When Financials are Due
Neil Berdiev is a commercial banker (most recently with Boston Private Bank in Boston), author and consultant with over 12 years of experience in the financial service industry.
As year-end financial statements (for December 31 year-end) are being finalized by accounting firms and forwarded along to commercial lenders, business owners and managers should have a good understanding and strategies of how this round of reporting can affect their existing and future borrowing ability.
The tax season is finally slowing down for accounting firms, which means that lenders' renewal season is just starting. For many businesses this will mean a test of their ability to secure new borrowing relationships or even continue the existing ones. Some companies will not be so lucky to pass this test. They risk failing not because they can't generate sufficient cash flow to service the debt but because they do not know what lenders expect or do not have a game plan on how to work effectively with their lenders.
The banking industry continues to be challenged by the financial crisis and this, in my opinion, is likely to continue throughout 2010 and into 2011. The next concerns are:
• A wave of maturities of commercial real estate loans and the health of the commercial real estate market in general;
• Credit card losses at larger banks under continued pressure from unemployment, subpar consumer confidence, and the fact that the average consumer is overburdened with too much debt and no savings;
• Possible outflow of deposits from smaller institutions to larger ones as the larger banks stabilize and begin advertising higher interest rates on savings accounts in order to lure customers that left out of fear of larger banks' possible failure, lack of attention or pure mistreatment;
• Unhealthy levels of competition among commercial banks in a thoroughly commoditized industry; and
• Continued losses from various loan portfolios that can erode capital that banks have been so painstakingly raising and guarding.
These and other challenges will force most, if not all, banks to pay particular attention to year-end financial statements coming out between April and June. Even if your company's year-end is different, the lending environment is not likely to thaw significantly in the next 12 to 24 months. As a result, you may be facing the same situation a bit later in the year.
Financial results of most commercial borrowers are tied to various covenants that will be tested by lenders when financial statements are received. This is typically part of an annual review and the renewal cycle. Furthermore, if you are in the market for new or additional financing, year-end financial results can alone, or in comparison with prior year's results, determine if you will be successful in securing loans.
Here are a couple of situations that are likely to affect your business:
a) If your business is doing well financially (the lucky minority) and is likely to be in compliance with covenants, you are probably safe. I say probably because I have been hearing anecdotal stories about some lenders not renewing loans or terminating financing relationships because they have chosen to abandon or curtail lending to some higher risk industries (higher risk as perceived by those lending institutions). Your business may be doing well, but, if your industry is in trouble, lenders may be rethinking their willingness to do business with the entire industry. Your business is a collateral damage of such thinking.
Based on my experience, larger lending institutions may be at a greater risk to make such indiscriminate decisions simply because they are made at executive levels, often far removed from customers. Individual lenders (or loan officers) have little power once the decision is made, even if they want to continue supporting their customers. Also keep in mind that if your loans are expiring (or maturing), lenders may have the right not to renew or demand full repayment even though you are making payments as agreed. This is guided by the loan documents. It may not be the best decision as far as the lender's reputation is concerned, but the industry is still in survival mode and their reputation is not always the top consideration.
b) If your company's financial condition deteriorated materially or if it violated loan covenants, then you are a candidate for higher scrutiny. You may also face higher interest rates at renewal, reduction in credit limit to only a fraction of its original amount, interest rate floors, higher loan fees, altogether losing your financing arrangements, and other higher debt costs to compensate lending institutions for higher risk.
I realize that many borrowers feel that lenders are taking advantage of their companies and doing it at the worst possible time, but the answer is much simpler and has nothing to do with lenders profiteering from the situation – higher risk of default warrants higher returns. With increased risk you may need to infuse equity, not debt, into your company, and equity investors require a much higher return for higher risk (much higher than conventional commercial loans). You would most likely do the same if you were running a for-profit lending institution. The question is whether lenders will approach this issue with professionalism and tact, and I realize that some may not. In addition, not every lender or lending institution is sophisticated enough to have an objective, correct assessment of risk.
If your lender informs you of non-renewal, even a couple of months before your loans expire or mature, there may still not be enough time to conduct a search for and find the right lending match, submit required information, negotiate the deal to your satisfaction, secure loan approval, survive credit and legal due diligence, review and negotiate loan documents and get them signed, and pay off loans and move deposits and various other services from one lender (and deposit institution) to another.
The anecdotal knowledge in the lending community is that smaller commercial lending institutions on average have been more relationship-oriented during this economic downturn than their larger competitors. Even if the cost of financing is likely to go up, borrowers were given ample notice. Nobody likes tighter loan terms or higher pricing; however, advance communication and ample lead times can offer some dignity and possibility to preserve whatever may be left of a good business relationship. Similarly, smaller lenders have been more patient in working through troubled loans or giving commercial borrowers more time to find refinancing options (if lenders wanted to exit the loan relationship). This makes sense because for a smaller institution a bad reputation in a local community can put it out of business. For a large institution, there are plenty of communities that will never hear about negative publicity.
