The moment a business development officer touches a client, the underwriters begin their work, getting familiar with the company and the industry in which it operates. The term “underwriter” goes back several centuries to a time when financiers signed their names under a written explanation of risk associated with a financial venture, such as a ship crossing the ocean with valuable cargo.
Today’s underwriters perform a similar service by thoroughly examining the lending risk associated with a particular company and presenting that information to a credit committee that approves or disapproves the transaction. We sat down with three ABL underwriting executives who explained the nature of their work, how it’s important and why they enjoy it.
Different shops approach the roles in different ways but comprise the same three elements: business development, underwriting and portfolio management. The business development officer (BDO) identifies the opportunity, the underwriter researches and assesses the risk and the portfolio manager oversees the account. MB Business Capital and PNC Business Credit keep these roles distinct, but BMO Harris Bank combines its underwriting and portfolio management responsibilities.
“Our portfolio managers underwrite the deals that they subsequently manage,” explains Jason Hoefler, managing director of Asset Based Lending at BMO Harris Bank. “The underwriter examines how the company operates, reviews its financial performance and assesses projections and collateral with the ultimate goal of recommending the closing of a new loan. Instead of passing off the deal when the underwriting is finished, the same person manages the account and continues to build the relationship with the company’s management team while also being on the front line of understanding the risks of the deal.”
At MB Business Capital, the BDOs bring in and cultivate the relationship. “Underwriting becomes the primary point of contact upon receiving a mandate to move forward,” says Jeff Seiden, SVP and director of ABL Underwriting. “Our work involves organizing and analyzing field exams and presenting a complete write-up that goes to a credit committee. We confirm the numbers and make sure the projections and cash flows make sense. After credit committee approval, we handle the legal work and set up the transaction to the point where it funds. From that point, it transitions to portfolio management.”
“The role of the underwriter is a unique one in that we have a dual responsibility,” says Joe Sum, SVP, national underwriting manager at PNC Business Credit. “Our work involves performing extensive due diligence on borrowers and getting comfortable with the risks. At the same time, we work collaboratively with our business development sales teams to come up with solutions or recommendations to try to get the deal approved for funding. We help point out credit concerns that the sales team may not have completely foreseen but needs to think about.”
As an example, Sum describes a recent deal at PNC Business Credit in which the BDO was evaluating “Company A,” which was ultimately owned by “Company B.” Company B also owned the main supplier to Company A. “Here we had a multitude of issues to consider, including Company A’s dependency on a supplier and whether Company A’s purchases from Company B were made at market prices. As underwriters, we not only have to understand the accounts receivable and inventory collateral in our deals but also the industry that the company is involved in, including core competencies, barriers to entry and competition.”
Assessing Outside Factors
Clearly, underwriters need to look at a company from all angles, so how do economic indexes fit into their work? The National Association of Credit Management’s (NACM) May report tells a story of sagging economic enthusiasm. It cites indexes that are dropping subtly after a brief post-election pick-up. In addition, the Thomson Reuters/PayNet Small Business Delinquency Index shows that delinquency has increased by 11% in the last year.
“The job of the underwriter at MB Business Capital is more specific to the client and transaction,” Seiden says. “Most of our borrowers are showing strength with better financial results. They want to expand their capital expenditures and add more employees. At the macro level, a small increase in delinquencies may help certain asset-based lenders. It can motivate more companies to leave their traditional commercial lending environment and refinance with an asset-based lender. Larger delinquencies would hurt the portfolio, but most asset-based transactions are well structured from the start. We understand that a small increase in delinquency doesn’t necessarily foretell a bad situation down the road.”
“Our risk within a loan tends to align with the risks of the client, so we look at events and economic cycles more than we look at specific indexes,” Hoefler says. “Recent focuses have involved Section 232 regarding tariffs in the name of national security as well as the effect of the continued growth of Amazon and other online distributors and industry-specific cycles and events. When we think about delinquency risk and potential challenges for a borrower, it normally boils down to their liquidity position. This is something we monitor very closely as a part of the ABL discipline.”
“The credits we have booked are performing well,” Sum says. “There has been a vigorous pace of acquisi-
tions of companies by investors and mergers of companies in similar businesses. This may be attributed to factors such as historically low interest rates, retirement of selling owners or the need for businesses to realize or enhance additional sales and purchasing power in order to remain competitive. This trend will likely continue to benefit asset-based lenders throughout 2017. If you are looking for a good gauge of the health of the ABL industry and the economy, take a look at the performance of the staffing/employment companies. They place more people in jobs in good times and exhibit strong financial performance.”
