As we enter another year uncertain when transacting business will return to a semblance of normalcy, many businesses will have to face the prospect of dealing with their lender.  As a business advisor, you may be asked by your client, what happens now?  While business owners will hope for a better year and seek a reopening of their business once vaccines are widely distributed, they may find that their lending institution has a different risk perspective and may be far more numbers-driven and focused on actual results, not aspirations. Lenders remain concerned about their portfolio of outstanding loans and the amount of both actual and potential loan loss reserves on their balance sheets.

Why Are a Bank’s Loan Loss Reserves Relevant?

Banks increased their loan loss reserves in the second quarter of 2020 to approximately $100 billion.  As borrowers benefited from the Payroll Protection Program and other CARES Act related stimulus, banks lowered their estimate of losses from loans in the third quarter of 2020.  Even outside of a pandemic, lenders are constantly evaluating their loan portfolio, performing risk review by regions and industries, and even exiting performing ones for the liquidity to address the unperforming loans.  While there may have been fewer instances of lender actions against borrowers during the past year, the expectation is that lenders will seek to recover losses in 2021, evaluating government stimulus programs, economic factors, the debtor’s industry, and covenant compliance.

The Lender/Borrower Relationship

The relationship between lenders and borrowers is like a marriage. During the courting period someone from the lender’s loan origination (who is compensated on closing loans) convinces management to choose them.  Before you can get married you sign a pre-nuptial (the loan agreement).  The loan sale and closing are handled by different parties, and the borrower is then assigned a relationship manager.  For any good marriage to work, communication and honesty are essential. Working together always works better than counter to one another’s efforts.  Borrowers should understand the loan agreement, particularly the covenants and guarantees. Not all lenders are the same— one lender’s risky loan is another’s acceptable risk. It’s important for the borrower to understand their lender’s perspective.  Concurrently, the lender’s relationship manager needs to be educated on the borrower in order to be their best advocate.

When Does a Loan Become Non-Conforming?

A business identifies a cash need, documents it with a business plan including financial projections, and applies for a loan.  The financial projection sets measurable targets that will typically form the basis of the covenants in the loan agreement, for example, levels of minimum income, working capital, debt to equity, and interest coverage.  Negative covenants include prohibitions on shareholder distributions, purchase of fixed assets, failure to provide timely financials, or failure to pay loan payments timely.  These covenants may be negotiable prior to signing the loan agreement.  The documents set the expectations for the loan and allow the lender to proceed with financing.  Advisors should seek to provide their clients advice on how to ensure projections are conservative enough to reduce execution risk in case performance is not met.

When the Bank Declares a Default

In many instances, there is no payment default, just a covenant default that may trigger a workout and the borrower must pay all costs of the workout, including the bank legal costs, fees for a financial advisor (acceptable to the lender) who acts as a mediator, and possibly forbearance fees.  The borrower must deal with a workout officer (the divorce attorney) who may not have any information or contact with the prior relationship manager and know little about the business.  The advisor balances between the borrower and the lender to provide perspective to both and navigate the challenges.  While the borrower may perceive the advisor as a hired gun for the lender, the advisor must gain the borrower’s trust. The advisor knows what data the lender needs to see and that such information must be accurate and informative.  The workout officer does not know the borrower and will rely on the advisor for the tools needed to complete the workout process.  The financial advisor should advocate for the borrower but cannot mislead the lender.

Personality Comes into Play

Every lender has a process for addressing its non-conforming loans.  They may have a department such as Special Assets, Workouts, or Restructurings.  While the playbook the lender uses is in some ways predictable, the journey is influenced by the personalities of the bank’s workout officer, the borrower and its financial advisor, the industry, the alternative capital resources, and what liquidation may look like.  The underlying factors that pushed the borrower into workout also play a part.

The Lender’s Goals and Rights in a Work-out

The advisor should learn the lender’s intentions.  Does the lender want to exit the loan? If so, what is the timetable?  Is it best to liquidate the company, or will there be time to find a new lender?  Will the lender stay in the loan and work with the borrower to redefine some terms of the loan, such as a limit on owner compensation?  Note the term “work with the borrower” as opposed to telling the borrower what to do.  Under the concept of lender liability, lenders can be litigated for providing too direct an instruction that can be construed as making management decisions.

The Forbearance Agreement

To remove the uncertainty of operating while in default, the lender and the borrower (with the financial advisor’s help) enter into a forbearance agreement.  A forbearance agreement is when the lender agrees not to enforce its rights for a period of time if the borrower complies with certain terms.  These terms can involve the payment of a fee, continued retention of a financial advisor, and/or providing the lender with periodic reporting.  The most common tool used in workouts is the 13-week cash flow projection.  The 13-week cash flow has multiple uses and serves to show the lender that the borrower will have enough funds to operate while projecting the lender’s collateral position during the period.  This report is updated each week and past performance is measured against the previous projection.  The forbearance agreement is also usually required by the borrower’s outside accountants to avoid a going concern opinion.

Liquidation Analysis

Another tool used by the workout group is a liquidation analysis.  This is not as ominous as it sounds as liquidation, even in an orderly fashion, leads to diminished returns to the bank, so it is usually a last resort.  Accounts receivable suffer impairment and inventory loses value.  In addition, costs of severance and terminating executory contracts, such as leases and employee agreements, can be considerable.  A good financial advisor can demonstrate that the lender is better off by not forcing liquidation.

Summary

As businesses begin to see more normal operating activities, it is likely that more aggressive recovery actions by lenders will be taking place in 2021 to stabilize their portfolios and generate liquidity.  Business advisors should encourage their distressed clients to communicate with their lender relationship manager early and often to assess how they are being viewed and what courses of action may be necessary to protect the business.  For those entering into new loans in 2021, business advisors should encourage them to seek advice in setting loan covenants, negotiating collateral, and limiting personal guarantees, leveraging conservative projections to best set expectations.

Frank Musso is a Senior Managing Director of KCP Advisory.

Frank is a financial advisor who works with regional banks to assess the financial condition of their distressed borrowers.

He also helps clients with cash flow projections, negotiations with stake holders, and in Chapter 11.