The subject of workouts, restructurings, etc., is a hot topic around the water cooler at many investment banks, law firms, accounting firms and financial institutions. Our firm, like most others, has seen a dramatic increase in the number of workout-related inquiries being received by the business development officers.
These well-intended executives and owners frequently reassure us that, although the company has been notified that it is in breach of certain loan covenants and may have executed a “forbearance agreement,” the bank is reviewing management’s turnaround plan and is going to help. The bank might even “suggest” a turn around expert of their choosing to review the company’s prospects.
The one benefit to working in a profession where only results generate fees is that we always get to tell the truth to prospective clients. When confronted with management’s calm explanation that they are working things out with the bank and everything is under control, I then explain the realities of the situation.
Believing that Sun Tzu was correct when he said, “he who knows himself and his adversary need not fear the outcome of 100 battles,” we offer the following anatomy of a “workout.” We will, to the best of our ability, give an outsider a “behind the scenes” look at what the bank’s workout group is doing while the bank’s loan officer is busy reassuring the client.
We always learn best by example, so let’s select a case study from the “lessons learned” file. The subject company is a second-generation heavy equipment leasing business. The business has grown steadily over the past 20-plus years. As with most leasing companies, short-term profitability is largely dependent upon effective use of leverage. Long-term survival of the company, however, is dependent upon inventory management. Similar to restaurants, in down cycles the inventory value is negligible in the event of liquidation.
The company generates revenue of roughly $100 million with gross profit of approximately 25%. Now for the not so good news: it has an SG&A expense of about 25%. The company was saddled with total secured debt of roughly $45 million against hard assets of $40 million and $11 million in accounts receivable. The company’s balance sheet shows a negative cash balance of $600,000.
As the bull ended his run, commercial construction starts declined, and the company was left servicing the debt resulting from the additional equipment purchased during the growth period. Some businesses are more susceptible than others to dramatic shifts in the market. In the heavy equipment leasing business, you had better keep a good shine on your crystal ball. If this were the extent of the story, it would already be a grim tale.
There were two additional factors about this particular transaction that limited the company’s chances of surviving the crisis. Keeping with the theme of this example, management ignored one factor and drew the completely wrong conclusion about the effect of the other.
First Factor. It seems that the owner had executed a Limited Personal Guaranty. The guaranty called recourse to the owner on a payment basis for up to $9 million of losses under the loan. The owner had a substantial personal net worth, including real estate and other monetizable assets that the lender could look to under the guaranty.
Second Factor. The second landmine appeared in the form of a bank merger. It appears that the lead bank, in the syndicate, was selling its portfolio to a foreign bank. This, management surmised, was good news. After all, it was the lead bank that had been pressing the company, demanding “Forebearance Agreements” and tying up cash flow with “lock boxes.” Certainly, a new lead lender could only improve the situation.
What management failed to consider was that the loan was already on the bank’s books as an impaired asset. This meant the new owner would be buying the asset at a reduced value. To a new owner, a foreclosure resulting in a recovery of $.75 on the dollar was a good result. Meet your new lead lender! With the added benefit of a $9 million personal guaranty, foreclosure was a guaranteed winner for the new bank. Possibly, the company could have been saved, but we’ll never know.
While we were trying to convince the company’s owner and CFO that they had indeed hit an iceberg, and it was time to do more than rearrange the deck chairs, the bank’s workout group was also hard at work. At this point in time, assistance from an investment banker or outside source would have been beneficial to the company.
Situation at the Bank
The bank has been very busy for a long time…months in fact, long before the borrower hit a covenant default. This has not always been the case with banks. They have become much better managers of commercial credit in the past couple of decades because of (1) experience, (2) a change in their product mix, (3) banking consolidations and (4) the emergence of the distressed debt market and the distressed debt investor in the mid-1990s.
Experience – Banks learned a great deal in the oil & gas lending debacles of the 1980s, and in their losses in the commercial real estate markets in the 1990s. Consequently, management of credit became more sophisticated and even more isolated from the sales side of commercial lending.
Product Mix – Banks in the last decade more heavily favored consumer lending where the decreasing cost of funds mixed with high credit card and consumer loan rates led to higher margins.
Consolidations – The synergies in banking consolidations result from a reduction in physical assets and human assets. They run leaner. Credit is numbers driven. The sales and marketing commercial loan officer is removed from the credit decisions. Personal relationships and politics mean little to credit departments in another city located one or two states away.
Distressed Debt Market – Investors have devoted significant capital to problem loan portfolios. It’s now not uncommon for up to a third of a banking syndicate, on a large transaction, to sell their claims in the secondary loan market within 90 days of a default. For some banks, this is an easy way to cash out of a credit problem cleanly and minimize workout cost.
The fact is that a good loan rarely becomes a problem loan because of a major market upheaval. A company’s products are not usually made obsolete by an unforeseen technological change. Rather, lenders believe a company’s finances deteriorate over time due to mediocre or tired management, and the company continues to advance its tired business plan that is no longer relevant.
Synopsis from the Bank
The bank has noticed the firm’s diminishing margins over the past several quarters. Thus, in the quarterly meetings with credit policy and loan review management, in which the loan officer has to rationalize the loan, the company has been judged long before any covenant default. The company didn’t realize it, but the reason senior management accompanied the loan officer on visits in the past couple of quarters was not accidental.
Let’s look at how this plays out in our example. As a result of the bank’s review, they knew that while the fundamentals of the business had declined, and the demand for leasing heavy equipment was down, the business was fat. SG&A expense of 25% was well in excess of the industry average. They knew that liquidation of collateral would not get them what they needed for a clean exit from the credit, even with the reserve they created, because of the weak market.
The personal guarantee, however would put them over the top. Prior to the consolidation movement of the 1990s, when banks maintained closer ties to the community, collection of personal guarantees was problematic and politically explosive in a localized market. In the present case, the bank elected to hold this card in the hole, preferring to sell the loan as part of a larger portfolio and avoid collection hassles altogether.
Their selected strategy was to forebear and convince the borrower to engage a turn-around expert (from the bank’s select list) to get new management installed or get the company refinanced.
The best workouts leave the borrower believing that they are getting something of value, like time and the ability to continue in business. In our example, the bank was buying time to sell the loan as part of a larger portfolio transfer. The new owner of the note and its discounted price, could easily liquidate the business. Our client was either unaware or unwilling to acknowledge the gravity of the situation. In the end, the company is foreclosed, the assets sold, the jobs are gone, the owner has had his personal wealth reduced and the bank booked an “acceptable” loan loss.
The moral of the story is this: be proactive. When the financial situation deteriorates, you had better be working as hard as the bank is working on the other side. Be cynical and assume the worst…allow yourself to be pleasantly surprised. The universe of financial institutions that specialize in workout situations is small and their opportunities are many.
By being proactive, you increase your chances of attracting a refinancing source. They will appreciate the fact that management is aware of the situation and has acted quickly to solve it.
Last, hire an experienced professional adviser. You may only get one chance to negotiate a restructuring. Hire an adviser that understands the process and knows who has an appetite for what type of transaction. You or your CFO will need to be in five places at once come crunch time. Make sure your adviser has the bandwidth to support you when push comes to shove. At the end of it all, remember: “Good judgment comes from experience…experience comes from bad judgment.”
Jim Priebe is vice president and managing director of the large transaction group at Allegiance Capital Corp., a Dallas-based investment banking firm specializing in domestic and international business ventures for the middle market. John Gilreath is vice president for Allegiance Capital Corp.