Here are a few tips to protect your financing arrangement and perhaps "manage" the process with greater confidence and control.
• Communicate often and honestly. There is nothing worse for a commercial lender than a bad surprise. You will make the situation worse by hiding problems. Every business has its good and bad days. What lenders want to see is that you are aware of issues, understand what caused them, have a plan to address problems and can demonstrate that you are making progress in turning your business around. I want to be honest by stating that frequent and frank communication cannot always guarantee success, but it is better than withholding information. However, especially when things get ugly, keep good records of communicating with lenders and be civil.
• Time is against you and you have no time to waste. If you choose to procrastinate, thinking that the storm will blow over and your lender will leave you alone, the odds are stacked against you. Have a plan ready as soon as possible and a few alternatives, such as a network of several other trusted commercial lenders on standby.
• Take the time to understand the business culture at your existing or prospective financing providers. For example, large institutions may use a centralized underwriting approach for loans up to a certain size, which means that your loan officer is more of a sales person. An entirely different person, whom you are likely never to meet, will be determining if your financing will be approved. That somebody could be hundreds or even thousands of miles away. While your loan officer may not have loan approval authority, he or she is your advocate and you should help them make a case on your behalf. Smaller lending institutions rarely have such business practices but may not always have the same resources and array of services or may not be able to offer the lowest pricing.
• Speaking of pricing, rationalize where you are on the straight line with one end being excellent service and the other being lowest pricing. You cannot have both (if you do, I want to know about it), yet some business owners and managers waste their time seeking the unattainable and periodically moving their lending and deposit relationships from one institution to another. Think about the cost of your time and the fact that moving those relationships takes a lot of time and effort, even with the best banking employees on the receiving end.
Also don't forget to look at the overall relationship pricing. For instance, if you are getting very low cost loan financing, analyze the cost of your deposit accounts, cash management services (e.g. wires, online banking, etc.), rates that you are likely to earn on deposits, and other services. If you are getting low pricing on loans, rest assured that your commercial lender will be making up for the loss elsewhere. They are not non-profit organizations, and there is no such thing as a free lunch.
• Last but not least, have a short list of at least a couple of high quality loan officers or lending institutions whose service vs. price value proposition meets your needs. Note that you cannot figure out overnight who has an excellent reputation. It takes time to get to know people. You should be prepared to make this investment to avoid costlier mistakes with potentially picking a wrong financing choice. If you rely on your service providers (e.g. accountants, attorneys, advisors, board of directors, etc.) for introductions to prospective commercial lenders, make sure that they don't just "feed" their network. Not everybody can balance doing something for his or her network members (i.e. introducing you to a new lender) with what's in the best interest of your business. Conduct your own independent assessment of prospective commercial lenders.
In conclusion, I want to share a story that happened with a borrowing customer of my former employer. A new owner of a manufacturing company decided to overhaul reporting systems and redesign manufacturing processes. Unfortunately, the operation that was being redesigned was not broken to warrant a repair. Well intended but mismanaged efforts caused the company to lose track of inventory and sales controls for an extended period of time. The owner continued to tell his loan officer that everything was going well and that the year was profitable. There was no mentioning of the challenging situation, and how it might impact the company's financial results. After the fiscal year closed and during the three months that followed, again, the owner made no disclosures or attempts to mend the situation.
When year-end financial statements reached the lender some time in May, they showed significant losses and covenant violations. Furthermore, the owner seemed offended that the lender began digging for answers and taking the owner's valuable time to question what was going on with his company. Very soon the loan officer and her institution decided to exit the lending relationship and asked the owner to take his business elsewhere. Only then did the owner become cooperative and cordial, but it was too late. It took the management team several months to find another lender to refinance the debt. Luckily for the company, this was before the current recession began, but the effort probably cost them hundreds of hours spent on searching, selecting, answering questions, reviewing loan documentation, and then moving accounts and learning the new lender's loan and cash management systems. In addition, there were loan fees that added to the overall cost. Last but not least, the new financing package was significantly higher in price because the company's financial performance in the recent year was viewed as higher risk by the new lender.
Let's hope that you will not find yourself in the above or similar predicament, and I truly hope that this article will be helpful in providing guidance in preparation for year-end financial statement reviews and discussions with your lenders.
-- Comments may be sent to firstname.lastname@example.org. Those who are seeking financing and are interested in taking a short survey about your experience, click here. Special thanks to Eric Gyllenborg of Rackemann, Sawyer & Brewster, P.C. and Brent Matthews of Boston Financial Funding for their feedback and article review.