Understanding smallbusiness. economic down cycle. An in-depth look at small-business performance in challenging market conditions

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1 Understanding smallbusiness risk through the economic down cycle An in-depth look at small-business performance in challenging market conditions

2 To say the past year has been a tumultuous time for the economy is clearly an understatement. The mortgage meltdown, which precipitated the crisis, was in large part responsible for numerous business bankruptcies. Household names such as Lehman Brothers and Merrill Lynch disappeared. However, while a lot has been written about the economic impact on large businesses and how they fared during the downturn, not much has been said about small businesses. This report will take a closer look at small businesses and how they are managing under challenging conditions. In the process, we will provide lenders with valuable insights into small-business performance and how that data can be used to reduce risk and grow portfolios. A closer look at small businesses To gain a better understanding of how small businesses performed during the downturn, Experian studied approximately 300,000 businesses over the past two years. Chart 1 shows that businesses that were doing well prior to April 2007 those with no derogatory items on their files, such as slow payments, 91-plus days delinquencies, bankruptcies, collections, judgments or tax liens against them fared significantly better than the overall small-business population during the recession by about a 2:1 margin across the board. A simple conclusion can be drawn from this data. Businesses that were wellrun prior to the recession more often continued to be well-managed during the recession. Small businesses that managed their cash position and cash flow well were better equipped to survive the downturn. This also may indicate that these businesses were well-capitalized and therefore had the necessary resources to weather the storm. Good-performing small businesses compared with all small businesses Comparison of negative events in small business sample population Good-performing small businesses All small businesses Negative event 13.83% 26.25% 91+ delinquency 7.72% 13.70% Bankruptcy 0.48% 0.94% Collections 5.86% 11.69% Judgments 1.30% 5.29% Tax liens 2.59% 7.64% Chart 1 Market Insight from Experian Page 3

3 Experience leads to stronger business performance Another interesting trend that emerged from our study was that generational differences appeared relative to business performance. Chart 2 reveals that small businesses run by baby-boomers (individuals born betwee 1946 and 1960 or earlier) and pre-baby-boomers actually performed quite a bit better than those in the Generation X and Generation Y categories. Experian found that 40 percent of the time, Generation Y run businesses experienced some sort of derogatory behavior. While it is difficult (and not advisable) to use owner age as a significant measure of credit risk, we can only speculate that business owners with more experience may be less willing to take major risks, are more careful with limited funds and may be more diligent about paying bills, behaviors which proved critical during the recession. Generational differences in business performance Pre baby boom (before 1946) Baby-boomers ( ) Gen X ( ) Gen Y (1981 ) Percent of sample Bad rate Slow 91+ Collections Judgments 3.14% 18.4% 8.9% 7.7% 3.5% 30.54% 20.8% 10.3% 8.6% 3.8% 65.35% 28.3% 15.1% 12.8% 5.7% 0.97% 40.3% 24.3% 19.7% 9.2% Chart 2 Why derogatory events demand immediate attention For lenders, being able to recognize early signs of trouble with borrowers is crucial. Chart 3 shows that the presence of a derogatory public record item or collection significantly increases the chance of a small business becoming severely delinquent on its loans within the next six months. Against the overall base line rate for severe delinquency at approximately 4 percent, small businesses that had a tax lien showed a severe delinquency rate of 13 percent; for those with a judgment filed, the rate jumped to 17 percent; and for those with collection items, the rate leaped to 21 percent. Observing these derogatories within 24 hours of their occurrence can help credit managers and lenders minimize exposure, allowing them to more actively manage potential bad accounts and in the process improve cash flow and avoid losses. Page 4 Understanding small-business risk through the economic down cycle

4 Derogatory events predictive of additional events Rate of severe delinquency Percent increase from base line Base line Tax liens Judgments Collections 4% 13% 17% 21% N/A 225% 325% 425% Chart 3 Payment performance indicators point to stability In Experian s Business Benchmark Report, we examined the current state of different performance categories. As Chart 4 shows, over the past six months, average risk scores were up about 0.5 percent, days beyond terms improved by approximately 2 percent, delinquency was nearly flat, and the number of 91-plus days beyond terms dropped by close to 2 percent all positive indicators. From a payment performance standpoint, it appears the credit landscape is stabilizing as businesses improve their ability to meet their obligations. Benchmark trends by category Business benchmark trends Key categories Category January Change Trend Risk score % Days beyond terms % Percentage delinquent 12.5% 0% Percentage 91+ delinquent 5.3% -2% Chart 4 Six-month trend shows improvement for smaller firms In looking at the six-month trend for days beyond payment terms for small businesses (those with 10 or fewer employees), we see that current payments were nearly the same as for other businesses. In fact, the credit scores for these small businesses actually were a little better than for other businesses. However, the key difference occurred when the percentage of dollars at 91-plus days beyond terms was taken into account. Chart 5 shows that small businesses (one to four employees) with 14.4 percent of dollars delinquent became severely delinquent 8 percent of the time. Conversely, large businesses with 19 percent of their dollars delinquent became severely delinquent only 2.1 percent of the time. This underscores the fact that any Market Insight from Experian Page 5

