Caught between a ragged economy and a bank credit crunch, many businesses are turning to asset-based loans, mezzanine financing and receivables factoring.
The official word from Washington is that it's a little easier for businesses to get bank loans today than it was, say, 18 months ago, when some of the nation's largest banking companies weren't even sure they'd survive. In early 2009, with the Great Recession at its nadir and federal bank bailouts the order of the day, commercial lending ground almost to a halt. For businesses that were accustomed to relying on lines of credit or low-priced term loans, bank financing became either prohibitively expensive or unavailable at any price. The commercial credit crunch was very real and very painful.
The Federal Reserve, which has pumped tens of billions into the banking system in an effort to loosen credit, says things are better now. The Fed's July 2010 Senior Loan Officer Survey on Bank Lending Practices reported that U.S. banks have eased lending standards and terms on commercial and industrial (C&I) loans to firms of all sizes. Large U.S. banks eased terms the most, citing increased market competition. For small business borrowers, the July survey was the first since late 2006 to reflect an easing of C&I loan standards.
That's the good news. Talk to business owners and CFOs, though, and you'll hear a grimmer story. For businesses struggling to regain the strength they had before the recession-or just to keep their doors open-securing traditional bank financing is very difficult.
"They're finding that the amount of credit they can get from their bank today is less than what it was just a few years ago," says Cheryl Turnbull, managing partner of Capital Transactions, a Columbus-based firm that helps middle-market companies find capital. "That amount may not align with what the company needs or wants, especially if they can't entirely refinance with the bank."
"Banks still are very cautious in lending," says accountant Paul Anderson, assurance director at GBQ Partners. "We're seeing more conversations about financing and securing working capital. Some situations are distressed and companies are very concerned."
Tight-fisted banks aren't solely responsible for the lending squeeze. As the economy limps along, more and more companies find they no longer fit the profile of a bankable business. Their balance sheets and income statements have deteriorated to the point that they might not have been considered bankable even before banks began raising loan standards.
"They've managed to hang on, but their performance is below what you'd have expected it to be three or four years ago," Turnbull says. "Traditional loan covenants are designed for high revenue, high profit and strong cash flow companies, but many companies are in some sort of loan covenant default with their lender."
As national and regional banks have tightened their standards, business borrowers have turned to community banks, but with only minimal success. "Community banks we know aren't doing alternative financing to speak of," says Columbus First Bank President and chief lending officer John Smiley. "We don't have an unlimited supply of loans we can do. We're busy with ‘A' deals, or those customers with stronger credit. ... We really aren't doing ‘B' and ‘C' deals."
Banks have been asking some customers to find a new financial partner or to secure additional resources-new equity investment, for example-to supplement what the bank will lend. Even customers who still qualify for the bank credit they need are finding themselves hammered by high fees for covenant waivers and credit facility amendments. Often, those fees drive the effective "cost of money" well above the stated loan interest rate.
So what's a cash-hungry company to do? Major sources of alternative financing include asset-based loans (ABLs), secured by the company's hard assets; mezzanine financing, which can bridge that gap between what the bank will lend and what's needed; and factoring, which provides almost immediate cash based on the value of the company's accounts receivable or purchase orders.
Be cautious before signing on the dotted line, though. Alternative financing may be pricier than traditional bank loans. "Business owners get so excited when they do find financing, but they don't necessarily think of all of its ramifications," Anderson says. "While it may be their only alternative, [owners should] talk with an accountant who can crunch the numbers and see the real effect the new financing will have on their company."
Here's a look at the pros and cons of ABLs, mezzanine financing and factoring.
ABLs are loans secured by company assets, typically inventory or fixed assets such as a plant and equipment. They're a good fit for borrowers that are asset-rich, but cash-flow-poor. A struggling manufacturer with $50 million worth of debt-free machinery on the factory floor, for example, might qualify for a $15 million ABL line from GE Capital, which bills itself as the world's largest asset-based lender.
Both commercial banks and nonbank commercial lenders offer ABLs, which can be written as term loans or revolving lines of credit. "In the old days, the stigma was that ABL was the lender of last resort. That's not necessarily the case anymore," says Steve Shepard, PNC Bank executive vice president and corporate banking market leader in Columbus. "About 10 to 15 years ago, ABLs became more commonplace."
While ABLs can be used to keep a company afloat, they're also used to fund rapid growth, recapitalizations, and mergers and acquisitions. "We see a certain segment of borrowers today [that] have a higher risk level than traditional commercial lenders are willing to take on. They're struggling to find financing. Many of them had a bad 2008 and lost money during 2009," says James Cannella, Huntington National Bank senior vice president and director of asset-based lending.
"If a company is somewhat challenged and lost money last year, we want to understand why they lost money and how they plan to turn it around," says Shepard. "With sound management and a good plan to turn the corner, we can lend them money and secure the loan with their assets."
Lenders perform rigorous due diligence and closely manage ABLs. "We appraise the fixed assets and inventory to get a good feel for their value if a liquidation scenario arises," Shepard says. "We conduct field examinations at each of the company's locations. We inspect the books. We review how they process accounts receivable and sales tickets. We want to see a strong computer system that can track the assets."
Companies report the status of the assets daily, weekly or monthly via a borrowing base certificate. If accounts receivable or inventory are among the assets securing the loan, the certificate states their value as of a certain date. "Because of the comfort level we have from the field audit, the close asset monitoring and regular information flow, we're often willing to lend more than the borrower could get from a traditional loan," Cannella says.
ABL interest rates generally are lower than those for an unsecured loan or line of credit, because the lender can seize the assets to recoup its losses if the loan goes bad.
