dealing with distressed borrowers
The credit crunch continues, the economy grows
slower than we all hoped and more borrowers are in default.
For banks and institutional lenders spotting the warning signs a
payment default may be on the horizon can enable then to provide
support or take early remedial action. In this article, Rich
Eldridge looks at some of the early warning signs. Rich also
looks at the options available to cure a distressed credit and the
routes lenders prefer in the current market.
early warning signs
Everyone wants to avoid a default due to non
payment, for example interest or an amortisation payment. The
key early warning sign a borrower may soon fail to make a payment
is a breach of financial covenant.
The most useful financial covenant is the one
which tests the ratio of profit to debt service (known as "debt
service cover" or "DSC") or, in the case of a non amortising loan,
the ratio of profit to interest (known as "interest service cover"
or "ISC"). Usually these covenants are set at a level to
provide headroom, so there would need to be a significant dip below
the covenant level for the borrower to be illiquid. However,
the more the headroom disappears the higher the chance the borrower
will become unable to make its
payments.
Spotting a breach of financial covenant is
often easy as compliance (or non-compliance) is usually reported by
the borrower in certificates. Lenders do of course need to be
wary of the potential for borrowers to produce incorrect
information. Lenders also need to be sceptical about
borrowers who delay providing certificates, particularly when the
borrower has delivered on time in the past – a change in behaviour
could indicate the borrower has something to hide.
Lenders are doing more than just checking
whether the financial covenants are met. Lenders are looking
for trends and making projections based upon historical
figures. For example, if there is a decline in profit lenders
are looking forward to see if a breach of financial covenant will
occur. Lenders are focusing on potential breaches of DSC and
ISC covenants. Where projections show a breach of financial
covenant the lender is proactively engaging with the borrower to
reshape the business to prevent the breach occurring.
To help lenders look to the future it is
becoming increasingly common for lenders to require financial
covenants to be complied with based on forward looking
projections. This is in addition to the usual requirement for
historical financial information to show compliance.
Requiring borrowers to produce projections should lead to borrowers
incorporating anything which will lead to a dip in performance
which the bank may be unaware of, for example because a key
customer of the borrower has said it will terminate a supply
contract. Lenders are of course wary of borrowers producing
over optimistic projections, but take comfort from the consequences
which would flow for a director providing dishonest
projections.
Engaging with the borrower based on a
projected breach is much better than waiting for an actual breach
to occur. At the projected breach stage the financial health
of the borrower will be better than at the actual breach stage and
there will be a smaller problem to solve. Borrowers are more
likely to be willing to discuss the issues at the potential breach
stage when they perceive lenders as working with them to avoid a
problem occurring. After an actual breach has occurred
borrowers can become defensive as they may fear funding will be
withdrawn.
Lenders have increased the size of their teams
monitoring compliance with financial covenants and looking for
trends. Many bankers who were originating deals in the boom
time are now managing relationships and looking for early warning
signs.
options available to cure a distressed credit
The most popular options are:
|
Option
|
When to
use
|
How it
works
|
Advantages for
lender
|
Disadvantages for
lender
|
Impact
|
|
Covenant reset
|
When a breach is projected
or the borrower is in breach and not expected to return to
compliance in the near future, but the borrower still has a
viable business
|
Covenant levels relaxed
|
Increase pricing to
reflect increased risk
|
Increased pricing when
profit has decreased may damage goodwill of the borrower and
contribute to a cash crunch. Cures a breach of financial
covenant, but does not improve the health of the borrower
|
Low
|
|
Equity injection
|
When the borrower's health
will be restored upon applying the equity to deleverage,
consequently improving DSC, ISC, leverage and loan to value
covenants
|
Equity funds used to repay
debt
|
Maintains goodwill of the
borrower and restores the credit of the borrower
|
If the borrower is on a downward slide it will be just a temporary
fix masking the problem – more equity or another remedy will be
required
|
Low – impact primarily for equity funder
|
|
Disposal
|
When the borrower's health
will be restored upon applying the disposal proceeds to deleverage,
consequently improving DSC, ISC, leverage and loan to value
covenants
|
Disposal proceeds used to
repay debt
|
Restores credit of the
borrower
|
Remaining business will be
smaller and lower debt means less interest income for the
lender
|
Low/
Medium/High - depends on asset sold
|
|
Enforce security
|
When the borrower is or
will be unable to meet its payment obligations and there is no
reasonable prospect of the situation improving
|
Security enforced and
assets sold
|
Allows the lender to take
control of its recovery
|
Ends the relationship with
the borrower, sale values will be less than if the borrower made a
voluntary disposal and there is a risk of reputational damage for
the lender (especially if it causes job losses)
|
High
|
|
Wind up the borrower
|
When the borrower is or
will be unable to meet its payment obligations, there is no
reasonable prospect of the situation improving and any security
realisations will not satisfy the borrower's liabilities to the
lender
|
Borrower wound up and all
assets sold
|
Allows the lender to take
control of its recovery
|
Ends the relationship with
the borrower, sale values will be less than if the borrower made a
voluntary disposal and there is a risk of reputational damage for
the lender (especially if it causes job losses)
|
High
|
routes preferred by lenders
Lenders with viable alternatives are keen to
follow the option with the least impact. Lenders are being
patient with distressed borrowers. Lenders are preferring to
work with distressed borrowers to reach a consensual solution,
rather than enforce security or wind up a borrower. The three
key reasons are:
- government and public scrutiny of whether
lenders are supporting businesses
- market values for assets are low on a fire
sale
- as the economy improves, many distressed
borrowers may recover with viable businesses.
Hopefully as the economy improves the focus
will move from monitoring distressed borrowers to lending for
growth.
