Finding New Liquidity Requires Bold, Cohesive Strategy
By David M. Weinstein
Principal, Lakeside Advisors
Reprinted with permission from The Journal of Corporate Renewal,
copyright Turnaround Management Association.
Businesses can no more survive without liquidity than people can without water. The ever-increasing need for liquidity among startup ventures, small firms, and middle market companies usually outpaces their internal ability to generate cash flow.
Even with the new sources of capital available in today's marketplace, a company seeking increased liquidity should recognize that navigating these sometimes confusing financial waters can be treacherous, especially for young or troubled businesses. Advisors are available to help determine a borrower's needs, explain what can be financed and by whom, and build a solid strategy to ease concerns that could cause a lender to back away from a potential deal.
There is a grain of truth to the adage that banks lend money only to people who can prove that they don't need it. A direct inverse correlation exists between the risk of a transaction and how many potential lenders are willing to finance it. As the real or perceived difficulty of a transaction increases, the number of potential lenders interested in possibly financing it decreases.
This predicament is not new. In essence, it gave rise to the banking industry and, more recently, to a range of alternative sources of capital. These include the private finance niche; the commercial finance or asset-based community, including factoring; debt and equity funds; and appraisal and liquidation firms, many of which now boast lending capabilities.
Complicating this plethora of financial alternatives is the further stratification of lending sources. Some factors and finance companies are privately owned. Others are owned by banks, and some banks own investment banks. Differences in ownership structure impact the kinds of deals these companies can make.
Commercial finance companies owned by banks are subject to regulatory constraints that may limit their ability or willingness to pursue some credit opportunities. A bank-owned finance company usually is required to report problem loans, much as its parent bank is. Unregulated finance companies, however, are not subject to many of the same restrictions as their regulated counterparts, which affords them latitude in reporting requirements and the manner in which they handle workouts. As a result, they may make loans that their regulated peers either cannot or will not fund.
In addition, although international, national, regional, and community banks all are in the business of making loans, they operate from different perspectives and therefore serve different segments of the market. For example, community and regional banks may prefer to lend only on real estate, while others will not even consider financing turnarounds. Some prefer fixed assets and term loans, and many others will provide only revolving credit secured by working capital assets.
Further complicating the financial landscape, the banking environment changes as often as business cycles do. Lenders that might have been very conservative a year ago may now be chasing transactions aggressively that they would have rejected outright 12 months ago. This may result from increased competition from alternative financing sources or simply a desire to increase the number of loans they have on the street. Transaction time has changed as well. Deals that may have taken six months to close last year can now be completed within six weeks.
Tough Terrain
Finding the right lender begins with a well-defined business strategy that can be set forth in a financing memorandum. To qualify for institutional financing, a company typically must be established for at least three years and have achieved or exceeded breakeven operating performance. At best, a company that has experienced significant losses and has been in operation for less than three years is severely limited in its access to institutional debt. Unless a startup is funded by venture capital, only non institutional money, such as factoring, is available to help it increase liquidity. A troubled company that has not yet turned around faces equally challenging prospects of obtaining cash from institutional lenders.
A borrower who needs between $1 million and $10 million finds itself in the most difficult segment of the banking spectrum to navigate. Large institutions and many smaller lenders shun this market segment completely. They argue that the effort required to complete due diligence for a $1 million loan is roughly equivalent to that necessary to approve a $20 million credit. Yet, a lender derives far greater fee and interest income for the larger transaction than for the smaller loan. This income differential does not account for the potential for risk-adjusted income, in which a lender charges higher rates for a smaller credit to mitigate some of the income disparity between large and small transactions.
In addition, lenders have more exit options for transactions involving larger companies than they do for smaller businesses. Larger companies generally have more assets, including entire divisions, that can be sold to raise capital. Larger debt amounts can be traded more easily.
Should a smaller company become a workout, however, lenders have much more trouble selling the loan, working out the loan, accessing capital markets to repay the loan, and even selling the company. Given this smaller potential universe of lending sources with whom to work, how can a smaller company access adequate financing to support its growth and business objectives?
A question that arises is whether a company seeking liquidity should search for financing on its own or hire an advisor or consultant to help. The drawback to using an advisor is the added cost in the form of a placement fee. At a time when a company is desperate for cash, the notion of spending money on a process that management might be able to handle on its own may be difficult to accept. However, a company should weigh an advisor's placement fee against the cost of failure to secure new capital in making its decision.
Advisors generally are in the marketplace every day and know where to look for capital. They have developed relationships and credibility with lenders and can stratify them by risk tolerance to offer clients a mix of banks, commercial finance companies, and private money. A borrower may have limited contact with lenders and, as a result, be unfamiliar with current lender appetites, acceptable leverage multiples, and pricing.
Making a Case
A common mistake borrowers make involves the preparation and presentation of their information for lender review. Most lenders receive two or three proposals for possible financings each week. Submitting information that is incomplete or is not organized in a way that a lender can review it quickly is akin to facing a third and long in a football game. The chances for success are diminished greatly.
The financing memorandum must be complete and, of course, accurate. It must detail the history of the business; the products or services it offers; the markets it serves; its customers, competition, and management; and its financial history and forward-looking business plan. By themselves, numbers on a spreadsheet do not constitute a business plan. The logic behind the numbers must be detailed in the accompanying assumptions. While bankers probably have never seen a set of projections on which they wouldn't lend under the right circumstances, the business plan behind those numbers must be credible.
After the financing memorandum is completed, the next step is to identify lenders who might consider financing the company. The pitfalls of taking a $1 million borrower to an international bank that traditionally buys tens of millions of dollars of debt through its syndication desk are obvious. Likewise, taking a $10 million borrower to a community bank down the street that makes loans only up to $5 million may be equally misguided.
There are different approaches to finding the right financial mate. Some firms believe in the "shotgun approach" and distribute dozens of packages in hopes of finding one or two lenders willing to consider the transaction. Other firms believe in prescreening lenders before sending memorandums. In fact, potential borrowers sometimes prescreen lenders even before preparing a financing memorandum to gauge the likelihood of success.
Ideally, this more focused approach for targeting lenders will limit distribution of the memorandum to no more than six lenders, all of whom were contacted beforehand and told of the company and its needs.
Choosing Wisely
Liquidity is the lifeblood of any company. Without cash, cash equivalents, or access to adequate financing, a company is on life support, and its odds of recovery diminish each day it survives without additional liquidity.
The process by which a company finds a financial provider is fraught with pitfalls and is not a task to be undertaken lightly. Many firms exist to make the best possible connection between borrowers and lenders. A company in need of such services should choose a firm that has a sterling reputation for its contacts, experience, and industry knowledge and then charge it with the responsibility of putting a financial defibrillator on the business.
|
