In each issue of The RMA Journal by ProSight, veteran workout leader Jason Alpert gives advice on thorny workout challenges. Have a challenge you would like Jason to address? Send your question to [email protected].
QUESTION: Jason, my bank, a large regional, recently completed the acquisition of a smaller community institution and is in the process of reviewing and transitioning legacy credits to our own credit and monitoring standards.
One inherited relationship is a lower middle market manufacturing company with a $5.25 million, unmonitored revolving line of credit. The borrower produces precision components for the industrial sector (in a mature industry) and has operated for several decades (albeit the last five years or so with flat revenue and near breakeven profitability). Under the prior bank, the facility was loosely structured with minimal reporting, occasional temporary over-advances, and covenant waivers granted informally.
As part of the post-merger integration, our bank plans to convert the relationship to a monitored borrowing base line, bring it into compliance with current credit policy, and upgrade the credit from watchlist grade to “pass” once compliant.
During the onboarding review, the borrower requested a change in terms to accommodate extended payment cycles from key customers. The modification makes commercial sense and the borrower appears cooperative and transparent. However, granting the request would create an over-advance and the customer does not have the free and clear collateral to pledge. Cash flow is too tight to amortize the over-advance in any meaningful way. Finally, the bank’s leadership team is lukewarm on the industry and relationship given the historical financials (borderline pass grade) and lack of ancillary treasury or other products with the borrower and its principals.
The borrower’s liquidity is tight, though collateral quality (A/R and inventory) appears generally sound. The company also owns the industrial/warehouse facility it operates from, but this property is held in a separate single-asset entity (SAE), with the mortgage financed by another bank. There may be some equity in the property, but the amount and accessibility are uncertain. How should we approach the borrower’s request for the change in terms and the potential over-advance?
JASON: Given the borrower’s transparency and willingness to cooperate, my take is that the bank continue evaluating the requested change in terms and simultaneously pursue a restructure to bring this loan into compliance with the bank’s policy. However, since the customer is over-advanced based on typical advance rates, they are inherently overleveraged, especially since operations are flatlining. Their apparent limited opportunity to grow topline revenue in their mature industry and generate cash flow growth hinders their ability to grow out of their leverage position.
I would recommend running dual paths:
- First, restructure the facility to give the borrower breathing room to continue servicing the debt.
- Second, encourage the borrower to consider capital alternatives to fix their balance sheet problem.
While you mentioned that bank management is tepid on this relationship, would they reconsider if the borrower found additional equity to right-size the loan and fund operational and efficiency initiatives to restore profitability?
If an equity solution isn’t available or if your leadership would rather just have the relationship resolved (perhaps due to purchase accounting benefits that have the loan marked less than what is outstanding, allowing for a recovery in the event the loan is paid off) then looking at a refinancing solution (either with another bank, credit union, or private lender) makes a lot of sense.
But first things first: In my view the loan needs to be bifurcated, and the borrower should have the ability to continue operating with a working capital line and a permanent working capital term loan. Assuming that the bank has received all current and historical financials and any third-party reports, it should have an idea of the appropriate size of the working capital line the borrower can afford. The remaining balance (or the over-advance) would be a permanent working capital loan that would have a different rate and would ideally be amortizing.
The reason for two loans is that each has a different repayment source and thus a different risk profile. (The working capital loan is repaid by current assets converted to cash and the permanent working capital loan is repaid by profits turned to cash). Both loans would be collateralized by the same assets; however, the permanent working capital loan will be under-secured because the value of the working capital assets is insufficient.
This lack of collateral could be addressed by requesting the borrower (through their SAE) provide a second mortgage on the owner-occupied real estate. However, the bank should be careful of requiring that pledge, especially since, most likely, the other bank’s mortgage documents do not allow for additional liens without approval. (The borrower would have to approach its other lender for approval.) If the borrower is amenable to that structure (and it receives the other lender’s approval) that may sway bank management’s decision to retain the loan, especially if the borrower has a plan to return to a stable cash flow and an ability to repay (with appropriate amortization or principal curtailments) the permanent capital loan.
Be sure to keep the restructured loans on a tight leash (a duration of less than 12 months) with adequate reporting and covenants to stay on top of the borrower’s turnaround plan. (You may also want to consider the requirement of a turnaround consultant.)
However, if the borrower can’t or won’t pledge the additional collateral—and a turnaround plan to have the borrower pay down the over-advance loan is too long of a putt—then it’s time to encourage or require the borrower to obtain alternative financing concurrently with the restructure. In today’s market there are a wide range of sophisticated and professional private credit groups that could refinance the relationship and restructure it to align with the appropriate capital stack for the customer. If the customer doesn’t have the expertise or Rolodex of private lenders to call, the bank could provide a few recommendations to get the ball rolling and the deal on its way out of the bank.
Whether through a restructured path or an orderly exit, maintaining control of the timeline and terms is key. As with any inherited credit, discipline and creativity must be balanced, especially when legacy goodwill collides with current policy.
Jason Alpert is managing partner at Castlebar Holdings, a distressed debt fund and financial institution advisor. Jason led and managed workout and special asset teams at major financial institutions for two decades. He is on the editorial advisory board of The RMA Journal and is an adjunct professor at the University of Tampa. Email Jason at [email protected] or reach out to him at 813-293-5766.
Disclaimer: The Workout Window is not intended nor is it to be considered legal advice. As The Workout Window stresses, consult with legal counsel and your institution’s management to be sure you are acting within the parameters of your institution’s policies and banking law.
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