Friday, February 14, 2020

Banking 101: Corporate Borrowers

Banks large and small engage in corporate banking, providing services, funding commitments, and loan products to corporate entities in the U.S. and around the world.  They address the opportunities, risks and regulatory compliance in different ways.

First, however, they each attempt to define what a corporate entity is, what industries they prefer to concentrate on, what countries in which they feel comfortable with exposures, and what goals and limits they may have in managing corporate relationships.

Then they assess their activities by assessing the value and risks of each relationship. Banks define corporate entities and review their goals differently, all of course under the auspices of bank regulators and under guidelines to ensure they have sufficient capital and funding to support those goals. 

(Some banks define corporate banking based on the size of the entity; for example, if the business has revenues less than $50 million, some banks may define the relationship as "small business" or "SME" (for small and medium enterprises). Other banks may define corporate banking based on corporate growth rates or expectations of the size of the entity going forward.  Global banks will define relationships based on "corporate families," where they consolidate a parent company with its operating subsidiaries into one global relationship.)

In fact, some banks in the recent decade have segmented corporate banking into three or more sectors (consumer banking, business banking, commercial banking, and corporate/investment banking), where a corporate entity could fall within any of the defined sectors.  They do so based on size of the corporation (as described above), but they may also do so based on the sophistication of products the company requires.  A small business might require derivatives for hedging purposes and advice on acquiring another company. Its banking relationship, therefore, could be managed by investment and corporate bankers, rather than a consumer banker in a branch. Or a small business could be an industry that may require the sophistication and expertise of experienced bankers in larger corporate banking groups.

No matter how defined, most banks tend to assess their products and services based on client revenues generated from an overall relationship (including, say, cash management, trading, custody, lending, syndications, etc.), Banks, too, must manage the risks of credit exposure with the entity on an ongoing basis. And over the past decade or so, banks compute the amounts of capital they must allocate to maintain the relationship (based mostly on credit exposures). They, in turn, will compute for each relationship (a) total revenues, (b) total credit exposures, and (c) capital requirements and returns on capital. 

Bank risk management units never stop examining the risks of exposures from old loans and also from new deals (including loans, commitments, letters of credit, trading-related activities, derivatives, currency payments, trade finance, etc.). How they manage a relationship or analyze the financial condition of a corporate client differs based on the industry and the type of exposure (short- or long-term, committed, uncommitted, outstanding, syndicated, collateralized, unsecured, e.g.).

Financial analysis, therefore, never stops throughout the existence of the relationship. 

Following are frequently-asked questions, answers and responses for how banks (global, domestic, large, community-oriented, etc.) try to assess ongoing risks in corporate relationships:

1. Banks and debt investors require more return (or reward) if the prospective corporate borrower is subject to more risks.  Hence, if the borrower's performance is average at best or is vulnerable to decline, then debt markets will charge higher pricing (or credit spreads). 

However, the higher debt costs will only lead to lower earnings or lower operating cash flow. How do banks and debt investors rationalize this, or can they justify lower pricing for non-investment-grade borrowers to help them during periods of struggle or decline?

The irony is that investors and lenders require higher returns (interest rate, yield) and more interest return from the cash flows, if the borrower is subject to greater amounts of risk.

Hence, a company that might be struggling to generate consistent cash flow to service debt and invest in new businesses will be further constrained with higher interest payments. The company, in effect, is penalized for a decline in performance with higher interest expenses and, therefore, less cash flow for purposes of reinvestment, growth or principal payments.

The borrowing company and the lender could, therefore, agree to structure the loan such that the lending bank will lower the rate, if it receives more protection (collateral, collateral advance rates or haircuts, strong guarantee, seniority, amortizing principal, shorter terms, etc.). Or if it has a public rating, the bank may choose to lower credit spreads if ratings improve. The new structure will help lower risks of loss in the loan, while permitting the declining company to have reduce interest costs and, thus, increase possible cash flows.

When they assess a deal, loan or proposal, banks and other corporate lenders certainly take into account the current relationship, current earnings from the client and the possibility of competitors taking away the client and future business. Therefore, they address this routinely and frequently as part of a loan or credit proposal. Competition is primary reason why a bank may reduce loan pricing, even if pricing models recommend higher credit spreads. 

In the efforts to try to maintain business ties with the client, they will focus on managing or reducing the expected loss in the transaction or consider ways to mitigate risk, reduce risk or transfer risks that accompany the deal.

Some of the options might include the following:

a) Ensure the rewards for the risk are adequate: Minimum pricing (and credit spreads) for the risk accepted.

b) Request acceptable collateral with high cushions or advance rates to offset the potential risk of loss in value of the collateral; ensure all exposure is senior, secured, and enforced with adequate inter-creditor agreements.

c) Implement strong, useful financial covenants that will track performance and financial condition regularly and permit banks discretion not to lend under commitments if that condition declines. Propose other structures that protect the lender/bank (including guarantees, requirements of minimum liquidity and cash flow, cash-flow sweeps, etc.).

d) Consider ways to offset or hedge that risk by (a) selling off portions of the commitment or exposure to others (possibly at fair value and possibly at a discount), (b) purchasing credit insurance (credit default swap, credit derivative) to offset the risk (at the market rate for credit derivatives), and (c) syndicating and selling participations in significant portions of the exposure and risk (to reduce overall exposure to tolerable levels)

If any of the above solutions do not permit the bank to get comfortable and if the borrower is not in agreement, then the bank should consider not doing the loan/deal/transaction even if it means jeopardizing the existence of a lucrative relationship. Many big banks acknowledge this will happen from time to time.

