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Problem Loan? No Problem
By Walter Schuppe
We are lenders and problem loans are to be expected. It is a risk of doing business. Businesses can be affected by self-inflicted problems such as poor cash forecasting, or worse, no cash forecasting. Lack of adequate expense controls and poor management are also self-inflicted wounds to name just a few. Businesses can also suffer from problems resulting from external factors such as recessions, industry shakeouts, unexpected government regulations, supply chain disruptions and customer bankruptcies to name a few. The key is how management addresses the issues and how they communicate with their stakeholders.
Economic cycles and the related recessions are always challenging for lenders to work through. The current economic environment brought on by a pandemic is without precedent and it is hard to predict how businesses and the economy will react in both the short and long term. It is unlikely any lender was prescient enough to have underwritten a pandemic as a risk. We are all now working in unchartered territory as we await the effects of the pandemic to fully unfold. Will there be a second outbreak? Will there be a near-term recovery? How will the recovery look? V-shaped or flat? However, the basic principles for managing a problem loan all apply to the current environment.
Before we talk about the basic approach to creating a framework to work through a problem loan, here are some facts from a study done by Harlan Platt of Northeastern University:
- It takes 6 to 10 months to turnaround a business that has emerging weaknesses.
- It takes 27+ months to turnaround a full-blown crisis
- 93% of companies with emerging weaknesses that were addressed early survived the turnaround
- 63% of companies that ended up in a full crisis survived the turnaround.
- 70% of the companies with problems had no cash flow forecasts
- 72% could not deliver timely and accurate accounting and financial information
- The most prevalent cause of problems was poor management.
Set Your Expectations
You need to have the proper perspective when assessing a turnaround plan. The longer the problem has been festering, the longer it will take to solve it. You can’t fix in a matter of weeks what has been developing for months – maybe years. Understand that there is a big difference between developing the strategic turnaround plan and the actual implementation of that plan. Execution risk is high, and these risks must be anticipated. Once you have properly set your expectations, then you must set the expectations of everyone in your organization who is monitoring the progress of your loan.
Workout vs. Get Out
Sometimes bad things happen to good companies. You need to assess if this is a relationship that your organization wants to preserve. The best outcome is to add value to your borrower by working through the problems, preserve the relationship and strengthen the relationship. However, if your borrower no longer has a reason for being or has substandard management, it may be necessary to exit the relationship. You have a business to run and it’s ok to fire bad customers.
Turnaround Decision Tree
The first step is to understand if this is a company that can be successfully turned around and if you have the right managers in place to effectuate the turnaround. The following decision tree can be helpful in making your assessment.
The first question to answer is, “does this company have a reason for being”? Once-strong and competitive companies can lose their way. Their products may be out of date, they may have alienated their customers, they may have lost their competitive advantages, they may have neglected investment in their physical plant or a number of other events may have combined to make a company that, at one time, had significant competitive advantages, merely a “me too” business. An undercapitalized “me too” business will have limited options and may not be a business you want in your loan portfolio.
The next set of questions you must ask yourself concern the quality and character of management. We will discuss management in more detail later in this article. You need to determine if you trust the management team. If you cannot get comfortable with the integrity or character of management or the ownership, you should develop an aggressive strategy to exit the loan. If you do trust management, you need to make an assessment of their ability to turnaround the business. Keep in mind, there is a distinctly different set of skills that are required to turn around a troubled business. Not everyone has that skill set. If your management team doesn’t have what it takes to create and implement a plan, but they are willing to accept help from an experience turnaround professional, you may be able to keep this company as a borrower.
Creating a Framework for a Successful Turnaround
There are several elements that will help you develop a framework and a process to manage your loan. It is then up to the loan officer to drive the process.
Early Recognition – The sooner you identify that a problem exists, the greater the likelihood of a successful turnaround. If you think there is a problem, but management does not, don’t give up. Engage in a detailed discussion based on data and analysis and try to help management understand your basis for concern.
