Don’t let me be misunderstood

My client’s company—a third-generation scrap metal recycler in the heart of Detroit, having survived the 2008 recession and banking crisis, while many similar family businesses were wiped off the business landscape—was able to reset its bank loan covenant violations and to extend payment terms with long-time critical vendors. The company returned to profitability in early 2010. At this point, strong regional commercial banks, via aggressive business development officers, were again hunting for “risk opportunistic” loans, specifically for working capital, and also were looking to refinance real estate and machinery and equipment (M&E) with strong, recovering loan to value (LTV) lending margins.

The client took advantage of one large regional commercial bank’s loan proposal, which included an SBA (Small Business Administration) 7(a) 25-year-term loan for the real estate and M&E loan portion and 50 percent advance ratio on inventories. This provided additional liquidity for expanded revenue growth. The client wanted to move away from its former banking institution that was reigning in its exposure to small and middle-market businesses. The loan size, less than $5 million, did not fit into the bank’s larger commercial banking group.

The scrap metals company, along with my firm, Lawrence Gardner Associates, its financial managerial consulting firm, helped guide the prospective loan officer and credit analyst through the complexities of financing a commodities-driven business: pricing fluctuations, client’s primary reliance on long-term purchase orders, avoiding speculative inventory purchases that could possibly result in slower, nonturning inventories, trying to “outguess” the market direction and a background of prior economic cycle downturns.

The scrap company’s balance sheet had been strengthened via reduced leverage through internal generation of earnings, a strong current ratio and good EBITDA (earnings before interest, taxes, depreciation and amortization) for adequate debt serviceability (as measured by the prospective takeout lender’s debt service coverage ratio (DSCR))—targeted at greater than 1.20:1.

After signing loan documents and funding, the bank’s business development loan officer sent the scrap company and my firm a testimonial, stating: “Thank you so much to you and [LGA] for your strategic and operational involvement in the transaction and for your bringing this opportunity to the bank. Your work on the company’s behalf in preparing pro forma projections, assembling historical financial and corporate information, walking our team through the information and providing insight into the business and the owners was essential to us gaining the knowledge and comfort needed to approve and close the transaction.”
 

Fast forward

By the first quarter of 2013, the global metals market suffered another severe economic slowdown. In the Midwest, this was coupled with a severe winter that greatly curtailed the normal availability of independent truckers to deliver product to the scrap company’s customers. The impact was a (manageable) first quarter loss and a marginal loss for the entire year. However, from the lender’s communicated perspective, a loss was a loss regardless of whether the borrower kept current with the principal and interest (P&I) contractual loan payments and maintained positive tangible net worth and current ratio. The borrower was still tripping over the bank’s DSCR loan covenant.

The scrap company again was caught in the crosshairs of a now risk-adverse bank with a replacement neophyte loan officer, who was not familiar with financing commodities and the company’s return to growing revenue and need for an increased inventory-based borrowing sublimit and M&E financing for a much needed new replacement baler (including an already paid 30 percent advance deposit to the overseas manufacturer).

After two years with this regional bank, the loan officer sent the following credit memorandum to the borrower: “Our bank’s review is that the operating entities are in a ‘high risk industry’ that sees highs and lows depending on the pricing of the steel commodities. … We would like to know the liquidity plan by the borrowers and guarantors for providing additional cash flow during those times of declining revenues.” (The newly assigned loan officer again showed a basic lack of familiarity with the company’s business and inventory, as its principal scrap commodities were aluminum and aluminum borings, copper and stainless.)

The bank then pursued a policy of reducing the working capital line of credit by half and effectively giving the scrap company “marching orders” to find a new lender.

The company had strong customer purchase orders and no receivables older than 60 days and current aging of payables.
 

Looking backward

Large commercial banks in the “too big to fail” category, along with larger “second tier” regional banks, blamed current cautionary lending practices on the consequences emanating from the Dodd-Frank Banking Act enacted after the 2008 banking crisis. Commercial bank lenders have to deal with overzealous banking regulators being on the prowl for assessing “risky/riskier” commercial loans. Lenders no longer rely on borrowers’ projections or a history of excellent days receivable and days payable, instead preferring overall to keep excess liquidity housed in low-risk, low yielding treasury bills.

While today’s banking metrics show relatively low loan delinquencies for small to midsized businesses, these same businesses should be finding easier access to bank credit (non-SBA reliant) from banks flush with cash. But robust credit access still remains a critical issue for middle-market companies securing financing less than $5 million in exposure. Per the Thompson Reuters/Payment Small Business Lending Index for January-March 2015, it is small businesses that rescued the sagging economy in the first quarter of 2015, with large companies continuing to hoard cash, buy back stock and pay dividends (not exactly contributing to accelerated economic growth, asset reinvestment or employee hiring).
 

