Why Commercial Lenders Have Many Conditions
This article forms part of a series written by Andre Schroer which is intended to de-mystify the commercial lending process. Too often than not, disconnects between Lender and Borrower are triggered by poor communication. To the untested Borrower, the process may seem fearsome, involving mystifying rules of engagement. Buzzwords and industry precepts often appear taxing. Perceptions of risk may not be understood and/or aligned. Hopefully, these articles will assist in closing the financing gap between Borrowers and Lenders.
The article builds on the previous one, “My lender does not understand my business/My borrower does not manage the growth risk”
Thou shalt and thou shalt not. What’s with all those conditions, margins and covenants?
When SME borrowers are presented with a new financing commitment, there is a somewhat pervasive propensity on their part to “humor” their lender. Commitment Letters are happily executed with the actual amount of the funding commitment front of mind. The subsequent umpteen pages of the document are either not understood or treated as “I will cross that bridge when I need to”. Especially in term funding commitments, there may be a tendency is to regard them as follows: “The lender has provided me with a mortgage that includes a five-year term. I see it is subject to an annual review; however, if I miss some of the loan conditions will the lender actually call my loan?” Maybe, maybe not! Nonetheless, the lender can turn the banking relationship into a protracted and painful disconnect, if commitments are not met. . . . or to put it into legalese, defaulted upon.
Essentially, loan conditions and covenants are imposed for a fairly straightforward reason. Once the loan has been advanced, the lender is dependent on the borrower’s future performance for the source of the loan repayment. The financial affairs of any business do not remain static. And in this regard, the lenders endeavor to establish some road maps that can provide early warning signals when the borrower’s financial conditions are no longer the same as when the loan was originally granted. Conditions are analogous to stop signs or speed limits on a road that is suddenly changing direction.
The matter of loan covenants and loan conditions is primarily centred around the relationship of the balance sheet and the income statement and the perceptive borrower soon realizes that his or her interest are well served, (as are the interests of the lender), by a mindful observation of the performance signposts that these conditions provide both parties. Conditions of credit should never appear to be like some form of financial voodooism involving black magic formulae only discernible by the enlightened few.
Credit conditions should be based on a rational formulation of a borrower’s needs and agreed upon guidelines on how these needs should be structured and monitored. If it is unlikely that the proposed conditions can be met down the line, then these concerns should be resolved at the start of the relationship rather than at some future emergency.
“Many of the loan conditions that are implemented by lenders are based on diverse experiences.”
At this point, it might be useful to return to some of the themes explored in earlier articles. Many of the loan conditions that are implemented by lenders are based on diverse experiences. The comfort level that they have with certain equity or working capital levels for specific industries is seldom based on whimsy. Usually, they are predicated on what has worked best for their financial institution vis-à-vis other borrowers of the same peer group. While this is a good thing from a knowledge curve perspective, there is also a flip side drawback to this approach, in so far as it may not encourage excessive outside the box thinking on the part of most lenders. (Again, it is not their primary role to be creative given that they are involved first and foremost with judging risk.)
It is therefore up to borrowers to champion the more creative solutions, bearing in mind that their advocacy for innovation will always be somewhat constrained by their lender’s appetite for risk. This having been said, borrowers need not be fettered into a straightjacket of unworkable solutions. Here are some of the more constructive steps that you, the borrower, can take to ensure that the relationship remains mutually beneficial.
- Make sure you understand where the lender is coming from. If he or she appears to be fixated on balance sheet concerns stop rhapsodizing about your amazing profitability. The issues raised about certain aspects of your financial conditions may be important.
- Still, don’t allow the lender to over-generalize. If you have established a firm grasp on the issues that concern your lender, he or she should be able to reciprocate in kind and understand your business and any special features it might enjoy that would mitigate the lender’s risk. In short, understand your lender’s hot buttons, but ask the same of him or her.
- Do not pay lip service to the conditions proposed by the lender. If they are not workable you are deferring a future problem. Also remember, that there is a good chance that your lender is not experienced in your industry and may require your guidance.
- Make sure that you are able to meet the called for reporting requirements.
- Do not personalize the process. Identify the elements of the loan structure that will help refine your financial performance and utilize same to your advantage.
The next article . . .
Analysis Paralysis or not? The significance and/or relevance of ratios