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Lien and Mean

The new rules of commercial lending in a credit-tight market.

In this credit-tight market, even the best-managed small companies are having to learn new rules of commercial lending

For 10 years Crown Coffee Services Inc., in Saugus, Mass., had been a model banking customer. The $2-million company, a growing and profitable supplier to commercial accounts throughout Massachusetts, had never missed a loan payment. Then early this year owner Joe Pegnato received a phone call from his new lending officer -- ringing only to say, apparently, that everything was fine. Pegnato believed this was true. "We were increasing our sales and decreasing our debt," he says. "[The loan officer] said we were in the best shape we'd ever been in."

But a few weeks later the banker called Pegnato again. This time he said he wanted to make some "adjustments" to the loan, even though the company's performance continued to improve. He wanted to boost the interest rate on the credit line by 3% to 5%. He also wanted Pegnato's house as collateral.

Pegnato invited the lending officer to pay a visit to his company. But the banker wasn't interested. "He said, 'You've probably heard what's going on in the banking industry. I suggest that you shop around.' " What he meant was: we're through, unless you meet the punishing new terms. But Pegnato, it turns out, was lucky. He was able to find another lender and stay afloat.

Pegnato's story isn't unique. Over the past several months scores of smaller companies on the East Coast and, to a lesser extent, in such cities as Minneapolis and Nashville have been invited by their bankers to pay down their loans and find other sources of credit. In the past, major credit crunches, such as the one in 1979, were driven by a general tightening in the country's money supply or by regulatory crackdowns on specific forms of lending. The result: credit was much more costly. But today, economists note, we're witnessing a crunch of a different sort. To begin with, higher interest rates aren't really the issue. What's changed, many argue, is the readiness of bankers to make loans. Having taken huge losses on loans to real-estate developers, hundreds of U.S. banks have less capital on which to lend. Yet even banks that are liquid are being more cautious about the ways they analyze customers.

Some bankers dispute the notion that a full-fledged credit crunch is in the works; in New England, New York, and New Jersey, many say that they and their banking colleagues are just acting with prudence in light of fundamental weakening in such sectors as real estate and retailing. Bank executives elsewhere in the country say that cutbacks in lending are at least partly the result of tougher loan examination policies by federal bank regulators, spooking bankers from making loans they would otherwise make. "In light of the thrift crisis, bank examiners have gotten a lot more adversarial," agrees David Cates, president of Cates Consulting Analysts, in New York City, which tracks the performance of banks.

Whatever the factors behind the increased banker caution, nearly everyone agrees it's small-business borrowers, with limited alternatives, who will feel it the most. And not just companies on the brink. "When things go wrong with banks and the financial markets," notes Bob McLennan, chairman of PlainsBank of Illinois, in Des Plaines, Ill., "one of the ironies is that good borrowers are punished." A troubled bank in need of liquidity will look for cash where it can be found -- in the hands of its healthy customers, the ones who can pay up if a credit line is called.

So what's a smart CEO to do?

Get inside your banker's head, for starters. Understand how his or her circumstances have changed and what he's looking for from you. Then take steps to give him -- or the new lender you'll be forced to find -- what he needs. The key to surviving credit-tight times is to be ready for them.

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Different bankers are playing different tunes (depending, in part, on their local market and the capital positions of their institutions), but here are some of the things lenders say they're looking for in today's deals:

Healthier cash flow. Prudent lenders have always looked first to the cash flow of the business as the way the loan will be repaid. The collateral -- a warehouse or a house -- was never viewed as the way the loan would be liquidated; it was the exit of last resort. The exception is in boom times, when collateral convinced bankers to overlook concerns about the underlying business.

But these days collateral doesn't have the currency it used to. And the reason is simple. When the economy turns to mush, as happened throughout much of the Southwest in the mid-1980s, there's no telling what kind of bath a banker may take. "In Oklahoma City," says Bob McCormick, president of Stillwater National Bank & Trust, in Stillwater, Okla., "you can buy a building today for what it cost to rent one eight or nine years ago." So lenders want to know more about how a borrower's company works than ever: who its customers are, how it competes, why it needs the cash, how it will pay back the loan. They're examining projections more skeptically, in some cases actually calling a company's customers to probe its assumptions.

Even if the banker likes what he hears, he'll still hedge his bet by asking for collateral -- in all likelihood, more than would have been required a year ago. "Remember," says Richard Chambers, president of the recently founded Bank of Nashville, "we're not talking about replacement value. We're talking about market value." Companies without enough collateral to pledge will have to scale back their borrowing needs and make do with less.

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More operational influence. Time was when many banks were willing to give borrowers plenty of room to determine how best to run the business. Once the customer had passed the "character" test, the banker stepped back. Of course, he wanted regular updates on how the company was performing. But decisions about inventory levels or how many people were on the payroll? Those were management choices. As long as the business was profitable and meeting its obligations, who cared about how it was done?

Today, more and more bankers do. They're trying to influence how customers manage their businesses. Indeed, they want to pin down such financial information as debt to net worth and inventory turns, and hold you accountable to them. Banks that used to be vague about what they wanted to see are specifying standards -- and putting them in their legally binding loan covenants.

For instance, Arthur Pappathanasi, president and CEO of West Lynn Creamery, a family-owned dairy business in Lynn, Mass., signed a new loan agreement in June with a New York bank that commits him to a debt-to-equity ratio of 3:1, a 1.5% pretax profit margin, and restrictions on capital spending and officer salaries and bonuses. Any changes need prior approval. With his old bank, he says, things were much looser. The penalties for breaking his new covenants are stiff. "If we blip, we'll really feel it," says Pappathanasi, whose interest rate will rise two points if he violates the terms of the loan. In today's environment, most bankers are putting such teeth into their agreements. And if things slide far enough, they're wasting no time in calling the loan.