Lessons learned

There is no proven method for securing financing for any type of business regardless of the circumstances. Having said this, here are some key pointers:

• Do not become a training ground for individuals who are fresh out of business school and/or credit departments that have not yet developed credibility before the bank’s credit committee system. Conversely, seek younger bankers who can mature together with the business owner(s).
• Determine who’s in charge—continually. In the modern age of banking, loan officers mostly do not have individual credit limits for authorizing loans, instead relying on a credit committee and underwriters. The business development loan officer presenting the loan request often is thwarted in presenting the borrower’s request for financing in the best possible light. There is a wide gulf between the generally opportunistic business development officer and the typically risk-adverse underwriter, fearing potential criticism from banking regulators. Your loan officer (existing or prospective) should be senior enough to be able to portray the necessary confidence to accommodate the business’ particular growth stage without the loan approval process being paralyzed through endless committee meetings. Be aware that the sales pitch from a business development loan officer can be significantly different from what the bank can realistically deliver. Be cautious before plunking down a large, nonrefundable deposit for due diligence/field audit, only to subsequently learn the bank’s earlier proposal did not clarify forthcoming, over-restrictive loan covenants. Bank underwriters may give an unrealistic reduced inventory borrowing formula after a field audit, resulting in insufficient borrowing capacity. There may be unexpected, steep loan documentation fees and difficult-to-understand terms. You must understand the terms and conditions without having an attorney interpret them.
• Do not choose a lending institution based strictly on a lower interest rate. Invest the time to find the right banker who will help structure a loan to fit your specific needs as the borrower. Avoid paralysis by doing the financial analysis of your business in advance.
  
   

Getting the loan & keeping the loan relationship

Bankers use an FDIC (Federal Deposit Insurance Corp.) scoring system to judge risk acceptability. They use this system for pricing the business loan. It is imperative to realize the rating is evaluated annually, regardless if P&I payments are punctually handled. Negative scoring factors include overdrafts, late submission of requested financial statements, violation of financial loan covenants and/or key financial ratio determinants trending in the wrong direction and without timely communication to the loan officer of key issues and remedial action steps to be implemented.

Consistently understand how the bank evaluates your company. Knowing what your numerical score is will enable you to put in place clear and measurable company objectives and financial goals to increase your score, reduce your borrowing cost and increase borrowing availability. This also will provide you, the borrower, with early warning signs for finding an alternative lending source well in advance of the existing lender unilaterally reducing the company’s borrowing facility, potentially leading to dissatisfied customers and key vendor relationships for you.
 

Tactics to employ

Business owners need to be aware that the lender is primarily looking for:

• adequate collateral to protect the bank’s loan exposure, especially in a competitive environment and unexpected economic downturns;
• demonstrated profitability as measured by both net income and EBITDA; and
• past and future cash flow for debt serviceability (measured in terms of the debt service coverage ratio), acceptable leverage (measured by debt to tangible net worth) and trending liquidity (working capital and current ratio).
   

As a practical matter, personal guarantees (PGs) are generally reasonable lender requirements in situations involving startups, highly leveraged companies and companies with poor or inconsistent track records. But, if this is not the case, business owners should:

• furnish the lender with the company’s financial pro forma, including key financial ratios measured against RMA (Robert Morris Associates) Statistical Industry Studies using the company’s NAICS (North American Industry Classification System) industry code (You should determine in advance if your company fits the financial characteristics of the top 25 percent in terms of revenue and asset size categories.);
• furnish pro forma projections monthly and quarterly with detailed assumptions and comparisons against the prior year end, along with explanations for year-over-year key variances, so the lender can better understand the company’s ability to forecast and manage “controlled growth”;
• prepare a LTV analysis to illustrate the loan is sufficiently collateralized with acceptable margins to justify release of the PG;
• submit timely internal financial statements and avoid being on the banker’s overdraft list;
• prepare a detailed cash flow and break-even analysis and justification of the all important gross profit margin and fixed costs to demonstrate the company’s positive debt serviceability for timely interest payments and principal debt reductions; and
• remember the adage, “Bankers can handle adversity; what they cannot handle are continual surprises.”
   

If asking for full release of the PG is rejected, consider asking for a limited guarantee or substituting with a fidelity guarantee that prevents the lender from attaching personal assets of the owner(s) for satisfaction of what may prove to be unreasonable, added costs in excess of the loan balance, such as potentially onerous legal fees (except when warranted in the case of fraud).

If the borrower is simply told, “Bank policy requires the unlimited personal guarantee,” the owner should strongly consider seeking a new lender that will look at the business as risk opportunistic versus risk averse. The owner should seek a lender that looks at the success of the business, not just the owner’s personal balance sheet.
 

A winning solution

In my client’s case, it was necessary to move on to the alternative lending route of an asset based lender (ABL).

The ABL funding source looked beyond a single loss year, growing leverage to finance the recovering, expanding business via CAPEX (capital expenditures) and increased receivables and inventory borrowing requirements.

The ABL lender grasped the need for purchasing the replacement baler to increase productivity and increase bottom line profitability by reducing labor costs. The replacement banking source was comfortable with asset collateral coverage of receivables, inventories and fixed assets and presented cash flow and debt coverage projections—and less concerned with leverage and a multitude of financial loan covenants—to provide required increased funding, albeit at a higher interest rate.

The client embraced the following adage: “Be more concerned over access to adequate funding than with the finest quoted interest rate and negotiate comfortable ‘wiggle room’ of loan covenant(s).”

Larry Gardner is the principal of Lawrence Gardner Associates, financial and managerial consultants based in Troy, Michigan.