July/August 2014

Restoring Disciplined Appraisals and Oversight: Why the Need for Diligence is Essential to Minimizing Risk

Over the past year, the competitive environment in the asset-based lending industry has reached a fever pitch. Competition for a limited number of deals has forced lenders to offer diminished rates to keep clients. In order to offer lower-cost deals, some lenders have decreased the frequency of regular appraisals, often to their own detriment in the long term.

Frank Grimaldi, Director, Gordon Brothers Group

Frank Grimaldi, Director, Gordon Brothers Group

When the economy faltered between 2007 and 2008, lending opportunities became scarce, and competition increased in a pool of fewer and smaller deals. Lenders began focusing their efforts on keeping clients in existing deals using an “amend and extend” philosophy. The need to generate business forced normally conservative lenders to step out of their comfort zone, and lend into situations where collateral values were less thoroughly vetted. While these practices by no means dominate the industry, some lenders have allowed this loosening of discipline to persist, considering appraisals and frequent oversight to be more of a luxury than a necessity. While most lenders have maintained their diligence practices, they may risk losing out to a lender that would forgo the appraisal and thereby offer a more attractive deal.
In the short term, this stripped-down approach may offer a way to pass on some savings to a potential borrower and win a deal, but it can come at a very high cost.

Ongoing Monitoring & Warning Signs
Despite the current competitive environment, the discipline of ongoing monitoring is still as important as ever. While there is no substitute for a thorough appraisal, key monitoring points can provide early warning signs of a troubled borrower. A regular appraisal will examine each of these criteria in depth; however, awareness of them at the very least will help guide lenders in determining what level of risk they may be assuming.

Inventory Mix: Does the borrower maintain a proper mix of complementary products and a full range of sizes? For example, a strong, healthy fastener company will carry a matching assortment of nuts and bolts in a variety of sizes in order to maintain relevance with customers. The proper mix of inventory is crucial in maintaining collateral values, as too heavy a concentration of weaker offerings or an imbalance in the assortment overall will have significant impacts.

Customer Base and Vendor Concentration: Is the company dependent on only a few, or even just one customer or vendor? An overreliance on a single relationship creates a precarious scenario and makes the borrower highly vulnerable should that relationship deteriorate. The full spectrum of the company’s customer base needs to be examined, e.g., which tier would absorb various products and at what discount levels would have a material impact on ongoing margin performance and recovery values in a liquidation scenario.

Systems and Information: Are the company’s systems up-to-date and efficient? Is the quality of information dependable? Inaccuracies in inventory records, or missing information represent potential pitfalls in performing proper monitoring.

Accounting Practices: Has the company changed its accounting practices, and if so, why? Moving from a retail basis to a cost basis might reveal changes in planning and the method of margin calculation.

Sales Performance: Have any internal or external factors significantly affected sales activity? If so, is that change expected to persist? Can the company withstand the duration of its impact?

Ineligible Inventory: Is all inventory eligible for sale during a liquidation event, or do certain licensing or other restrictions exist? This is often the case with luxury merchandise and key brands, as involving these products in a liquidation sale can impact the perception of the brand as a whole. In these cases, affected collateral should be excluded from the borrowing base.

Seasonal Business: Does the company experience extreme or even moderate seasonality? While seasonality is not a cause for concern in and of itself, maintaining proper advance rates in and out of season is crucial to the realization of collateral values in a disposition. Monitoring seasonality and utilizing “high/low” advance rates is something that a proper valuation would guide.

Gross Margins: Are they consistent, or have there been noticeable shifts up or down? If so, what is driving these changes? Is the company discounting to generate cash, or laboring under increased costs? Is there a pricing bubble that cannot reasonably be maintained? These issues should be uncovered and considered as the implications are far-reaching.

Case in Point
If overlooked, the above monitoring points can develop into warning signs that manifest in any number of ways — in isolation or in combination throughout the supply chain. The following case studies represent a few possibilities of underlying issues and how they can be uncovered, within or outside of the structure of a regular appraisal.

Gordon Brothers Group recently worked with a lender considering a deal in the home products market, specifically windows and screens. After a thorough review, it was determined that a portion of the materials originally considered “raw” materials were actually custom-fabricated screen and window materials, and as such, could not be re-used as originally thought.

Determining the exact nature of the realizable assets allowed the prospective lender to shore up the collateral package, restructure its commitment, close the deal and sleep better with a full understanding of the underlying collateral values.

In another instance, a large international sportswear and equipment distributor undertook expansion plans for its U.S. footprint. It sought financing from a major U.S. bank that subsequently engaged Gordon Brothers Group to perform an appraisal. Through the process it was soon revealed that one of the most significant brands carried by the company was subject to a non-transferable license, which would have a significant impact on asset values and any potential disposition strategy. This weakness in the asset base would have exposed the lender to profound vulnerability, but fortunately the lender was able to take into consideration the limitations of the collateral and adjust the structure prior to agreeing to terms. Ultimately, the transaction went forward with the parent company funding a greater portion of the deal to offset for the exclusions, thus the lender was fully covered through the duration loan.

In another recent situation, management changes proved to be symptomatic of other underlying challenges. This kind of turnover, particularly in the finance department, offers an early warning sign and can have a significant impact on the operations and perceived value of a borrower. The lender was considering partnering with a textile manufacturer that had been underperforming, and where the CFO had abruptly quit. Upon further investigation led by the replacement CFO, it became clear that the previous CFO had been manipulating the accounts to improve the appearance of the manufacturer’s cash-flow. It also turned out that a proper appraisal had not been performed in 18 months. Had an appraisal been performed during that time, the threat could have been revealed before significant damage was done.

Just as problematic as a small customer base is an overreliance on a limited number of vendors. Gordon Brothers Group recently worked with a lender that had an outstanding loan to a lawn and garden equipment wholesaler. During a routine appraisal, the lender was advised that the wholesaler was heavily concentrated with one vendor. As it happened, the wholesaler lost that vendor, and with it a huge brand in that space. Even with the advance warning of that risk, the impact was still significant. Ultimately, with the assistance of our Commercial & Industrial Division, the lender was able to wind down the company and minimize the loss.

Safeguarding Against Risk
Lenders are subject to a very tough environment today, and the pressure to maintain a steady flow of business has not abated. While some lenders may adopt practices that introduce a higher level of risk into the equation, that risk may not always result in the expected reward. While there is no substitute for an appraisal, the best safeguard against that risk is information, education and awareness.

Frank Grimaldi is director of Business Development Valuation & Advisory Services at Gordon Brothers Group. He is responsible for developing and maintaining client relationships for the Valuation & Advisory Services Division. He works closely with asset-based lenders, private equity sponsors and corporate management teams to help them understand the underlying value of all types of assets.