|
Today’s newsletter looks at what to do if you are in danger of breaking — that is,
defaulting
on — your loan or loans.
As a reminder,
a default is when a borrower doesn’t perform as it is contracted to do.
At its most basic, that means not making payments.
Typically, however, before a default occurs, covenants (such as required financial ratios) are first broken. This is by the lender’s design; it is their early warning system. (To calculate loan covenants, one needs to know what they are. So,
read the loan agreement.)
Usually, there are also financial reporting requirements,
such as annual audited financial statements, monthly internal financials, and more, all due by certain dates. With most loans, if your financial reporting is late, the loan is
technically
in default.
Ideally,
before
the default happens,
a company will warn its lender(s).
Why? Two reasons.
#1. If a lender discovers a default before you tell them, it will assume one of two things (sometimes both): Either you don’t have financial control of your business and didn’t see this coming or, you foresaw it but lack integrity and hid it from them. Neither assessment is good. (For more details on why, read
here
and
here.)
#2. In extreme cases of lost confidence, if it believes the proceeds will pay off the loan and there are no better options, a frustrated senior secured lender may decide to liquidate — junior creditors be damned.
Steps to Take
With all of the above in mind,
step one is to have the financial projection tools in place
that allow you to project a one- to three-year
income statement and balance sheet.
Most critical is projection of the balance sheet, since changes in this are the key drivers of liquidity needs, collateral for lenders, and more. These projections should calculate all the covenants in your current loan documents and, where required, the borrowing base. Additionally, have and use a
13-week rolling cash flow projection.
Next, develop a set of action plans to fix the problem(s).
Is it poor sales due to market changes? Is it squeezed margins due to customer or product mix? Can costs be lowered through design modifications? Can liquidity be improved with help from suppliers? And don’t forget to consider poor execution by yourself and the rest of management. An honest assessment across all fronts is required.
Model your proposed solutions to gauge their impact on profitability, first focusing on the income statement and related key metrics, as well as immediate liquidity. Adjust from there as needed.
Next, focus on the balance sheet
to uncover what is needed to fund the company and how creditors will be repaid. Evaluate the
fixed charge coverage ratio (FCCR)
in particular, as well as other
key liquidity ratios.
Remember the fixed charge ratio takes an accounting proxy for cash flow and divides it by expected debt service and similar payments. So, if the FCCR is below 1, then the business is cash flow negative. If the FCCR is barely over 1, then any slip up and there will be a default somewhere. When the fixed charge ratio is challenged, see if term loans can be amortized over a longer period. Perhaps, equity is needed. If you have an ABL (Asset-Based Lending) or C&I (Commercial & Industrial) loan, both of which require collateral, make sure you have what is required to support your borrowing needs.
Finally, make sure you understand the relationships among the creditors.
Which are secured (have liens on property) and which are not? Are there any inter-creditor agreements between the lenders? Who is the “fulcrum creditor” — that is, the creditor with something to lose short of everything? They will likely be the one to step up with additional funding, lengthening of the term and so forth. Most important, if more equity is needed and none is forthcoming, work with the fulcrum creditor to convert some or all of the debt to equity.
If the projections are still dire, or the above options are not available, consider selling some or all of the business. A friend of mine accepted a CEO role from a private equity-backed firm, only to quickly discover that the company was a disaster and in default with its lenders. Projections showed his turnaround plan required more equity. But when the private equity firm said no, he shelved the turnaround plan and sold the largest business to pay down the loan to a manageable level. Then, he quit.
At this point, you should have what you need to
go back to the lenders, lay out the problem, and offer your solution
(along with a candid assessment of its risks).
A Few Additional Tips…
Get help.
If you were surprised by the default, you shouldn’t have been. If you don’t do these projections routinely, get help ASAP (I have made things sound much simpler than they really are). You need it and your lender(s) will react positively.
Look elsewhere.
Don’t expect a lender, particularly a senior secured lender, to be the sole source of help. If there is a junior lender, consider suspending their payments. Put more equity in. Cut owner’s cash taken out of the business, whether in the form of distributions, dividends, salaries, or management fees.
Build and maintain trust.
Be honest of course. Equally important is demonstrating the ability to consistently execute by doing what you tell the lender you will do.
Maintain financial transparency.
That means timely and accurate financial reporting to the lender. When lenders can’t see what is going on in your business financially, they get nervous. Their biggest fear is you don’t know what is happening financially. That is why lenders mandate certain financial reporting in the loan agreement.
Know your lender’s comfort zone.
Are they cash flow-focused, collateral-focused (as with an ABL), or a blend of both (as with a C&I lender)? The latter two will look more closely at the collateral. If the risk level has increased too much for the lender’s comfort, look at alternative lenders, whether bank or non-bank.
Know whether your default is
idiosyncratic or systemic
in nature.
Simplified, idiosyncratic means the problem, in this case loan default, is caused by your business. Systemic causes are industry- or market-wide, perhaps even global, such as a recession, tight labor markets, and so forth. Lenders often treat idiosyncratic defaults differently than systemic defaults.
Beware that during a financial crisis, lenders tend to tighten up and go back to their roots. For example, during the Pandemic, I heard one very large bank say that while last year they would do a five-year term loan, today they are only looking at two- to three-year (and possibly zero!) term loans. When there is a systemic problem across all industries, lenders, who need their principal back to survive, take on far less risk.
Bring in legal resources.
The legal options to implement what needs to be done are beyond the scope of this newsletter. But unless your defaults are minor, you will need legal counsel experienced in restructuring and insolvency.
Final Thoughts
Lenders expect a modest contractual return with low risk.
For them, preservation of capital is paramount. For you, that means repayment.
All solutions to a projected loan default should credibly show a return to what the lender contractually bargained. That entails more than just principal and interest payments — it means a return to the same risk level. The Fixed Charge Coverage Ratio should return to compliance. If not, a new lender that will accept a higher level of risk is likely needed.
|
