A Tale of Two Clients
In 2006, I met with two potential corporate clients. Coincidentally, they had about the same annual revenue, were in the same industry, and were located in the same broad metropolitan area. Each wanted to borrow about $10 million for capital (long-term) projects.
I?m not sure why the first prospect even requested the meeting. A dominating board member had already decided to borrow from a local commercial bank, for a five-year term. The bank, in addition to the usual collateral demands, also wanted personal recourse from several of the principals. A discussion of financing alternatives was met with an argument, or outright doubt that other viable alternatives even existed.
The chief financial officer of the second client considered the alternatives, and the associated trade-offs, and chose a thirty-year, fixed rate, non-recourse bond issue, privately placed with one mutual fund.
Then the credit crisis struck in 2008.
The businesses of both clients suffered in the aftermath. Interest rates spiked as all financing alternatives evaporated.
The first client?s business failed to sufficiently improve by the time the bank loan matured in year five. The bank would not renew the loan, at a time when even credit-worthy borrowers found it difficult to secure financing. The client tried to negotiate, but the bank had no incentive to do so, since it had recourse to the principals. The bank ultimately foreclosed, and seized the collateral from both the company and the guarantors.
The second client was initially indifferent, since long-term fixed rate financing by definition sidesteps any refinancing risk. Then they realized that bonds, unlike bank loans, are marketable securities, and that bond prices fluctuate with changes in market interest rates. More specifically, the price of the bond issue they ?sold? a few years ago had fallen precipitously as interest rates spiked. The client subsequently negotiated with the mutual fund and bought back their bond at a tremendous discount. The mutual fund was a willing participant, since they trade their portfolio and are accustomed to profits and losses in any given market. The client dramatically lowered their outstanding indebtedness, improving their cash-flow and competitive position for the coming years.
Granted, this example lacks the high drama of a merger or hostile takeover. But reality tends to be boring, and these types of capital raising assignments are the bread and butter of investment banking.
And unfortunately, the two clients in this example are not unique. My business practice often involves an endless round of educational meetings with clients and prospects who may not appreciate the nuances and ?bets? inherent in their financing alternatives; or the fact that markets (and opportunities) change, and at times may even contradict their own past experiences. For example, it?s easy to dismiss the board member of the first client as a jerk who wouldn?t listen. In fact, he was a wealthy entrepreneur who had worked with this particular bank for many years to build his own business. The short-term bank loan carried a slightly lower interest rate than long-term bonds, which he valued for the immediate cash-flow savings. For the last thirty years, lenders have always lent and interest rates have always fallen. He knew what worked. And if it?s not broke…
The capital markets, of course, have always been far bigger than just the local commercial bank. But these days, the game has changed. Maybe not changed, but certainly shifted.
This series of posts will discuss capital raising in the post crash environment, from inside the sausage factory. I?ll spend more time on borrowing, because borrowing is far more prevalent than raising equity, and far more institutionalized. If you follow certain rules and meet certain criteria, you can always find money to borrow. Raising equity is different. We?ll discuss that in a separate series.
I will not spend much time on exotic or specialized forms of debt, other than perhaps to note their existence. Rather, this discussion will simply reflect the discussions I routinely have with current and prospective clients.
I tend to think of lenders as single-cell organisms (and I?ll bet most lenders would agree). They are simple creatures, and if you internalize some very basic concepts, it will make the process much less aggravating.
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- Lenders are not venture capitalists. They will not ?invest? in your business. They have no incentive to take business risk. Think about it: under the best of circumstances, all they get is their money back, with some interest. Your borrowing – your eligibility, the rate, the terms – all depends on the lender?s perception of downside risk .
- Lenders are not perfect. They mis-perceive risk. And 1% of the time, they do go insane. The recent real estate bubble is an example. Unfortunately, everyone in need of financing spends too much time looking for that one insane lender. It is a wasteful and often futile approach. Shop around, but keep in mind that lenders are sheep, and tend to look at the world with the same risk-averse mindset.
- If you are creditworthy, you have options. If you are not creditworthy, you may not have any options. It is surprising how often a client, with no net revenue and no collateral, will insist on a non-recourse loan at interest rates comparable with Treasuries.
- The availability of construction financing will directly depend on the evidence of take-out financing. ?If there is bankable take-out financing in place, it is very easy to find construction lenders. ?No evidence of take-out financing, no construction loan.
- There is no free lunch. There are trade-offs. Listen for the trade-offs. Variable rate loan rates fluctuate in both directions. ?A twenty year loan with a five year put is really a five year loan.
- Strong commercial banks have the capability to offer non-recourse loans to creditworthy projects. ?Weak banks will always insist on recourse.
- Lenders are not objective financial advisors. They are not looking out for you. They are looking out for themselves. Loan officers (investment bankers, whatever their title) have an employer. They have a product line. They are evaluated by their revenue production. They are salesmen. Salesmen are always nice. Do not misinterpret nice.
- A smart banker is uncommon. If you find one, stick with them.
- If you are creditworthy, a little competition can make a big difference. If you are not creditworthy, you may have to take what you can get.
- Relationships are important, but do not exaggerate their influence. These are not your parents. These are not your friends. If you have assets and surplus revenue, every lender will want a relationship. If you default, your trusted friend will cut you off at the knees. Just ask the board member of the first client.
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