5 delinquency on a small business, even if only 30 days, needs to be taken very seriously and acted on quickly since the odds of that delinquent payment becoming severely delinquent are very high. Employee size trends National average Risk score January Average DBT Percentage $ delinquent Percentage $ 91+ Risk score Six-month change Average DBT Percentage $ delinquent Percentage $ % 5.3% 0.5% -2% 0% -2% Number of employees Nonemployer % 5.0% 0.7% -2.4% -1.4% -1.4% 1 to % 7.9% 0.3% -2.2% -1.3% -1.6% 5 to % 7.2% 0.2% -2.9% -1.2% -1.8% 10 to % 6.3% 0.2% -2.1% -1.3% -1.3% 20 to % 4.7% -0.1% -1.4% -0.4% -0.6% 50 to % 3.7% -0.2% -0.9% -0.3% -0.1% 100 to % 2.9% -0.2% -0.8% 0.5% -2.0% 250 to % 2.2% -0.3% -1.2% 4.7% 1.7% 500 to % 1.5% -0.3% -1.8% 2.2% 2.8% 1,000 and more % 2.2% 7.8% -2.0% 1.5% -0.6% Chart 5 Industries not yet out of the woods While positive signs for economic recovery clearly are evident, some industries are still struggling. The chart below highlights some of the industries with the riskiest credit scores, such as construction, hospitality and retail. Obviously, when consumer spending dried up in the downturn, retail trade was adversely impacted. With widespread job insecurity amid massive unemployment, many people reduced their travel plans, which significantly affected the hospitality industry. In addition, the collapse of the housing market proved to be a devastating blow to the construction industry. All these factors are contributing to the continuing higherrisk nature of these industries. Page 6 Understanding small-business risk through the economic down cycle

6 Industry Risk score January Average DBT Industry group Percent $ delinquent Percent $ 91+ Risk score Six-month change Average DBT Percent $ delinquent Percent $ 91+ Agriculture % 6.38% 0.29% -3% -4% -4% Business services % 7.9% 0.35% -3% -2% -4% Communications % 7.89% 0.48% -4% 0% -2% Construction % 9.79% 0.30% -2% 0% -1% Educational services % 5.28% 0.09% -4% -1% -3% Finance % 7.97% 0.28% -3% -2% -1% Forestry % 18.02% 0.20% -2% -9% -16% Health services % 3.80% -0.03% -2% 0% -2% Hospitality % 1.87% 0.17% -1% 6% 5% Insurance % 5.72% 0.27% -4% -2% -3% Legal services % 8.59% 0.06% -4% -2% -3% Manufacturing % 4.49% 0.13% -2% 1% -5% Mining % 1.19% -0.03% -1% 10% 17% Public admin % 4.48% 0.43% -3% -2% -5% Real estate % 3.48% 0.22% -3% -2% -3% Retail trade % 5.68% 0.26% -2% -1% -2% Transportation % 6.06% 0.44% -2% 1% -1% Utilities % 5.22% 0.25% -2% -2% -2% Wholesale trade % 3.36% 0.25% -2% 0% -2% Chart 6 Industries showing clear signs of strength Conversely, sectors such as educational services, health services and public administration are thriving. Payment performance for these sectors is strong relative to some of the other industries we measured. Chart 6 confirms this information. The educational services sector was at 5.32 days beyond terms, health services was at 4.68 days, and public administration was at 4.89 days. The health services sector in particular has been less vulnerable to the economic downturn, and perhaps with the recent passage of health care reform, this trend could continue. Market Insight from Experian Page 7

7 Conclusion Although the economy appears to be recovering, it is still too early to know what tomorrow holds, particularly for small businesses. Certain industries continue to struggle even during the recovery, especially those tied directly to consumer spending. Experian s research has shown that well-managed small businesses have performed significantly better during the economic downturn. Yet, lenders should remain cautious as they evaluate prospects for portfolio growth. By looking more closely at the data on small businesses, lenders and credit managers can detect indicators that might portend severely delinquent payment. Such early triggers should be monitored to help minimize exposure. Lenders and credit managers can gain valuable insights into small-business performance by using data that sheds light on key underlying factors. Armed with this information, they are better able to reduce risk and find opportunities to grow their portfolios. Methodology Experian analyzed data from its Business Benchmark Report, which looks at how businesses are faring in the United States. Designed to monitor the progress of business recovery, the report looks at four key indicators of business health: commercial risk score, days beyond payment terms, percentage of dollars delinquent and percentage of dollars severely delinquent. Additionally, Experian tracked more than 300,000 small businesses in the United States over the past two years to determine the rate of risk trends on multiple measures. Experian applied its definition of a small business a business that has fewer than 25 employees and generates less than $10 million in annual sales to establish the study sample population. To determine the trend of newly derogatory events for small businesses, Experian started with a clean population that did not have, as of April 2007, any liens, judgments, bankruptcies, collections, tradelines more than 91 days delinquent, or an overall delinquency average beyond 30 days late. Experian analyses and studies To review additional Experian information, including data analysis, research and related information, visit Page 8 Understanding small-business risk through the economic down cycle

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