Lending today is complicated. It seems like every new deal requires piecing together a combination of value and compliance totally unlike that of the previous deal, which was completely unlike the one before. What brought us to this state of affairs? Data. “Big data” is threatening to overwhelm lenders who are expected to analyze and act on the daily mountain of incoming information at the speed of light.
While managing all of this data is daunting there is a tremendous upside, which is the more you know about the foundations of your deals — the collateral that backs your loans — the better you can mitigate your risk and reduce your exposure.
So how do lenders adapt to this fast-paced, data-rich world? By utilizing portfolio management systems that customize controls and workflows to meet the unique requirements of each collateral type on a deal-by-deal basis.
Accurate Valuation of Collaterals
The borrowing base methodology, which asset-based lending relies heavily on, has two primary objectives. The first is the accurate valuation of assets, and second is the control of the associated risk via collateral monitoring. The overall goal is to match the underwriting standard to each and every funding decision.
Most borrowing base collateral values are submitted to the lender as the borrower’s book value. And at times there is a great disconnect between the borrower’s value of an asset and the lender’s value of the same. To establish a realistic value, lenders need to apply internal business rules to convert the borrower’s book value to one that can actually be relied upon to support the loan balance.
There are many techniques for restating value into the lender’s terms. Most of them start with identifying the prime elements of an asset to place reliance upon only the best assets. Afterwards, lenders must continue to monitor the collateral, verify data and analyze trends to assess risk.
Each collateral type is, by necessity, assessed in a distinct way:
Accounts Receivable — With A/R, the primary collateral in borrowing base lending, the most obvious risk mitigation technique is identification of ineligibles, so that only the highest quality invoices support the loan balance.
Not every A/R should be monitored the same way; in some cases specific controls should be used for specific types of A/R. The most commonly used method is certificate posting, which rolls forward the total A/R value from time to time by adding new sales, reducing net collections and making additional adjustments to determine the current A/R balance. In some cases, such as medical receivables lending, it may be more effective to establish the value of A/R by specific debtors or by segments of the A/R so that controls (like limits and advance rates) can be set at the category level or business class level. And there are cases where the A/R can be better controlled by setting up the advance rate based on aging buckets rather than on the overall A/R balance. All methods should be accommodated by the portfolio management system.
Inventory — As with A/R, lenders must determine ineligibles to separate the best items from those of low value, a task that requires close examination of the inventory list. The inventory is then further evaluated based on its character because some segments carry higher values than others. For example, finished goods tend to be more valuable than work-in-process, and certain materials — even certain colors — carry higher values. Consequently, segmenting inventory within the portfolio management system can benefit the lender by allowing for higher advance rates and limits on prime inventory segments. This method ensures that you are not relying too heavily on inventory items that can’t deliver real value.
Inventory should be further re-valued by converting the book value to market, or “orderly liquidation,” value. A portfolio management system that allows for trending analysis and viewing of inventory in terms of the lender-stated value, in addition to measuring and reserving the anticipated cost of liquidation, ensures the loan is truly supported by the borrowing base.
Equipment — In some cases, lenders tend to set equipment valuation based on a single line item on a balance sheet, but a granular look at equipment is far more accurate. By identifying within the portfolio management system the items of highest value, the lender can better focus his collateral support. Then, should a piece of high-value machinery be sold off, the impact to the borrowing base can quickly be determined.
Typically the appraised value determines what the reasonable lending value is. However, we know that machinery and equipment depreciates over its useful life, and the borrowing base needs to reflect that fact. To ensure that the true collateral value is being used to support the loan at all times, the stated collateral value needs to be automatically reduced in the system on a periodic basis as the asset depreciates.
Real Estate — When using real estate as a borrowing base, the asset’s value is restated to reflect the lender’s position. This is done by establishing and tracking offsets in the portfolio management system that account for the cost of mortgages and liens already in place. Updating the offsets periodically will ensure that the value of the asset is more adequately reflected and can be relied upon to support the loan balance. A system that prompts the lender to obtain those updates can prevent such crucial checks from slipping through the cracks.
Purchase Orders — More and more, lenders are using purchase orders to support short-term borrowing bases. The value of the purchase order borrowing base is determined by the contract, but it is pre-scheduled to revert to zero once the purchase order expires or is filled. In some cases the purchase order value reduces as commitments are met. This ongoing re-valuation ensures that exposure is reduced as the value of the asset is used up. Handling re-valuation in an automated, rules-based collateral management system reduces risk to the lender.
Monitoring Collateral Character
The second aspect of the borrowing base methodology is controlling risk by monitoring the character of the collateral over time. The problem is that a disconnect can exist between how a collateral performed in the past and how it is performing today (or the near future) and memories can be short, particularly in a fast-paced business environment. Lenders need to track performance by setting expectations on anticipated outcomes and measuring the exceptions against those standards. Serious exceptions must command serious attention.
Periodic collateral performance evaluations (typically monthly) to identify any significant trend changes and calculate new ineligibles is the standard tool used by commercial lenders today. Integrating this periodic analysis with the daily borrowing base activity can help demonstrate the strength of the collateral support and create efficiencies in processing. Applying automated detail A/R confirmations from coordinated processes and tracking inventory listings can reveal deficient values that have not been identified in the past.
Vendor interfaces are helpful tools for monitoring collaterals. The ability for a lender’s portfolio management system to exchange data with industry experts providing services such as appraisals, field examinations, credit monitoring lien monitoring, and more is a tremendous time saver and boon to accuracy. The objective is to get as much deal-related data “in system” as possible, no matter the source.
Other significant tools are customized controls and automated workflows within the portfolio management system that can respond to the requirements of any given deal. These integrated tools can identify exceptions that require lender action, trigger deal-specific workflows that adjust controls or activate new pricing and lending strategies.
With the newest technology-driven valuation and control tools in hand, lenders are now thinking in terms of a strategy that employs a 50% to 60% effective advance rate on well-defined, qualified collateral values rather than picking one or two assets with loosely defined book values and controls.
Lenders thinking outside the box want to know the true value of collaterals and control risk at all times so they can claw back or hold off a segment to extend the safety margin. By focusing on the prime elements of collateral they can stretch availability to safely offer an earning accommodation when needed. These lenders know that utilizing the latest technological tools is essential for interpreting and managing the big data that holds the key to true collateral value.
Michael Charleston is a program manager at Bayside Business Solutions, working on CADENCE, the company’s portfolio management software solution for commercial lenders. Formerly, Charleston was an executive consultant with Cerra & Associates, which advised software providers on system development and ABL program integration. He has more than 15 years of experience in commercial lending in both operations and credit administration. Overall, Charleston has 30 years of business experience, having worked in the automotive engineering industry as a controller and project manager developing and maintaining business systems and project control procedures.