Root-Cause Problem Solving – Management should be digging beyond the obvious symptoms (weak cash position, declining sales, high returns, etc.) until they reach the root cause or causes. This is often not an easy process and could take considerable time and analysis. It is like peeling an onion. When the root cause is ultimately identified, develop a root cause corrective action specifically targeted at the underlying causes.
Control the Purse String – In a cash crisis, cash preservation is the key focus. When a company is out of cash, it is out of options and likely out of business. If management can control the purse strings, they can control their destiny.
Timely and Accurate Financial and Operating Data – Without operating metrics and a 13-week cash flow, managing through a turnaround will be impossible. It would be like going on vacation without a map and your wallet.
Be Visible – As the lender, you can increase the sense of urgency with your borrower with frequent visits to your borrower’s place of business. Nothing replaces face-to-face meetings. However, in this period of COVID-19 that may be impossible. The next best thing would be video conferences at a regularly scheduled cadence.
Turnaround Plan – It should be written, comprehensive and subject to change as facts unfold during the turnaround. The plan should have deliverables, timetables, benchmarks and personal accountability for each. Management and employees should know exactly what they are being held accountable for and the timeframe for the accountability.
Drive the Process – Once you have the first six elements in place, now it is time to drive the process. This is done with consistent and timely follow-up, rigorous analysis of the data provided by the company and holding the company to its timetables.
Find Leverage and Use It – Understand your rights under your loan documents. Understand the strength of any guarantees, the value of your collateral and the value of the business in its current condition. Finally understand your borrower’s hot buttons. Having a strong understanding all of these factors will help you identify your leverage and guide you in how aggressive you can be in your negotiations.
J.P. Morgan said, “The first thing (in credit) is character… before money or anything else. Money cannot buy it.” As many of us have come to learn, people pay back loans, not business plans or loan documents. Integrity, character and ethics are all personality traits that are tested in adversity. This is a very subjective analysis and is often the weakest part of any underwriting package. Competitive pressure and the need for quick responses on loan requests do not allow lenders to develop the insights and relationships necessary to truly evaluate management and ownership. Now, in the midst of a crisis, it is important to honestly and fairly assess the abilities and integrity of your management team and ownership.
Without trust, character and integrity in the management team and ownership, a lender is operating at a significant disadvantage. If you determine that you cannot trust the people who will be responsible for paying you back, it is time to develop an aggressive exit plan. Conversely, if you trust the management, you must assess if they have the skills necessary to turn around the business.
As mentioned earlier, it takes a distinctly different set of skills to turn around a business than to grow a business. This may be too big of an adjustment for management to make. For people who are accustomed to developing new products, building customer relationships, hiring employees and building teams, the shift to killing unprofitable products, firing bad customers, layoffs and stretching vendor payments may be too far outside their comfort zones for them to be effective.
Human nature plays a big role in the success of a turnaround. Emotional attachment and admitting responsibility can be difficult hurdles for mangers and investors to overcome. Managers may have a personal attachment to certain aspects of the business that stand in the way of making decisions to turnaround the business. It could be a tough decision to make organizational changes if the decision maker set up that structure and/or hired the people who could now face termination.
Money can make good people do bad things.
There are four principles that will drive a successful turnaround. Look for your management team to embrace these principles.
Do not rely on sales growth to solve the problems. Or, said another way, you can’t grow your way out of a problem. This is an easy path for management to choose. They built the business by growing it and that is their comfort zone. Many a manager has thought, “If I have more sales, I will be a bigger business and therefore have bigger profits, so that will certainly solve the current problems.” Unfortunately, sales are the only line on the P&L that a CEO can’t control. Why? Because you can’t make people like your product or be satisfied with your quality or be willing to pay your price. You can control how much you spend. You can control the timing of your spending and you can negotiate concessions, even if only short term, that can immediately impact cash flow in a positive way.
Aggressive hands-on management – Is your CEO and management team driving the turnaround process? Are they on the premises every day checking on deadlines and deliverables? Are they controlling the situation or are they letting the situation control them? Are they visible to the work force? In a crisis, people are looking to be led. The best way to lead is from the front and in person.