A company may be an ABL borrower today and then later return to traditional bank borrowing. "We encourage that, if it's right for them," Cannella says. "But many customers like the fact that ABLs force them to manage their working capital every single day. Some customers are perennial ABL borrowers because of the nature of their business. Others want to use them because of the discipline."
Mezzanine financing is unsecured debt that supplements traditional bank financing. Similar to a mezzanine in a building, its name references the place it has in the tiers of capital.
"Mezzanine is less secure than traditional bank debt, but more secure than equity. The return is greater than traditional bank financing, but less than riskier equity," says Pete Davies, a principal at Stonehenge Partners, a Columbus-based private investment firm.
Instead of financing everyday working capital needs, mezzanine often funds an event such as an expansion, buyout or acquisition. Borrowers may pay interest on a current or deferred basis. Mezzanine lenders often have the right to take an equity position in the company through the use of warrants. Such stock conversion rights can give lenders a big upside if the company prospers-and the power to take control if things go badly.
Red Capital Group is one Central Ohio firm that regularly uses mezzanine financing in mortgage-related transactions, including multifamily housing, senior housing and health-care facilities. "Cash-in refinances can have a significant balloon risk as the current mortgage loans mature," says Michael Wood, president of Red Capital Advisors. "In the multifamily and apartment sector, there can be a gap between the mortgage loan balance and the current valuation. Red Capital could fill that gap with mezzanine financing."
"Mezzanine makes the most sense for owners with a value-creating opportunity," Wood adds. "They can pay the first mortgage, pay the mezzanine lender an appropriate level of return, and the equity is able to earn a higher rate than it otherwise would if mezzanine financing hadn't been used."
Mezzanine financing relies on the company's cash flow. "Banks aren't extending credit much beyond the collateral value. Mezzanine debt isn't backed by assets like ABLs, but with cash flow. It's ideally suited for companies that can support a higher level of debt with [their] cash flow," Turnbull says.
Fast-growing companies that outpace a bank's ability to provide capital through traditional loans are good candidates for mezzanine financing. It's not as appropriate for weakened companies, but that doesn't mean it doesn't have a place in the wake of the recession.
"We're looking at companies who are making the turn back to profitability after the downturn. We've got capital to put to work and we can provide mezzanine borrowers with a good opportunity," says Randy Stickler, Huntington National Bank senior executive vice president and commercial real estate director. Huntington just reintroduced mezzanine financing in August.
How a company responds to adversity matters to mezzanine lenders. "Very few companies haven't had some difficulty over the last few years, and we take that into account," says David Abshier, managing director of Huntington Capital Markets. "We're looking at how they've adjusted during the downturn, such as keeping expenses to a minimum. We want to have confidence in the management team and understand their plans and business model."
Borrowers shouldn't expect the same bank that carries their line of credit or commercial term loan to step up when they seek mezzanine financing. "We usually use mezzanine financing in conjunction with other lenders, rather than doubling up within PNC," Shepard says. "We can do both layers, but we must consider how much in total we want to lend to a single borrower."
Mezzanine lenders usually have more "skin in the game" than traditional bank lenders, so the pre-loan homework is rigorous. "We start from the top down," says Stonehenge's Davies. "We spend time with the management team to understand the industry and where the company fits. We review their business plan and their balance sheet. Then we develop financial models that provide optimal capital structure for their plans."
"Mezzanine investors work with companies much more closely than when banks make traditional financing available," says Turnbull. "They're often on the board or advise the board. There's ongoing and specific communication with the CEO and CFO regarding strategy, budgeting and operations."
If your incoming cash typically lags your expenses, factoring may provide the cash fix your business needs. "To use factoring, you must have customers and generate invoices for goods and services delivered," says Tom Bielski, managing director of Northwest Capital in Toledo.
"We specifically buy an eligible invoice. We give you 80 percent of the invoice upfront. When your client pays the invoice, we'll give you the remaining 20 percent, minus our fees. We physically own the invoices we buy, and the payments go directly to our lockbox," Bielski says.
Purchase orders also can be factored: "Same concept, different product," Bielski says.
Credit-squeezed entrepreneurs and small business owners are customers of Northwest Capital. "They've maxed out their credit cards and probably borrowed against their house," Bielski says. "Our volume increased 300 percent this year. We attribute a lot of that to banks not lending money. We're seeing the credit crisis firsthand. A lot of good, established bank customers aren't meeting their loan covenants right now and are being asked to find financing elsewhere. We're helping many of them."
Northwest Capital doesn't focus on how bankable the client is, but rather on the profitability of their customers' customers, who are known as account debtors.
Bielski reviews a potential client's accounts receivable aging report, the total dollar amount outstanding and the customer list. "That way I can decide what invoices are eligible. We use the term ‘eligible invoice' to describe a well-rated customer of our client," he says.
Factoring can be done on a daily, weekly or monthly basis. "It depends on the urgency. We're geared toward when the business needs the cash," Bielski says. "When a company is using our money, it's like riding in a cab. You want to minimize the time. If payroll is due Wednesday, borrow the money from us on Wednesday. If you borrow it on Monday, you're paying us for two more days you didn't need to."
Northwest Capital's fees are determined by how long each invoice is outstanding. "We charge 3 percent for the first 30 days and then 1 percent for each 10 days after that," Bielski says. "Our portfolio turns every 47 days. But remember, I'm cherry-picking the invoices."
Factoring is expensive-3 percent for 30 days works out to 42 percent annually after compounding-but it's fast money. "It provides cash to get from Point A to Point B. They can make payroll this week or pay the rent. If they go to the bank, it can take six weeks to process the request. The company won't need the money in six weeks. It'll be out of business by then. I may be the only avenue they had to keep the business going," Bielski says.
Lisa Hooker is a freelance writer.
Reprinted from theNovember 2010 issue of Columbus C.E.O. Copyright © Columbus C.E.O.