Easy to Hard: Questions and Transitions in Credit Standards

 

A recent conversation with a friend who works in commercial lending was brought to mind when I read the article "A Change of Season" in the October 2006 issue of CFO Magazine.  We had been discussing the lack of loan convenants in many commercial lending packages recently. 

 

The article's subtitle is "Don't Let  a Turn in the Credit Cycle Catch You Napping" and the article deals with just that, changes in the availability of credit or the transition of the credit environment from an "Easy" credit lending environment to one that is more of a "Hard" credit lending environment.  As I read the article, I started to get a new appreciation of the purpose that loan covenants serve, for both the borrowing business and for the lending institution.

 

As someone who has done extensive commercial borrowing, I generally felt that loan covenants were unnecessary at worst and restrictive at best.  In hindsight, I realize compliance with these covenants introduced more financial rigor into my business, which in turn reduced risk to the lender as well as to the business and to me personally, by extension.

 

As examples, consider one of two of the most common covenants, the cash flow coverage covenant which requires the business to meet certain standards of liquidity and reserves to meet their debt service requirements.  Among other things, this keeps owners and management from  succumbing to temptation to overspend on projects or to remove liquid assets from the business.  Maintaining a robust balance sheet gives the company a safety margin when conditions become adverse or when there is an unexpected event.

 

The other common loan covenant requires submission of financial statements to the lender on a regular basis.  If the covenant requires these financial statements to be in GAAP format, then this will have the effect of introducing more discipline in terms of the type of accounting used in the business.

 

So, think about these covenants from the lender's point of view.  Very simply, they help the lender keep an eye on the condition of the borrowing business.  Until reading this article, I haven't previously appreciated the function of loan covenants from the lender's point of view.  The article makes the point that the existence of loan covenants creates an early warning system for the banks.  When a business starts to have trouble meeting the conditions of the loan covenants, the bank can then initiate a series of conversations designed to assist the business in stabilizing and thus reducing the risk to the business and to the lender.

 

Also, in a general sense, when more of a bank's borrowing businesses start to have trouble meeting their loan covenants, the bank can get a sense that the general business environment is getting more challenging and will then raise their lending standards, thus making credit less available which becomes the "hard credit" lending environment.  This "hard credit" lending environment can be frustrating if you're trying to borrow during that time, however it may be useful to think of hard credit as a protection for everyone involved...the bank, the borrowing business and the owner of the business.  It forces better analysis and business justification for lending and investment projects.

 

Another concept worth thinking about is the transition itself, the shifts between the relative availability of credit.  As described above, it is easy to see that with good loan covenant systems in place, banks can gradually adjust lending standards based on the information they're getting through their early warning system.  This gradual transition from easy to hard probably isn't too painful or surprising for anyone involved.

 

However, what happens when there is no early warning system and business operating conditions are changing?  Is the transition likely to be gradual or sudden?  Is the magnitude of the change likely to be small or large?  What will be the nature of change itself or 'the delta"?

 

We've had times of relatively easy credit for the past few years.  If you've only started or grown a business in these times, you might tend to think that these conditions are permanent.  If you have a capital project on the planning board for the next couple of years, you might be in for a real surprise if a transition to a hard credit environment happens soon and abruptly as some are predicting.  The article points to several signs that the transition to a tougher credit environment has begun.  One example they provide comes from Darren Wells, the Treasurer of Goodyear, who estimates that the amount of financing banks are willing to provide in terms of multiples of EBITDA has fallen from earlier levels by roughly 0.25 times.

 

If you're a business owner thinking about selling your business to a buyer who will finance some or all of the purchase externally, guess what?  Your business just lost value.

 

Business owners and management might want to ask themselves some questions:

 

What are our loan covenants?

 

Are we on track to meet these covenants at year end?

 

Do we need to raise our internal financial and accounting management standards?

 

What do we and our lender(s) think the lending environment is going to look like over the next few years?

 

If there will be a change in the availability of credit, will this transition be slow and gradual or fast and abrupt?

 

How might this future lending environment and the transition, if there will be one, impact our capital project planning?

 

 

 

In a recent BusinessWeek (Feb 19, 2007), there was a feature article about the new low rate capital environment and reasons why it might be here to stay.  Interestingly, some of the themes of my post were echoed, in regards to credit standards and the consequences of change in that area.