how investment capital flows is evident in the consumer segment, through equity crowdfunding sites like Kickstarter and lending marketplaces such as Lending Club. It's now working its way into small business finance, providing a source of transactions for investors.

What to Keep in Mind

To be fair, the risks to small business investing are material. Small business loan losses have averaged 5-6 percent through economic cycles, including the financial crisis in 2008. They're not liquid, so capital is usually tied up for 3-5 years.

Small business investing also requires different expertise and due diligence compared to public market investing. Start by defining what types of small business you are willing to invest in, and the form of investment you're willing to make. Source opportunities, or work with someone who can help you find them. Do the analysis. Small enterprises cannot solely be understood through financial ratios, though there are a few financial metrics that clearly signal dangerous investments. One challenge: financial information on individual small businesses is idiosyncratic and often much less organized than it is for public companies. Plus, small enterprises are inherently linked to their owners, financially and operationally. A few warning signs: lack of formalized financials; absentee owners -- or worse, those who use the company as a personal piggy bank; declining sales and profits. (This last one might not be a deal killer if you can understand the reasons, and have a vision for how your capital will help correct it.) The markets in which small businesses operate are often intensely local, so microeconomics will be more important than macroeconomics.

Investing in small businesses is activist investing, but requires more than financial engineering. The keys to growth are often found in product, marketing, merchandising, distribution or operational changes. Sometimes it requires a willingness to play a role in implementation. That can be immensely rewarding, but it's not easy. I've been both an entrepreneur and a provider of capital on behalf of large banks, and the fact is that entrepreneurs relish their control over a business. Telling them what to do is akin to telling parents that they need to raise their children differently. It is important to find that balance of transparency and engagement while giving the entrepreneur space to operate.

All told, against an otherwise difficult investing backdrop, the rewards of investing "local" outweigh the risks -- it's more "fun house" than "haunted house." Small business investments offer a unique opportunity to generate attractive returns that are less correlated to public stock and bond markets. The confluence of technological change, regulation and supply/demand imbalances make this a particularly interesting time to invest. For those that do, look forward to affecting an important part of the U.S. economy and participating more directly in investment growth, while seeing attractive returns on capital.

Kevin Harmon runs Elvaston Capital Management, a Connecticut-based investment management firm focused on small business finance and event-driven macroeconomic strategies.

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