When executives at Cal Coast Data Entry looked about in the fall for capital to launch a worldwide expansion, they knew it wouldn’t be easy amid the worsening credit crunch.

Indeed, the privately held Cerritos business outsourcing provider considered a traditional bank loan before it settled on an unlikely source: a Los Angeles-based investment firm willing to provide not just equity, but debt financing.

St. Cloud Capital LLC, which specializes in financing local middle-market companies, provided $12 million in hybrid financing using funds raised from institutional investors.

“Banks are getting tighter in their lending policies they had 99 million pieces of paper for us to fill out,” said Nelson Brooks, chief financial officer at Cal Coast. “They are not as flexible as private equity.”

With banks tightening their commercial lending belts, companies all over Los Angeles are finding themselves looking for other financing options as they seek to expand, acquire or merge and alternative lenders are stepping into the breach.

In some cases, it has been hedge funds that are providing the financing, in others it has been private equity firms or players such as St. Cloud, which has a business model based on both debt and equity financing.

Scott Kolbrenner, a director at Houlihan Lokey Howard & Zukin, a Los Angeles-based investment bank, said that while tightening credit requirements are putting the squeeze on L.A. companies, there are more alternative options available than after the dot-com crash.

“(We) believe that 2008 will be a very strong year for growth through mergers and acquisitions, but getting the deals done will require more creative financial structuring,” he said.

Seeking flexibility

In the case of Cal Coast, the company could have qualified for a bank loan, but the tightening credit markets made the application process onerous. What’s more, Cal Coast liked the fact that St. Cloud maintains close relationships with its funded companies, sometimes putting a principal on the board of directors.

“Our target is to build an organization doing $30 million to $50 million in sales through organic growth and acquisition. And we think our deal with St. Cloud will help us reach that goal within five years,” Brooks said.

Marshall Geller, senior managing director of St. Cloud, which was founded seven years ago, said the company has seen an uptick of business since banks began tightening their lending standards.

The firm recently set up a $200 million fund, has made three investments and has three more about to close. The fund’s first deal was a $15 million loan to World Industries, an expanding Costa Mesa skateboard, apparel and accessories company.

“Is the credit crunch hurting or helping us? It’s helping us because there is less ability for companies to meet the stringent requirements of banking institutions,” Geller said.

“If a guy doesn’t pay us, we can sit down with the guy and say, ‘What’s wrong? What’s going on here?’ We don’t have to send the wrath of God upon this guy. We work with him. We don’t have the same issues of a bank ‘You didn’t make your payment. It’s got to go on the watch list right away.’ ”

According to recent statistics from the Federal Reserve, there is no indication that banks will be loosening their purse strings anytime soon.

Nearly 40 percent of senior loan officers at U.S. banks tightened terms for commercial and industrial loans over the past three months, while 45 percent reported rising credit costs, according to a January survey by the Fed.

The survey also showed a growing conservative sentiment among lenders since the last poll in October, when only 16 percent of commercial loan officers said they had imposed more strict lending standards.

“There is more of an emphasis on getting paid for risk,” said David White, regional president for Comerica Bank in Southern California. “Deals that are out there on the risk curve are either not getting done or getting done on tougher terms.”

Stender Sweeney, a regional manager of commercial banking in Los Angeles for Wachovia Bank, said companies now generally need to provide hard assets in order to secure commercial bank loans, with loans based on cash flow falling out of favor among loan officers.

“The asset-based model is very much in vogue right now,” Sweeney said.

For many Los Angeles-based mid-market companies, hedge funds in particular are expected to be increasingly prominent players in corporate finance, according to local dealmakers.

“While (hedge funds) were active in the public markets with larger cap players, as alternative lenders to middle-market borrowers, hedge funds represent a very deep pool of capital that did not exist during our last credit crunch five to six years ago,” said Kolbrenner, also president of the Los Angeles chapter of Association for Corporate Growth.

However, accessing the funds can be pricey.

In a recent deal just signed and expected to close this month, a Los Angeles-based mid-market services company turned to a hedge fund after the firm encountered difficulty securing an asset-based bank loan for growth capital, despite steady business and good cash flow.

The hedge fund agreed to provide junior debt, though it came with higher borrowing costs than with a traditional asset-based bank loan. Kolbrenner noted that junior hedge-fund debt can cost much more as much as 750 basis points more than secured senior debt.

George Blanco, a partner in business restructuring services at BDO Consulting in Los Angeles, has a somewhat different take on hedge funds’ interest in middle-market financing.

He noted that should businesses default or miss an interest payment, the result is likely to be a “workout” that could shift the ownership of the business: “Hedge funds are willing to take the downside risk knowing that they may end up owning most or all of the company.”

Traditional players

While many local investment banks agree that alternative lenders are growing in popularity in the slow economy, traditional financiers are continuing to operate.

Bernie Zaia, managing director of Barrington Associates, a Los Angeles investment bank, said the firm brought in a hedge fund to complete a debt recapitalization in the first half of 2007. But it also has tapped a combination of traditional bank lenders, commercial finance lenders, mezzanine funds and other sources to complete middle-market transactions at lower costs.

Publicly held business development companies such as Washington, D.C.-based Allied Capital Corp. and New York City-based Ares Capital Corp. which specialize in financing middle-market transactions are continuing to underwrite subordinated debt. And commercial finance groups such as GE Capital, a unit of General Electric Co., remain players in senior debt.

Earlier this month, Barrington assisted a mid-market electronic component distributor complete a successful recapitalization with a private equity firm. But two commercial lenders teamed up to cover the senior portion, and a business development corporation added the subordinated note.

“There is no question that hedge funds are more committed and active in the middle market, but they are not the only solution,” Zaia said. “We still see a good universe of players for the debt pieces of our transactions.”