AN INSIDER’S PERSPECTIVE ON SMALL-BUSINESS WORKOUTS
BY JEFFREY SWEENEY
The truth about bank workouts is that there is a shortage of good execution, plenty of bad
practice and some really ugly situations out there. Banks, under renewed pressure from the
FDIC, are being forced to rethink some of their policies and strategies for taking nonperforming
small-business loans off their balance sheets. Jeffrey Sweeney, CEO of direct lender and
advisory firm US Capital Partners, LLC, explains why much of the traditional approach to
workouts is outmoded and where innovative approaches can be more widely used
to solve workout problems to the mutual benefit of lenders, borrowers and the
market in general.
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Beleaguered by large portfolios of
bad loans and the need to make more
small-business loans, some forwardthinking banks are starting to change
their strategies for small-business
workouts. Some of the cleverer guys
in the bank boardrooms are focusing
on large principal repayments and
core competencies, with measurable
benefits for all parties involved.
Optimal Workouts
In a previous issue of The Secured
Lender, I discussed a progressive
approach for financial workouts
(“Intelligent Workouts: Embracing
a New Paradigm in Small Business
Refinancing,” The Secured Lender,
November/December 2010). To secure
the maximum refinancing amount for
a company, I argued, several different asset-based lenders will often
have to participate. I made the case
for bringing in a specialist advisory
firm that understands lending from a
lender’s perspective, preferably with
the ability to lend and take at least
some balance sheet risk on the deal.
This specialist advisory firm can coordinate among the borrower, the bank
and the different asset-based lenders
to ensure that a refinancing occurs.
Importantly, the bank then needs
to segment its nonperforming loan
into a conforming asset-based
tranche “A” and an unsecured or
junior secured tranche “B.” The bank
can exit tranche “A” through the
borrower refinancing with assetbased lenders and carry tranche “B”
— which is the uncovered loan or “air
ball” balance — as an unsecured or
second-lien loan. The borrower then
repays all or part of this second-lien
loan over some reasonable period as
the borrower’s cash flow or new working capital borrowings and advances
permit. Agreed payments on the
bank’s tranche “B” can be protected
through cash management and intercreditor agreements administered by
the asset-based lenders.
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The Banks Give It a Try, but the Feds
Are Not So Sure
Lately, commercial banks have been
attempting to apply this technique
but are keeping the entire loan. In
other words, some banks have been
dividing the loan into tranche “A”
(properly collateralized) and tranche
“B” (nonperforming) and retaining
both segments. This, approach is not
working well for a number of reasons.
Generally, the borrower does not have
a scalable line of credit, which constrains its growth. This then, prevents
the loans from gradually moving to
fully compliant or performing status,
or from improving to the point where
another lender can refinance them in
their entirety.
Additionally, the FDIC is putting
pressure on the banks to keep the entire credit facility within nonperforming status and is not allowing banks
to segment the original loan into two
parts. Consequently, this particular application of the bifurcation approach
is not working well.
Painfully innovative as it may
feel, it is time for the banks’ workout managers to reach out to their
ABL brothers and commit to selling
tranche “A” (the secured portion of
nonperforming loans) and to hold all
or some of tranche “B” (the nonperforming amount). This means the bank
will have to be second-lien holders
on these deals. This concept tends to
elicit a visceral reaction from most
banking institutions, which virtually
never take second-lien positions.
Challenges of the Typical Workout
When a small business defaults on
loan payments or trips a loan covenant, the bank’s traditional response
is to put the company in loan workout.
The aim is to recover as much of the
principal as possible as soon as possible. Recovery of principal can take
the form of either a meager partial
repayment through a refinancing with
a discount or, alternatively, a long,
painful liquidation of the borrower
and partial recovery of the princi-
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pal. The workout terminating in full
repayment is difficult in a distressed
situation for obvious reasons. Usually,
the bank must set aside some or the
entire loan against earnings in loan
loss reserves and spend money managing the problem.
Getting refinancing can be challenging in a distressed situation.
Usually, the bank workout officers
and the borrower are not familiar
enough with the ABL debt market,
ABL appraisers, or even the customary
practices among asset-based lenders, to create solutions. Equally, the
borrower is generally at a loss for solutions because it likely has been a bank
customer for many years and has not
dealt extensively with the fragmented
ABL world. Small businesses usually
cannot articulate their deals in the
ABL marketplace effectively, even if
they know whom to contact. They cannot demonstrate the ability or provide
the assurances that the bank wants in
the deal.
Small businesses not only struggle
to find the right lenders, but almost
always lack the know-how and experience to structure optimal refinancing,
as well as manage and coordinate
the relationships among the different parties. This is especially so if the
borrower needs several asset-based
lenders to make the deal happen, as
is so often the case in small-business
refinancing.
How to Move from Conflict to
Cooperation in Workouts
A typical workout puts the two parties
— the bank and the borrower — in
direct opposition. I have seen time and
again this scenario play out where the
bank is concerned, quite rightly, about
one thing and one thing only: repayment — how soon and how much. The
small business, on the other hand, is
concerned about ongoing viability and
about returning growth, profitability
and cash flow to preworkout levels.
The current model of bank workouts does not address both parties’
concerns or even their available skill
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sets to resolve the problem. Rather, a
crisis of trust develops between the
parties. This aggravates the situation
and leads to a far-less-than-optimal
outcome for both parties. Usually the
borrower comes to an awareness of
the bank’s motivations, and the intransigence begins.
These situations need a trusted
third-party adviser. By a specialist
adviser, I don’t mean the typical distressed-debt negotiators. Sometimes
the borrower engages a “debt renegotiation specialist,” which usually only
complicates the situation further and
alienates the bank. The compensation
model for the debt negotiator is generally a fee based on the amount of debt
forgiven. This is not going to engender
trust and cooperation with the bank.