Paying attention to macro events and watching marketplace trends that could affect customers takes precedence for underwriters. Hoefler cites forestry and the resulting products such as paper as an example. “A tariff currently under discussion relates to the softwood lumber trade between the U.S. and Canada, and this is an important issue for us. There is a similar focus for the entire metals industry as it relates to Section 232. We track and monitor other trends, such as what is happening in retail, through our borrowers’ financial statements. We stay familiar with the ups and downs of any cycle that affects a particular industry in our portfolio. Our industry verticals within BMO Harris provide another source of information.”
Seiden says there was strong business optimism just after the election, but now borrowers sense risks associated with this administration. “They don’t know how tariffs and alliances with other countries will change. If a company has had the same trading partners for two years, will they still have them two years from now? Will it be harder for some businesses to import their products? These uncertainties have kept growth at bay.
“There are also concerns about undocumented workers and whether there will be increased costs for some industries,” he continues. “We have clients in the food industry who are unable to get the products they need because farmers don’t have enough workers to harvest the crops. Whatever your feelings about immigration, there will be an impact on production. Our retail clients are experiencing changes in their industry. These companies need to find a way to stick out in the crowd, manage their inventory better than ever and offer services as well as products.”
“From what I have heard anecdotally from middle market companies, they don’t necessarily care who is in office,” Hoefler says. “They keep a tight focus on controlling overhead and growing revenue. When they make a CAPEX decision, it has more to do with their individual business and whether or not that expenditure is right for them as opposed to who sits in the Oval Office or controls Congress. That said, all businesses are concerned about how laws and policies might affect them.”
“The uncertainty with the impact on the domestic economy with the change in the White House is probably behind us now,” Sum says. “The stock markets have ramped up since the election and now are at historic highs, a sign of anticipated and continued business growth and investor confidence. We see the same trend in the middle market businesses we finance.”
We asked our panelists to share their thoughts about a potential lessening of government regulatory and compliance rules. “There is an increased scrutiny of highly leveraged transactions and a possibility of penalizing banks that finance such transactions,” Seiden
says. “It would be helpful to relax some of those rules as we compete against finance companies that don’t have those regulatory restraints. Tax law changes would be helpful if they lower tax rates on businesses or allow the repatriation of cash from overseas.”
“Regulatory compliance on companies affects everyone differently,” Hoefler says. “For banks, it means, among other things, that a portion of any underwriter/portfolio manager’s time must be spent on compliance and regulatory issues. Without a doubt, the level of compliance and time spent has increased over the years. If there was a retreat on some of those rules, it might lighten the day-to-day workload.”
Know Your Customers
For new prospects undertaking a financial turnaround, a critical ABL underwriting concern is management’s ability to cope with the situation. Is the CEO or CFO someone who can handle a crisis? Has he or she ever dealt with adversity? Does top management know how to cut expenses or downsize the business to deal with the realities of the situation? Underwriters ask these questions as part of their management assessment.
“If we ask a company how it plans to return to profitability, and the answer is, ‘We expect to increase sales next year’ or ‘We’ll slow down our payment of vendors,’ that’s the wrong answer,” Seiden says. “The right answer often involves a plan to reduce costs, limit benefits or forego bonuses that year in conjunction with a potential sales increase. Then we watch them to see if they do it at the beginning of their business downturn, or if they wait. We look for management that confronts the problems head on and takes immediate action.”
“We need a deep understanding of the business and the industry, so that in a situation when a company becomes distressed, we are able to restructure or come up with alternate solutions,” Sum says. “This is how underwriters contribute to booking desirable transactions.”
“In any asset-based loan, liquidity position is first and foremost, so we are very aware of our customer’s liquidity and are routinely in discussion with our customers about liquidity as well as financial performance, industry trends and, of course, our collateral,” Hoefler says. “We consider our customers to be our partners, where we are all on the same team. When a company faces challenges, hopefully, we are already aware of the causes and actions the company is planning to take. We really try to work with them.”
“A delinquency with one borrower does not necessarily predict a problem with another similarly challenged borrower,” Seiden says. “Industries are different, and so are companies. Our goal is to build a relationship with the company, so we can stay on top of things from the get-go. If you can get upper level management to be frank with you from the start, you are less likely to chase your tail down the road when an issue surfaces.”
With certain sectors showing troubles, it is the underwriter’s job to assess the industry as well as the company. “We’ve come a long way since the Great Recession of 2008-2009,” Sum says. “At that time, all sectors were in decline. Then, in the past two years, we have seen oil prices decline by half, and that has caused havoc for some businesses in the oil and gas industry as well as for ancillary businesses tied to it. Further, Amazon and online retailers have changed the landscape of traditional retail stores.”
