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The Hocus Pocus of Business Financing:
Now You See It ... Now You Don't

By Mark W. Sheffert
April 2003

More and more companies are being given the shocking news that their bankers want to “dial down their loan availability” or that they “no longer want to be in the loan.” The surprise is that these aren’t necessarily companies in trouble. Many have been exemplary bank customers with longterm, mutually satisfying relationships. It’s as if the banks waved a wand and magically turned them into skunks overnight.

And don’t you believe for a minute that a healthy company can’t find itself in a fragile banking relationship. It can happen for reasons entirely out of the company’s control, such as turnover among the bank’s lending officers, a merger with another bank that has different credit or underwriting standards, or a chief credit officer who suddenly decides that a particular industry or “space” isn’t desirable in the bank’s portfolio – regardless of any individual company’s performance.

While it might seem to be just hocus pocus, there are valid reasons for lenders to demonstrate volatile behavior, including underlying economic factors and changes occurring in both the capital and debt markets.

Economic Voodoo

The federal government is attempting to stimulate the economy with the lowest interest rates in 40 years, and with last year’s tax refunds and reforms. Yet, we’re still in an economic malaise, and everyone’s wondering why these economic stimuli are not working. Although threats of terrorism, uncertain global political situations, and unstable overseas economies have hampered stimulative efforts, the domestic economic reality is that there is simply too much capacity in our businesses.

During the ‘90s bull market, businesses spent with reckless abandon. We overbuilt in property, plant, and equipment (PP&E) in anticipation of continued growth. Then came a big dose of reality – the current bear market. And, according to the Federal Reserve Board, businesses are now operating at only 75 percent of their capacity.

Combine that with the weak demand side of the equation, where unemployment and a weak job market have caused a lack of consumer confidence and an unwillingness to spend, and – insto presto – we have an economic squeeze.

What does this have to do with banking and financing? Well, what do you think this economic squeeze does to PP&E valuations? If there’s more supply than demand, I think we can agree that values go down, thus the value of the collateral that is supporting loans is going down.

The Capital Markets’ Vanishing Act

In addition to these macroeconomic trends, the capital structure in our country has fundamentally changed. First the dot-com bubble burst, proving that you can’t build a business without real assets. Then September 11 proved that we’re vulnerable as a country. And the demise of Enron, Worldcom, et cetera, proved that profits aren’t always what they appear. As a result, the capital markets are morose.

Because the value of the stock market has declined so dramatically, large companies have turned to the debt markets for capital. It is less dilutive to finance with debt than to use undervalued stock; also, low interest rates make debt a cheap and easy solution. Small and middle-market companies are not going to the capital markets either. IPOs and secondary offerings are virtually non-existent: Nobody wants to invest in small- and mid-cap stocks when they can invest in under-valued large caps with less perceived risk.

On top of that, overcapacity in our businesses is causing stiffer competition as companies struggle to survive. The result is pricing and margin compression, which results in lower profits – eventually resulting in lower earnings per share, values and stock prices.

The Mystical Debt Markets

Debt markets are no safe haven, though. They’re in turmoil as well. Because large companies, which are usually healthy companies, are turning to debt for their capital needs, they have sucked up most of the liquidity and capacity in the debt market; it’s not available to smaller companies. Many banks that were playing actively in cash-flow lending to middle-market companies are no longer doing so.

Meanwhile, banks, still saddled with the underperforming loans they made in the ‘90s, are trying to minimize their risks. Credible evidence shows that banks have been dealing with high levels of bad loans. According to reports from the Federal Deposit Insurance Corporation (FDIC), net interest margins and net interest income are at historically high levels as a result of increased fees associated with the repricing of loans, default interest rates, restatements, stand-downs, and forbearance agreements. Portfolio quality is dismal; the default rates for commercial and industrial loans are the highest they’ve been in more than a decade.

The banking industry’s ratio of assets to reserves is low, which indicates that reserving for banks is a problem. It seems that banks are keeping many underperforming companies alive.

Not surprisingly, regulators are pressuring banks to reduce their levels of underperforming loans. But even without pressure from regulators, banks have reason to be critical of themselves.

Consider this example. A few years ago, a $10 million loan was made to a printing company for new equipment. At that time, the equipment was given a collateral value of 50 to 60 percent of its value. Today, because of overcapacity in that industry, that same equipment is given a collateral value of just 10 to 15 percent of its value. On an undercollateralized loan such as this, the bank could be required to hold a 50 percent reserve ($5 million) out of its equity.

Most nonbankers don’t realize that a “good” bank can leverage its equity up to 20 times. But my previous career as a banking executive taught me that $5 million could be leveraged up to $100 million in assets (loans). Given current net interest margins of 4 percent, that $10 million loan repr esents $4 million in lost opportunity, countered only by the bank’s ability to collect 4 percent interest on the loan ($400,000), or 10 times less.

Hmmm…can you see why a bank would want to wave its magic wand and make this loan disappear? I think you get it.

Just Like Houdini

So if the capital markets have vanished and the debt markets are fickle, how does a company break out of the bondage and the box to find financing today? Well, there is no evidence that truly credit-worthy companies are being denied credit.

Quite the contrary, those that are performing well but have found themselves without a lender should be able to sniff out other lenders who will find their company and their business plans attractive. Those that have experienced problems, like missing a covenant or losing money, are probably on a fast track to their bank’s exit, but they might be able to refinance with an asset-based lender if they have a good balance sheet.

Companies that are capital intensive with eroding PP&E collateral value and depressed earnings might be able to find a replacement lender, too. But due to their lower collateral values, they might not be able to get enough to pay off their old loan. And – abracadabra – that’s where some new players ar e magically appearing to fill the gap left by traditional lenders.

Rather than assets, these new players base their underwriting on the enterprise value (EV) of a company. They recognize when companies are undervalued and are willing to go deeper into a company’s assets by placing value on tangible assets, such as accounts receivables and inventory, but also on intangibles, such as intellectual property, proprietary technology, customer base, distribution systems, and brand name. The net effect is an emerging trend of “layered” financing or “Tranche B” financing that provides additional debt capital to businesses that are maxed out with their existing lenders.

Generally provided by hedge funds, distressed-debt funds, or specialized funds, this new debt is an additional layer of financing, structured with a junior lien behind the senior lender on all company assets and a secured lien on additional assets considered to be “boot collateral”.

The difficulty of finding capital nowadays can put constraints on a company’s current operations and its plans for the future. Businesspeople are feeling trapped by current economic realities – kind of like Harry Houdini when he was put in a straitjacket, chained into a trunk, and dumped into the river.

You have two choices: You can stay in the trunk and drown, or you can master the hocus pocus of business financing through hard work, creativity, and resourcefulness. Remember, Houdini always magically survived.


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