Know Your Lender

high tech business background

The Interpeak Report, November 2019 |

Small to medium sized companies encounter lenders of all types, with complex funding sources and structures.  Businesses should know how their lenders are funded.  This understanding is critical in providing a guide on how a lender may behave should the company experience financial difficulty.

Depository Institutions – Banks

While commercial banks generally have the most reliable source of funding, they are also the most regulated.  Consequently, loan portfolios are subject to a high degree of scrutiny by both federal and state regulators.  How these regulators view a given loan can play an influential role in how a bank manages a troubled credit.

Business Development Corporations

BDCs were created by an act of Congress in 1980 to support lending to small businesses.  These organizations raise public equity to make direct loans to small businesses.  Should an BDC suffer reduced interest income or loan losses due to a poor performing loan portfolio it may be forced to reduce its dividend, which may have a material adverse effect on the BDC’s stock price, which in turn could effectively eliminate its ability to access the public equity markets to make new loans.  This funding reality is an important consideration in how BDC’s manage their loans.

Collateralized Loan Obligations

While CLOs predominately invest in the corporate leveraged syndicated loan market, increasingly CLOs are being formed to invest specifically in the loans of middle market companies.  CLOs are a structured interest rate arbitrage vehicle.  These vehicles are financed predominantly with AAA rated bonds, representing on average approximately 65% of the vehicle’s capital structure, with equity and lower rated bonds filling out the rest.

In order to maintain the AAA rating of their bonds, CLOs are subject to stringent portfolio constraints and testing imposed by its bond holders and rating agencies.  Borrowers should have a solid understanding of these constraints.

Shadow Banking

This category includes finance companies, hedge funds and credit opportunity funds.  These entities generally rely on private investors and lines of credit from banks as their primary source of funding to make loans.  Borrower’s should understand how these entities are funded and, equally important, how much capacity or dry powder the fund has to make additional loans.  Also, the fund’s performance is an important consideration to keep in mind as it may influence how the fund manages its lending relationships.

Credit Default Swaps

All businesses should have some basic knowledge of credit default swaps.  Lenders can purchase CDS as ‘insurance’ against a loan going bad.  Alternatively, any institutional investor can purchase CDS as a way to ‘short’ a loan.  If a loan stops paying interest, or the principal is not paid when due (either at maturity date or by acceleration), the CDS holder receives a recovery generally equal to the par amount of the defaulted loan.  Complexities arise when a lender may purposely seek to accelerate a loan to collect on the CDS, even if the company could otherwise be successfully restructured and has the support of the majority of its lenders.

Final Thoughts

Before entering into a lending relationship, borrowers should have a good understanding of how their lending institution finances itself.  This can easily be accomplished by simply asking your lender.  From my experience, how a lender will react to a pending debt modification/restructuring can be traced to its funding source:  just follow the money.

Email:  frank.turner@interpeakconsulting.com with any questions or comments.

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