Continuous improvement philosophy – Does the company have a continuous improvement mindset? Are the employees truly encouraged to find faster, more efficient and lower costways to perform everyday tasks? Is management thinking outside the box to turnaround the business? Do they encourage the employees to think outside of the box? This is the opportunity to make significant changes that previously would have been considered too disruptive to the day-to-day business.
Sense of urgency mentality – Management needs to set an example by approaching the turnaround with a visible sense of urgency. Keeping deadlines as short as reasonably practicable, timely and continuous follow-up of deadlines and deliverables along with clear and consistent communication are all part of building a sense of urgency throughout the company.
Tactically Managing Your Loan
There are some basic tactics you can you use to manage your borrower as they try to turn their business around. Earlier we said cash was king and, if you control the purse strings, you can control your destiny.
- The Turnaround Plan – It should be formal and reduced to writing.Refer to it as the turnaround progresses and track deadlines and deliverable and implementation tactics.
- 13-week cash flow – a tried and proven management tool that is as useful to the borrower as it is to the lender.Amid a crisis, 13 weeks is about as far as you can forecast with a strong degree of accuracy.This cash flow should be updated weekly and delivered on the same day each week along with an analysis of actual compared to the forecast.
- Management Dashboard – This is also a management tool that is as useful to management as it is to the lender.The dashboard may vary from borrower to borrower in terms of the actual operating metrics tracked, but all dashboards should track the metrics that are the most critical to the success of the business.
- Site Visits – The company is where the action is.Phone calls and emails are useful, but they do not replace in-person visits.Absent a pandemic with prohibitions on travel, you should be visible and walking the operations to compare any changes to the last time you were there.This is especially important for manufacturing companies.Being on-site can alert a lender to production issues, such as out-of-service machines, unusually large amounts of WIP, messy and disorganized facility, large amounts of scrap or rework, etc., which have not yet impacted the financial statements
- EBITDA vs Cash EBITDA – EBITDA is often a starting point for the analysis of cash flow.Remember to analyze CASH EBITDA because cash is king.Accrual-basis EBITDA should be adjusted for non-cash items and for uses of cash that do not flow through the income statement.For example, as deferred revenue declines your borrower is generating non-cash EBITDA.Capitalizing software costs means you need to reduce EBITDA for those cash expenditures.
- The Written Record – All of your site visits and phone calls should be memorialized in writing.This avoids lapses in memory, misunderstandings and can be useful if litigation develops. Use clear and precise language, avoid editorial comments and emotional statements.Write as if you were going to have this read back to you in court in front of a judge.
Private equity and venture capital groups can often be part of the solution. Their willingness to invest additional funds to help fund a turnaround plan, bridge to a sale or a larger equity raise, or the sale of the company may help in stabilizing a crisis. However, this often is not the case. Sponsors will continue to invest as long as they can convince themselves that there is value in the business. Their first responsibility of a PE or VC group is to their limited partners. Despite all the talk about working together as partners with their lender, they will not simply step up and solve a lender’s problem.
It's important to keep in mind that the majority of investors are not operators. They are professional fund raisers and are often experienced in providing advice regarding growth as a board member. These are also very smart people who often believe they are the smartest person in the room at all times. This combination of factors can lead to flawed turnaround strategies, under-investment and an unwillingness to make management changes.
It is important to keep in mind that when you ask for an equity infusion as part of a turnaround strategy, you should err on the high side of what you believe is necessary. Since their primary loyalty is to their limited partners, you may not get a second trip to the well.
Finally, it is important to know if the fund that has invested in your borrower is a committed fund or an uncommitted fund. If it is an uncommitted fund, the investors will have to “pass the hat” each time additional funds are needed, which leads to uncertainty of 100% investor participation.