How can a bank trust a debt renegotiation specialist’s assessment of the
borrower’s ability to repay when the
specialist’s compensation is based on
the bank’s discount?
Of course, this plays the other way
too, when the bank insists that the
borrower take on one of its stable of
“advisers” to help refinance the business out of the bank. Again, you have
a conflict because these advisers, in
many cases, rely heavily on the bank’s
referral for business. It does not take
too long for the borrower to figure out
that the “adviser” is really a borrowerpaid bank representative with no
solution other than to pay the bank
out 100% right away, regardless of the
long-term effect on the business.
The better approach is to get an
advisory group that is independent
and capable of honest and dispassionate analysis. Such a group can assess
the status of the business, its ability
to repay debt going forward and its
ability to refinance, given its condition
and the state of the ABL marketplace.
The ideal third-party adviser to
smaller businesses will be a small-cap
investment banker that specializes in
restructuring, knows the small business asset-based lending market and
can structure a deal among multiple
asset-based lenders. Such an adviser
will need to have excellent contacts
and relationships with appropriate
lenders. It will be able to bring these
lenders together, speak their language
and solve all the various possible
lending problems beforehand. An ideal
third-party adviser will have experience in the same size and sector as the
borrower, as well as with the possible
problems that can arise. It is helpful,
of course, if the adviser is able to provide a strip of capital also.
Putting the Theory into Practice:
An Example
As is often the case, US Capital Partners, LLC was brought into a situation
in which a company was in trouble
with its lender. The company was an
international produce supplier and
shipper. This is a typical scenario in
today’s challenging lending environment for small businesses.
The borrower had a very good
multiyear relationship with its commercial bank, which had provided
some creative overadvances for its
seasonal business. The bank had large
loan losses and write-offs, primarily
from commercial real estate lending
gone wrong. The borrower had a year
of weak earnings and declining topline sales, with a resulting bottom-line
decline below historical levels — not a
catastrophe, but a good excuse for the
bank to get out. The bank was cannibalizing its commercial loan portfolio
of weaker or creative loans to shore
up its balance sheet against very bad
loans to other borrowers. This international produce supplier, which had
never missed a payment and was not
used to going outside the bank, was
dismayed to find its long relationship
with the bank suddenly breaking up.
With the required appraisals and
analysis, US Capital Partners entered
into discussions with the bank about
refinancing. Unlike the produce company, US Capital Partners was able to
articulate a deal structure and pledge
new capital, giving the bank confidence that something was actually
happening to get this deal done. This
diffused the situation and bought the
company some more time to allow us
to complete our due diligence process.
As a result of our due diligence on
assets and cash flow, we concluded
that the company was not going to be
able to refinance the bank out fully.
The bank agreed to our proposal to
bifurcate the loan into two segments:
a new $5 million senior loan from
asset-based lenders that was supported by company assets and cash flow
(tranche “A”), and a $1.5 million loan
unsupported by company assets but
supported by cash flow (tranche “B”).
The bank carried this $1.5 million debt
strip, taking a second lien on company
assets for it. As a result, the bank collected what was owed to it over time.
Through this intelligent workout
plan, we were able to arrange a successful exit from the bank at 100%
debt payout. In other words, the bank
did not have to take a haircut, even
though this was a workout situation.
US Capital Partners’ intervention
and negotiation with the bank also
allowed refinancing to take place for
the company, facilitated a safe and
orderly exit for the company from
its relationship with the bank and
allowed the company to be financially
viable going forward with a scalable
senior revolving line of credit to support growth. There were no losers in
this arrangement.
Needless to say, this approach to a
workout will not turn the second-lien
loan (tranche “B”) into a performing
asset. The bank will have to list this
new, much smaller, loan as a troubled
asset on its balance sheet. However,
all principal and interest payments
will go straight to the bank’s bottom
line, enhancing the bank’s performance every quarter.
Conclusion
The workout strategies of the past
continue to be problematic both for
lenders and for borrowers. All too often an old-school, aggressive approach
pushes a small business over the edge
into bankruptcy, leading to needless
job losses and adding to a sluggish
and uncertain economic recovery.
The better approach, as explained,
is for the bank to bifurcate its nonperforming loans into performing
and nonperforming segments. The
bank can sell off the asset-supported
performing segment to asset-based
lenders, which are better equipped to
handle a problem credit, and retain
the “air ball” portion (that has a likelihood of repayment) as a subordinated
debt strip. The key element to this
strategy is that the bank must subordinate and collect out on the portion of
the loan that we asset-based lenders
will initially fund. Regulators will not
allow banks to retain both loan pieces
and will likely require the bank to set
the entire loan aside.
As our example of the produce supplier illustrates, banks are increasingly
embracing the subordination strategy
and optimally divesting themselves of
large portfolios of bad loans. By doing
so, they avoid moving into asset-based
lending, an area that requires a very
specialized skill set that most commercial banks lack. If a bank allows
asset-based lenders to take this senior
debt off its balance sheets, the bank
gets paid what it is owed, the borrower pays what it should and it gets a
scalable line of credit to recommence
growth. This strategy also ensures that
smaller companies are not put out of
business accidentally or unintentionally. It’s a strategy that benefits all the
parties involved. TSL
Jeffrey Sweeney is an investment banker
with years of experience in direct lending
and corporate finance for small-cap and
lower middle-market businesses. He is the
CEO and managing director at US Capital
Partners, LLC (www.uscapitalpartners.
net), an innovator in affordable smallbusiness lending and a leading financial
restructuring specialist for small
businesses.
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