“Challenged industries often result in opportunities for ABL lenders to book more business,” Hoefler says. “A lot of those industries may have been under a traditional cash flow loan, but due to industry headwinds, have morphed into ABL borrowers. Industries that tend to have cyclicality also tend to make great ABL borrowers. Retail is a perfect example. We are able to comfortably provide an advance on inventory and corresponding credit-card receivables in what is a predictable downside scenario; so they fit really well with ABL. That is why ABL is such a great product!”
“We have seen close-out liquidations of many retailers and will continue to see more,” Sum says. “As experienced asset-based lenders who have gone through several economic cycles, we’re not hesitant to finance companies in rough sectors — as long as the deal is properly structured and the company is run by competent managers. We also take a hard look to understand our collateral recovery values.”
“It’s easy to say we avoid oil and gas, but in truth, we don’t have any hard and fast rules about industry sectors,” Seiden says. “Any time you start generalizing about industries, you miss good opportunities. If the right deal comes along in any industry, we’ll look at it. We plan to fund two deals in the oil and gas sector this month. Across the entire spectrum of industries, we’ve seen strength for most companies.”
“Where there were a great deal of bankruptcies, coal companies are coming out the other side much healthier and are experiencing favorable market conditions today,” Hoefler says. “Those deals have been active in the ABL marketplace. In ABL, we can be comfortable lending to an industry experiencing challenges, given the strength of the collateral. We monitor those collateral values with appraisals and field exams and address problems as necessary.”
Facing the Challenges
Now that the first half of the year is behind us, we asked our panelists about the challenges they keep at top of mind. Seiden focuses on keeping the pipeline filled. “We’ve been fortunate to see a strong uptick in new business over the last year or so. Through June, we are probably going to fund the same number of deals we did for all of 2016. It’s a matter of keeping that pipeline as strong as it has been in the second quarter and carrying it into the third and fourth quarter.”
Other challenges at MB Business Capital include finding qualified employees to support growth and looking for a new way to increase their activity in the buy-out market. “Most of our growth has been in refinancing other banks’ deals, because the acquisition market has moved towards cash-flow structures. The question is whether we wait for valuations to decrease to closer to historic levels — where ABL is often a great fit — or do we find a way to be more proactive in meeting the market and perhaps increasing the amount of risk we should take? With interest rates rising, it will be interesting to see whether there is an increase in defaults on some of these highly levered cash-flow transactions.”
Competition ranks high among Hoefler’s concerns. “New asset-lending groups are popping up at banks and finance companies. There’s more money out there waiting to be lent, and that has resulted in increased competition and pressure on pricing and structure. We think pricing has leveled off in the last year or two, but structures remain aggressive. It’s important to stay in front of your customers, pick the spots where you want to be more aggressive and stay on top of the industries and management teams where there is comfort and experience.”
“There is a massive amount of information available that we have to sort out in a compressed amount of time for every deal,” Sum says when asked if anything keeps him awake at night. “Sometimes I wonder if there was something significant that was missed.”
Seiden wants the bank to be protected if there’s a sudden downturn similar to the Great Recession. “We have to determine the point where they have reached on credit, reduced pricing and stretched lending to the degree that they are unable to pull back fast enough in a downturn. Ultimately, it’s the underwriter’s job to make sure we are protected if the customer loses money or goes out of business. It’s a fine line determining when you’ve gone too far.”
“You can rest assured that the banks are calling your customers,” Hoefler says. “I sleep well, but competition is always at the top of my mind.”
With so much on their plates, do underwriters have any fun on the job? “Underwriting is like putting together a jigsaw puzzle,” Sum says. “There are many pieces of data that have to be sorted through and arranged to make sense. It is rewarding to work with multiple teams to put the puzzle together, including the sales and portfolio teams, field examiners, appraisers, attorneys and others. It is also satisfying to witness the accomplishments of my underwriting team that enable transactions to get approved and funded and how their work allows companies to thrive and grow.”
Seiden enjoys the transactional nature of under writing. “Every day brings a new type of company and industry. I enjoy dealing with CFOs, private equity groups and fund managers that I’ve not dealt with before. Each has a different perspective, so it’s never the same routine. Each day is a new challenge, and each transaction is different from the last one. That’s by far the best!”
“ABL is a great industry,” Hoefler says, who started as a field examiner and feels rewarded by the mentoring aspects of managing his team and teaching people new to the business. “We work with different industries, capital structures, family-owned companies, private equity-owned companies and publicly traded companies. Every deal is different, every customer is different and every management team is different. It’s been a lot of fun, and after being in ABL for almost 15 years, I am still having fun!”