Managing your bank group is one of the most important tasks a loan officer can have. It doesn’t matter if you have an outstanding turnaround plan, buy-in from the management and investors and adequate funding if there is no consensus among the bank group members on how to manage the loan. If you are the agent, you must provide leadership. The participants are usually looking for someone to lead them. Over-communicate, be straightforward, have thorough analysis to share, clearly outline the options, the related risks and how the risks are mitigated– and then tell the bank group what you believe is the course of action that should be taken. Remember, you have direct contact with the company, management and the investors. Because you have this direct relationship, the participants understand that you should have greater insight into the situation. Take advantage of this and use it to lead the group.
If you are a participant, be vocal and aggressive in your role. Make the agent provide all of the information and data necessary for you to be able to make an informed decision. If you don’t like the direction in which the agent is taking the bank group, control your own destiny and form alliances with other bank group members. Fully understand your rights and the voting requirements in the document that governs the rights and responsibilities of the lenders.
Understand your legal documents so you clearly understand your collateral, your rights, your enforcement options and your points of leverage with your borrower. Your first step should be to read the documents yourself. It is often very beneficial to have a law firm that was not involved in closing the original loan documents and has a strong restructuring and insolvency practice review all of the legal documents. Have the law firm provide you with a summary of the important terms and conditions. At the outset of a problem you should perform updated lien searches, title bring-downs and searches for suits, judgments and litigation.
From a loan management perspective, you may have several options in how to work out the loan. These options may include but are not limited to:
- Comprehensive restructure
- Consensual sale
- Chapter 11 or Chapter 7.
- Assignment of the Benefit of Creditors (ABC)
- An exercise of stock voting rights to replace the board
Your options will be circumstance and fact specific. From a documentation standpoint, you may elect to use an amendment, a waiver, a forbearance or simply leave the borrower in default. Understand what you gain and what you give up using these different approaches. I want to re-emphasize the importance of having legal counsel with a strong background in restructuring, insolvency and negotiation as part of your workout team.
Some specific actions a lender may consider taking as part of a workout are:
- Increasing the interest rate, charge the default rate or charge fees in recognition of the increased risk
- Obtain additional collateral
- Update field exams/collateral audits/appraisals
- Establish reserves, reduce advance rates, expand ineligible collateral definition
- Require Personal guarantees or guarantees of the fund that has invested in your borrower
- Correct flaws that may exist in the legal documentation
- Obtain a release of claims
- Require the engagement of a financial advisor or investment banker
- Additional financial reporting
- Block cash
- Seek federal or state Receiver
When an agreement cannot be reached or the turnaround efforts fail, it may be time to consider your enforcement actions. These may include foreclosure, a secured party sale, Chapter 11 to effectuate a 363 sale, Chapter 7 liquidation, or an ABC. It is worth mentioning that in-court proceedings are very time consuming and, therefore, very costly. If it looks like the best path to resolution involves the court system, it is better to come to a consensual agreement with your borrower and any other creditors who can hold up the process before filing. Spend all the time necessary outside of a process, where the costs are much lower, to get a plan agreed upon. Then, file and look for a timely exit.
The basics of a bankruptcy proceeding would require a discussion well beyond the scope of this article. However, as a lender, you shouldn’t be afraid of the bankruptcy process. Especially if you have a borrower who refuses to cooperate and may be squandering your collateral. The court process and the judge can hold difficult borrowers accountable.
I thought it would be worth mentioning the benefits of using a qualified financial advisor (FA). As with any other personal service, the abilities and experience of the individual who you select is far more important than the firm they work at. You should look for an FA with strong analytical and problem-solving skills, good communication skills and strong negotiating skills.
You may be in a position where you can recommend your borrower engage an FA from a list of at least three firms with which you are comfortable. This is often the preferred approach because if the FA works for the borrower, the company is more likely to listen to their advice, rather than advice coming from an FA that is employed by the lender. If the lender is comfortable with the company’s FA then it may not be necessary for the lender to engage their own FA and thereby hold down costs.
No matter what environment you may be operating in, you will be able to effectively manage any troubled loan if you can determine if your borrower’s business has a reason for being, if you can build a process and then drive the process and find your leverage and capitalize on it.