In today’s bifurcated world between traditional and alternative lenders, borrowers of senior debt that operate in the lower mid-market space are increasingly being wooed by traditional banks offering a lower cost of capital. This comes at a price, though, as these financial institutions are increasingly forced by the regulatory environment to separate new business teams from credit administration.
Gone are the days when the CITs and Congresses of the world would be managed by one or two individuals responsible for building, growing and managing risk of the entire ABL division. Today, credit and new business run through different channels in most financial institutions.
Not surprisingly, these channels clash over transactions, and ultimately the borrower experiences an enormous disconnect that has the potential to negatively impact its business. This purposeful organizational design of decision making ensures the best transaction structure and risk management policies for these financial institutions.
However, lower mid-market cap companies aren’t set up to live in long-term harmony with these institutions as financial partners. Whether it be financial distress or macro market dislocation, these companies will always have to deal with a performance cycle that is occasionally affected by cash flow stress.
To illustrate this stress during the new business process, I’ll give you a hypothetical scenario that is occurring across the lending platform today between traditional lenders and lower middle market companies. One of the large money center traditional lenders, in the process of pursuing a borrower, initially brought in to refinance an owner-occupied piece of real estate, looked at the company’s revolving line of credit and, in turn, ended up proposing on both.
At the closing table — following the borrower’s request that its existing lender provide a payoff letter — the new lender pulled the commitment following a telephone call from its risk department, which indicated because the borrower’s financial reporting was not exactly what they wanted, the deal should be pulled and the commitment revoked.
This left the borrower in a bind with its existing lender, which was not only alerted to the fact that the borrower was shopping its credit facility, but left to wonder what was uncovered during the new lender’s due diligence that caused it to walk away at the closing table. Of course, nothing nefarious was found, and the reason for pulling the commitment was something that the new lender knew about for weeks.
This is a prime example of the danger faced by lower middle market companies that have potential limitations in reporting, systems or some other area, which demonstrates that the allure of lower pricing isn’t necessarily the panacea to greener pastures.
Also, this example demonstrates the potential issues that can arise when new business and credit/risk administration report up through separate chains of command, creating a negative situation for a company in the lower middle market. This is particularly true for companies that don’t have the expense structure to meet the increasing demands of the regulators in the traditional lending world.
Alternative lenders provide a different approach in the lower middle market space centered on price, product and flexibility. Whether it is through less rigid regulatory requirements, flatter organizations or direct access to decision makers, the alternative lender’s approach matches the limitations and strengths of lower middle market companies and fits the borrower’s financing needs more efficiently than traditional lending institutions.
Through a deep understanding of all micro and macro financial aspects, alternative lenders provide lower middle market companies with a sounder financing platform that compliments existing capital structure.
Cash Conversion Cycle
When lenders discuss the strength of a potential or actual borrower, it is always in terms of net worth, revenues, EBITDA, net availability and similar measures. While these are important metrics, the greatest threat facing borrowers in the lower mid-market space is the order/build to cash cycle of its products.
A good lender’s strength is identified by how it gains an understanding of the cash erosion pressure points within a company’s production to the A/R collection timeline. All companies that either distribute or manufacture products have become global in their procurement. In order for a company to fill future sales orders, it must be precise in the timing of procuring, manufacturing and shipping.
If there are delays at any point in the procurement to ship cycle, companies run the risk of not only losing revenues but of straining cash flow as well.
Additionally, if previously granted trade credit terms of 30 to 60 days suddenly evaporate, there is a tremendous pressure placed on the borrowers’ liquidity to complete the sale process. These liquidity events are usually not anticipated and rarely can be mitigated other than through funding with excess (blocked) availability, over advances or having strong, liquid guarantors or equity owners that can step up to fill the liquidity stress.
Illustration: A distributor of kitchen gadgets sells on 20% gross margins, orders $1 million of product from its China-based supplier for eventual sale to Retailer A for $1.2 million. In a normal order to cash cycle, the distributor would receive 60 day payment terms from its supplier beginning FOB shipping point.
If shipping takes 20 days, plus another 15 days for the goods to arrive in the distributor’s warehouse, the distributor will need to pay the supplier well before the goods are sold and shipped to Retailer A. Assuming there’s a normal lending relationship, an ABL facility provides approximately 60% advance rate on the inventory ($600 million) to the distributor and the remainder of the supplier payment comes from existing availability.
The distributor then sells the product to Retailer A and the ABL facility provides an 85% advance rate on the associated accounts receivable (eliminating the inventory advance).
Now, suppose that the Chinese supplier experiences cash flow difficulties, or the government restricts money flow in China. Terms are no longer given and our distributor has to come up with an additional $600 million to release goods.
While this scenario may appear overly simplistic, this occurs every day to companies operating in the lower mid-market space. If a lender does not show flexibility and understand that there are inefficiencies in the marketplace, they will not only lose out on potentially good opportunities, but also possibly do harm to companies that have short-term cash shortages through no fault of their own.
Lenders today need to know how a potential borrower brings products to market and build in unanticipated events that will not strangle the borrower. The last thing lenders want to receive is a call on a Thursday from a borrower that just had an unanticipated liquidity event and can’t make payroll.
Lenders focus and build structures as protection from frauds; however, lenders lose much more money in a wind down/liquidation due to not truly understanding the cash conversion cycle and the weaknesses therein than to borrowers committing fraud.
Lower middle market companies that utilize an ABL facility are most likely not equipped to deal with significant detrimental economic, political or inflationary events. That sentence should not surprise anyone reading this article. However, as the supplier to the buyer world gets tighter and more interdependent on one another, there are unforeseen consequences to your client’s availability.
If your organization is hierarchal in its approach to decision making, or if your first focus is reviewing past financial performance to understand impacts on financial covenants, you may miss or be unaware of how factors that occur thousands of miles away from the U.S. can have a detrimental impact on collateral valuation and, ultimately, availability.
Nimble lenders, structured flat in their decision making processes, can assist these clients because the decision makers will take the time to “get” the story and support temporary market disruptions.
Illustration: Taking advantage of an opportunistic bulk purchase of frozen salmon, a wholesaler of frozen fish requested a temporary over-advance accommodation from its lender. The opportunity arose due to sanctions imposed on Russia from the EU.
In retaliation for those sanctions, Russia stopped purchasing fresh and frozen fish, including salmon, from Norway and other Scandinavian countries. As a result, Norway had an oversupply and needed to sell the fish quickly.
The lender was able to quickly understand this issue and confirm its validity, and provided the borrower a seasonal over advance facility. While this increased the reliance on inventory, the lender was able to quickly work with the borrower, analyze the sell through data and provide the accommodation. By purchasing in bulk, the borrower was able to acquire the product at a very favorable price, providing a seasonal product and improving the borrower’s gross margins and overall bottom line.
The illustrations previously presented highlight some of the differences between the traditional and alternative lenders servicing the lower middle market space. I’m not saying one is better than the other. Simply put, a borrower in the lower middle market should be aware of the lender, its processes and the hierarchy within the organization before making a decision to leave or sign up with another lender. If a borrower solely looks at pricing as the impetus to sign on with a lender, it may do so at its own peril.