Let’s get something straight An enterprise is considered a firm; an establishment is an operational location of a firm. In the case of sole-proprietors and small businesses with less than five employees, the enterprise and the single operating establishment are usually the same. For larger corporate entities, there is still only one enterprise (or firm), but many establishments operating across geographies.
Please, Exit to Your Left
According to data sourced from the Bureau of Labor Statistics (BLS) and the Federal Reserve Economic Research Database (FRED), companies operating with fewer than five employees exhibited the highest overall firm exit rate during the pandemic-induced recession.
This trend is significant for lenders that provide capital to small businesses. The challenging operating environment and potential for a rate hike imply that small business loans will incur more scrutiny than loans made to larger enterprises. Interestingly, the same data reveals that companies with 500 or more employees exhibit the second-highest rate of establishment exit.
According to Crane et al., the BLS uses two lenses to view economic shutdown:
- Establishment closure: Locations that report employees in the final month of the prior quarter but report no employees in the last month of the current quarter
- Establishment exits: Locations that report zero operating activity for the past four quarters.
Uneven Impact
According to data from the BLS and Automatic Data Processing (ADP), between January 2020 and August 2020, exit rates among companies of all sizes were elevated above averages between 2015 and 2019. However, following August 2020, company exit rates began trending below averages from the previous four years, implying that much of the firm exit in early 2020 was temporary.
Still, recoveries vary by super-sector, with the Leisure and Hospitality super-sector taking the longest to resume business activity elevated above 2015 to 2019 averages. Conversely, the Manufacturing and Professional and Business Services super-sectors were the least elevated and quickest to resume increased operating activity compared to the prior four years.
However, amid current labor shortages, the share of companies with 500 or more employees that are closed has trended toward historical averages after a dip through February 2021. The trend indicates that the nation's largest employers are likely more exposed to labor shocks and may relocate due to insufficient labor in specific locales.
Some Economic Implications
Research from the Federal Reserve indicates that firm exit is a natural and encouraged economic phenomenon—unproductive companies drop out while more productive companies fill the open market niche. There is a net increase in aggregate productivity, and the economy grows in real terms.
Of course, the pandemic-induced recession comes with some caveats. Though the nation's largest employers exhibit the second-largest establishment exit rate, the exits tend to be temporary. Corporations lean heavily on their economies of scale, closing unproductive locations and opening new establishments in more profitable geographies.
The varying nature and intensity of state and local restrictions on operating capacity, and the uneven distribution of economic stimulus funding, may have caused the exit of productive and unproductive firms, implying a net loss to aggregate productivity. The relocating of establishments by the largest employers means a net loss to local employment, tax collections and real and financial capital.
While the recovery is well underway, rising inflation, declining household wealth and regional capital flight are expected to cause some local economies to flourish and others to be left behind.
Implications for Commercial Banks
Lenders are motivated by presenting potential clients to the underwriting teams that will scrutinize their credit policies. With pandemic-driven exits varying by industry, smart lenders include information specific to why the obligor will be successful, even when the industry may be facing greater than normal exits.
With this understanding, IBISWorld has developed Industry Segment Benchmarking, which allows bankers to compare similar-sized clients based on various metrics. This tool allows lenders to compare their customer with businesses in the same industry, helping develop the narrative as to why the bank may decide to extend a loan to the business, despite the potential of higher exit rates within their industry.
If there are greater exits rates within your customer's industry size segment, but the company is generating greater revenue per employee compared to other businesses of the same size, the lender should include this information within their loan request. With this data, lenders can develop stronger credit memos, easing the concerns of their credit underwriters. While there is no magic 8-ball to determine the probability of default solely based on exit rates, banks utilize this data to determine loan-specific covenants, rates and to assess their portfolio's risk.
Bet Your Bottom Dollar
When considering the Federal Reserve has suddenly become much more hawkish on inflation, it is worth considering how a potential rate increase could affect an already challenged market and what this means for lenders and borrowers alike. With exit rates originally elevated above 2007 to 2009 maximums, the potential for company exit has never been higher and commercial lenders are becoming more scrupulous.
Simply put, comparing exit rates of a five-person enterprise to a 500-plus-employee corporation is like comparing apples and oranges. The varying structural nature of these enterprises demands differing lenses of analysis by which commercial lenders can compare the performance of similar-sized companies and make informed decisions on whom to make loans.
