As a new year gets under way, there are opportunities for secured lenders to add new business as markets emerge from one of the worst financial crises in decades. The middle-market loan sector, in the $5 million to $20 million range, is becoming more active and competitive. Even large syndicated deals are starting to close again. The restructuring market is picking up, with borrowers seeking to ensure continued access to financing as existing credit lines come up for renewal. Lenders are becoming more active and portfolios are once again beginning to grow.

On the flip side, in response to the financial crisis, there will likely be an unprecedented shift toward greater financial transparency and oversight. Regulators, investors and other stakeholders will demand the development and dissemination of higher levels of information to manage and mitigate risk in the new economy.

But whether responding to investor pressures to make deals or regulatory pressures to minimize risk, or very likely to both, asset-based lenders will need to possess accurate, timely and sound information and analysis of their collateral. Having a complete picture of their risk profile is vital if lenders are going to be able to respond aggressively to shifting market needs and opportunities, while ensuring a heightened level of security for more risk-averse investors and regulators.

A New Environment for Secured Lenders

The environment for secured lenders has been fundamentally transformed by the global financial crisis, as it has for all financial institutions. The economy has placed enormous strain on the asset-backed loan facilities of secured lenders. Although the vast majority of these lenders will emerge from the current crisis, they will be required to demonstrate new levels of transparency and responsibility, especially in larger syndicated loans where participants may be more anxious about risk.

Secured lenders, like most financial institutions, face a critical information problem: How do they safeguard their collateral, ensure they have up-to-date, unvarnished and candid assessments of their ongoing risk, and make certain the due diligence process on prospective and existing loans meets the highest internal, industry and regulatory standards?

Responding to these demands will require that secured lenders have more precise and timely information about the assets pledged as collateral backing their loans. While there are any number of valuation, workout and disposition firms that handle segments of this work well, this new environment puts a premium on the ability to tie the information together and to think through to the exit strategy (disposition) even as the loan is being originated.

Therefore, lenders will need to enhance their capacity to evaluate assets in light of changing market conditions and to effectively monitor collateral over the lifetime of a loan. This will require establishing new and more effective assessment and reporting requirements that capture not just more information but the right kinds of information. It will require putting in place the decision-making tools to evaluate the range of strategic alternatives available to lenders in the event of a problem loan.

It’s All About Knowing Your Collateral

Collateral is the principal factor asset-based lenders consider in making lending decisions. While analyzing financial and cash-flow reports is important, it is deemed less critical than understanding and monitoring the collateral.

Secured lenders invest considerable resources during origination evaluating the collateral on which the loan amount is based — assessing the accounts receivable (A/R), preparing a Net Orderly Liquidation Value (NOLV) of the inventory and machinery and equipment, and establishing a fair market value for real estate. A borrowing base formula is established based on these analyses of the collateral pledged by the borrower.

Once a loan is in place, secured lenders make a concerted effort to monitor the value of the collateral. However, most ongoing reporting systems have limitations that cast doubt on the quality of information lenders receive. For example, while many lenders require daily updates on accounts receivable, this information is usually reported on a gross basis, which may conceal changes in the quality of the A/R.

Reliance on borrowers to provide reports on the value of collateral poses risks since it does not necessarily serve the borrower’s interests to report changes in market conditions impacting the value of collateral. Outdated information can mislead lenders about a company’s performance. By far, the greatest risk for asset-based lenders is in monitoring inventory. Inventory is the blind spot in the ongoing collateral appraisal process of most asset-based lenders.

First, this reporting is done on a gross basis, which can hide more than it reveals about the quality of inventory the borrower has in stock. When it comes to inventory, the devil is truly in the details. For example, acceptable inventory turnover rates may hide the fact that a portion of that inventory is not moving, (i.e., market demand for that product is declining). In this case, shifts in the market can drive inventory prices, and thus collateral value, down without the lender being aware.

Further, an additional risk is that inventory levels, which may have been turning ten to12 times a year, can thus drop precipitously in the course of a single monthly reporting period. Secured lenders need to be able to relate a company’s financial and cash-flow reports to its collateral value in order to detect potential risks to inventory levels.

The level of volatility that we have witnessed in the current economic crisis has magnified risk as companies have gone from solid to the brink of bankruptcy in a short period of time. Usually, the curve to insolvency resembles a gradual slope, but in a difficult market that slope can become very steep, placing the inventory backing a loan at considerable risk. By the time asset-based lenders receive the information they need, it can be too late to take any preventive steps. Over time, a considerable gap can emerge between the appraisal NOLV and the real liquidation value.

While generally very adept at monitoring the value of collateral, asset-based lenders may have limited staff with the experience to manage this level of market volatility and may lack the resources to monitor collateral, especially inventory, for the subtle and not so subtle shifts that can occur in market value. Often, secured lenders face intense resource and time constraints that limit their ability to understand, in depth, the risks they face across the lifecycle of the loan and to act on timely information, if they possess it.

Conclusion

Secured lenders face a dramatically changing landscape, which is being shaped by economic fault lines, growing regulatory pressures and shifts in the internal tolerance for risk. Lenders will face enormous pressure to ensure that their loans are fully collateralized and that they are prepared to act before the underlying collateral value shifts unalterably beneath them.

Secured lenders need to increase the quality and timeliness of the information they possess. Now more than ever, secured lenders must ensure that they understand not only true collateral value, but also their changing risk environment. They need to understand how vital realizable collateral values are at every stage in the life cycle of a loan — from origination to disposition.

Institutions that can analyze that information from multiple perspectives and can bring together all of the disciplines — from evaluation to workout to liquidation — will have a tremendous advantage in the re-emerging asset-based market.

As secured lenders face a more demanding regulatory and internal risk environment, it is important that they fill any gaps in the monitoring of collateral if they are going to meet changing expectations and standards of risk tolerance. If lenders are unable to meet these higher standards, they will be constrained in their ability to capitalize on emerging market opportunities.

Henry Mittelman is president, managing partner, Bill Davis and Terry Ullrich are senior partners, and Mark Rosenbaum is managing director of AGENTA, a multi-disciplinary advisory firm. AGENTA provides financial institutions, throughout the lifecycle of a loan, assessments, strategic guidance, and insight in how best to monitor, manage, safeguard, and if necessary, attain the highest realization on the collateral pledged to support their loan facilities.