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Less lending against inventory and receivables. No financing is more critical for many companies than the loans they get against inventory and receivables. But, increasingly, bankers are getting edgy about the quality of the assets behind these loans. Do they really want to encourage customers to buy inventory that may not sell for months or to perform services for people who won't be able to pay? No. So bankers are becoming a lot more cautious. Besides doing more physical inspections of companies, they're revising their lending formulas.

A carpet installation company in Atlanta, for example, was recently told by its banker that the bank could lend only 25% of the value of inventory versus the 30% it had previously lent. The business is still profitable, says Mike Balsley, who administered the loan when he was president and CEO of Vinings Bank & Trust Co. "But we believe the market will soften." Less demand, less need for inventory. In some cases, banks are drawing sharper distinctions between the sorts of inventory a company might have (offering a higher advance on completed goods than on, say, work in progress).

Bankers are making similar judgments regarding the financing of receivables. If the bank was willing to finance 85% of receivables up to 90 days, the new formula might be 70% up to 60 days (with no financing at all on older receivables). Unless you can speed up your collections or slow down your payables, you'll have no choice but to shrink the business. A California lithography business recently found itself in such a bind. Without any warning, its bank threatened to slash its working capital, reducing the loan by $250,000. Fortunately, the owner lined up another bank that was willing to offer better terms. "Without the cash flow," says David Murphy, a former banker and now a partner in Murphy, Lento & Co., in Newburyport, Mass., and Salem, N.H., "you can easily croak a company."

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More cash from owners. Yet another way bankers are downsizing their risk is by demanding that owners put more capital in the business. And it's not just the companies looking for new loans that are being asked to invest more capital; additional capital may be a requirement to keep the loans you have. Many lenders don't care how you do it -- whether you get a new partner who brings equity or put up your own money. What matters is that someone (besides the bank) is on the hook. Indeed, say bankers, the pressure on small-business owners to guarantee debt personally has escalated over the past couple of years, partly in response to bank examiners. The best -- perhaps only -- way to avoid guarantees is to commit more money.

Last winter, for example, a Massachusetts manufacturing company wanted to renew a $1.7-million credit line. Anticipating some seasonal needs, it asked its banker for permission to go $200,000 beyond its limit for a finite period of time. But the bank wasn't interested, not unless the principals came up with additional capital. To satisfy the bank, they borrowed $1.1 million against some personal real estate and lent it to the business on a subordinated basis.

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What Bankers Want
Credit crunch or no credit crunch, rest assured that very few bankers are looking to shut the window on lending altogether. Making loans is how most of them earn their paychecks. Your challenge is to package your company in such a way that your banker has complete confidence in the business and, more important, how it's being managed. Here's how:

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(1) Cut your leverage. "Leverage may have been fine when Mike Milken was riding high," says James L. Basey, executive vice-president of Colorado National Bank of Denver. "But now we want to see some liquidity." No banker wants to think that he's absorbing the entire risk when and if your market begins to drag. So now's the time to reduce your dependence on bank debt, to pay down that credit line (if you have one), and to build your own financial cushion.

You can lower your costs by, among other things, getting rid of weak products. You can speed up your collections by requiring customers to pay COD or offering cash discounts for prompt payment. Another option: forgoing dividend payments and leaving cash in the business (even if you operate as an S corporation). By doing these sorts of things, you may not eliminate your need for borrowing. But you'll show your banker you share his concerns. And that can't hurt you when he has to choose between your company and someone else's.

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(2) Set your company apart. Bankers tend to think in terms of categories: if you've got a food wholesaling company, they'll compare you with every food wholesaler they've ever known. At their fingertips, moreover, are volumes of industry data supplied by trade associations. Obviously, you can't stop them from flipping through these books and making comparisons. But you can attempt to correct their biases. How? By showing them how your company really operates and how you differ from your competitors.

In the past, lenders point out, basic information -- two or three years of P&Ls and projections for the coming year -- was usually enough for most credit decisions. Assuming that you were making money (and that there was sufficient collateral), all you had to prove was that you could handle the debt service.

Today the informational requirements are stiffer. "Bankers want to understand the details of how borrowers plan to use the money," says Chuck Doyle, chairman of Gulf National Bank, in Texas City, Tex. To the extent that they're relying on cash flow more than before, they want to know as much as possible about the quality of that cash flow. Who are the customers? Historically, how fast have they paid? What are the seasonal patterns in the business? How will you cover the time gaps between your collections and payables? The more detail you can provide about the business and your underlying assumptions, the more likely it is your lending officer (and the one who takes over after the current one moves on) will go to bat for you. And if he doesn't? Well, you'll have done much of the groundwork for presenting yourself to other banks.

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(3) Stay close to your banker. Bankers hate having bad news sprung on them. A lack of candor can jinx a relationship with your lender faster than anything. "What you need to remember is that your banker has to tell your story to other people in his organization," says Roger Smith, president and CEO of Silicon Valley Bank, in Santa Clara, Calif. So, rather than doing things that might make your lending officer hem and haw in front of his superiors, you should be looking for ways to plug him into the most important aspects of your business.

In less nervous times, most bankers felt that quarterly financials were enough. Now many like to see updates monthly, with calls or notes when significant events occur. If a major order falls through or your marketing manager is fired, a conscientious lending officer will want to hear about it (why it happened, what it means to your operation, how you intend to adjust the business). Feeding bankers regular information is, of course, time consuming when you have a company to run. But it's all part of building credibility and trust. Given the pressures that bankers are feeling these days, it isn't easy to do. But, as many companies are learning, the alternative is a whole lot worse.

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Last updated: Aug 1, 1990

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