Do you believe in the adage “History repeats itself”?  There are a number of examples supporting this – Economic cycles, stock market fluctuations, music trends, clothing styles (let’s hope that’s not the case for the 1980s!!), and the list goes on.

We believe that history does repeat itself, especially when it comes to challenged loan relationships in the lower middle market…time and time again, privately-held businesses face challenges as a result of Fixed expenses/obligations – a Borrower’s inability (or unwillingness) to shed the business of fixed expenses.

Yes, of course each loan relationship has specific nuances and different scenarios identified as the impetus behind a performance issue  – loss of a major customer, over-distribution of liquidity to support a lifestyle/outside investment, ownership disruption (death of an owner, family disagreement, etc…), employee theft, fraud or any other number of unexpected ‘Black Swan’ events.  That being said, we’ve all had borrowers who have experienced one of these without material adverse impact; therefore, is the problem caused by one of these events or is the ‘real’ issue due to a borrower’s inability to manage fixed expenses when one of these events occur?

The “Why” Behind Fixed Expenses: Why is it that Fixed Expenses can be difficult to resolve in a short period of time, especially in a recessionary environment? This is due to a Material adjustment of fixed expenses requires not only an action plan and commitment by the borrower, but also negotiation and agreement with any counter- party(ies) involved.
  1. Commitment from the Borrower – Resistance by the owner due to the assumption that a material adjustment to fixed expenses will adversely impact ability to grow/meet potential customer demand in the future.
  2. Negotiating with 3rd party, counter-party(ies) are at the root of the Fixed Expense problem – whether it’s a landlord, other creditors, insurance companies, municipalities and taxing bodies, etc… even getting that 3rd party ‘to the negotiating table’ to discuss is difficult enough, let alone, agreeing to a material adjustment.

Identifying potential Loan Problems: Fixed Expense “Red Flags”

What are the most effective ways to project which loan relationships could experience cash flow challenges in a recessionary environment when faced with declining revenue levels?Especially for loan relationships already internally identified as potential downgrades, the followings is an example of an analysis of the Borrowers’ ability to materially modify or reduce its operating expenses will provide an in-depth understanding of circumstances causing cash flow stress.

1-Categorize expenses as “Fixed” or “Variable”
2-Calculate each fixed expense as a % of revenues.
3-Review each fixed expense with the Borrow to identify:
  • The counter party(ies) involved in each,
  • Ability to negotiate and affect each expense,
  • Willingness of the borrower to reduce/eliminate each expense,
  • Impact of the reduction/elimination of these expenses on the business, and,
  • Realistic timeframe to materially reduce these expenses.
4-Utilize these findings to better assess the Borrower’s ability to adjust to future uncertainty
 Are there a material amount of expenses that the Borrower would be committed to address if necessary?
  • Does the reduction in expenses provide sufficient cash flow based on a reasonable future projected revenue level?
  • Would the benefit of the identified cash flow improvement outweigh any potential adverse impact of these fixed expense adjustments?
This process is one approach that has worked in the past; however, the “How” is less important than the “Now”… it’s more important that a game plan is developed early enough in the “cycle” to ensure that the Bank has identified the potential problem loans, communicated with the Borrower and is comfortable with the plan or actions that those Borrowers have taken/will take. A lesson we all learned from 2008-2009 recession was that the business operators that were either in denial or that hesitated were much less likely to survive.