2. In lending and debt markets, what other factors, besides historical financial performance, figure into the final decision of whether to lend (or not) or whether to buy the debt issue (or not)?

Financial and credit analysis is a very important part of that decision, and that includes a thorough analysis of historical performance and current balance sheets and financial condition. Financial analysis also provides a basis for analysts to project performance, balance sheets, and cash flows (particularly the cash generated from operations that will be available to bank lenders, debt investors of a different ranking levels (junior, mezzanine, etc.), and even equity shareholders).

But bankers and risk managers must be forward-looking and not be too focused on past financial reporting. The analysis should be complemented by assessing the following:

a) Management and ownership--to assess their ability and competence to lead the organization, to determine what their business goals and investment objectives are, and to assess whether they can raise capital if and when necessary. Management and sector leaders develop and implement overall business strategy; they are also responsible for ensuring the right people are in place (talent) today and tomorrow, the right products are funded and delivered, and the right response is executed in times of crisis.

b) Business model and industry--to determine how the industry and business model will evolve over time or how it will react to downturns, competition, and stress (recessionary periods). Analysts often examine the industry the company operates in by analyzing products, markets, consumers, suppliers, and competition. Industries and products, especially in current times, evolve, transform and can even disappear.  The analysis should review where the industry is headed in the years to come.

c) Projections and outlook--to determine beyond historical analysis whether the company can continue to sustain performance and generate returns and cash flows. Projections permit the analyst to assess future scenarios and worst cases. Yet they can certainly miss the mark. The exercise forces the analyst to maintain a forward-looking approach and examine the impact of markets, products and competition on the company. It also helps to show whether the company is prepared for industry transformation or macro-economic upturns and downturns. Ultimately analysts project cash flows from business operations and attempt to project how the company will use those cash flows to respond to changing markets or reward shareholders and, of course, manage debt loads.

d) Operating environment--to determine if regulatory, legal and political factors could have an impact on sustainable performance. No doubt changes in rules and laws and changes in the macro-economy have impact on future performance and operating cash flows.  As a result, they can have impact on the borrower's ability to meet financial obligations:  principal payments, interest due, preferred dividends, etc.

No meaningful financial analysis of a company and a specific deal or transaction can exclude an assessment of the operating environment and a consideration of how these changes have impact on a company's business, business model, demand for product and/or cash flows. The analyst should assess the likelihood of changes or the impact of unforeseen events and risks (probability vs. impact). Just like projections, this might require the analysis to examine various scenarios.

e) Lessons learned in the past and common sense--to review problems, losses and bad decisions in the past to determine whether past lessons can be applied to current risk decisions. After a bad deal or transaction or after a financial crisis of any kind, banks often regroup and identify lessons to be learned. They attempt to incorporate such lessons into new risk policies and guidelines. This may translate into new approaches to assess familiar clients and industries or might involve the bank choosing to avoid certain regions, geographies and industries altogether.  Or it may be related to specific scenarios and transactions.  The lending bank may choose to require more collateral, choose to examine more closely worst-case scenarios or choose to conduct portfolio reviews more frequently.

Outlining and adopting lessons learned from bad events or bad times may not be difficult. The challenge is not allowing lessons learned to be forgotten or recede into the past--a scenario many banks and investors too often slide back into.

f) Structuring--to determine whether the risks of having exposure (or doing a loan) can be mitigated by terms and conditions in the loan (collateral, seniority, covenants, amortization, and pricing).

Theoretically structuring a loan or debt should focus on (a) the expected loss of the transaction or deal (or exposure), (b) the bank or investor's risk tolerance for that expected loss, (c) the lender's ability to compensate for such expected loss via pricing (or credit spreads), and (d) ways the lender can reduce expected loss from the expected credit exposure.

Structuring in practice may focus on (d). There is a toolbox of ways to reduce expected loss, including from shortening tenors, requiring more collateral, ensuring seniority on the balance sheet, requiring principal to be amortized steadily during the life of exposure, and requiring the borrower to meet financial metrics and requirements (in the form of financial covenants).  In practice, structuring is also influenced by negotiations with the client-borrower and from competition with other banks and debt investors.

3. Why would a company, seeking to grow or expand, prefer to issue debt and borrow funds, rather than issue new equity? What are the basic advantages of debt over equity?

When a company is doing well and generating positive cash flows, debt can be used to enhance and increase returns on equity or returns on capital or investment.

In corporate finance analysis, we can use a traditional "Dupont equation" to understand how debt can  enhance the returns to investors. When a company is considering ways to increase revenues to increase earnings and returns to investors, it will likely consider increasing operating assets or investments (which will help generate incremental business activity and revenues). It must consider ways to finance the new assets. By financing with more debt, it will permit the company to boost its returns to shareholders.

Debt, of course, comes with obligations to make regular cash payments of principal and interest, where equity payments can be deferred (and shareholders may be willing to permit that). Thus, while the DuPont equation shows how higher debt/equity levels increase ROE, debt can be a burden when cash flows disappear or company performance is in decline.

ROE = NPAT/Equity = (NPAT/Revenues x Revenues/Assets x Assets/Equity).

The equation suggests investors or shareholders (with management acting on their behalf) can maximize ROE by maximizing any of

(a) NPAT/Revenues (or via controlling costs),

(b) Revenues/Assets (or via productivity and efficiencies, maximizing revenue generation from the current level of base assets), and

(c) Assets/Equity (=Total Liabilities/Equity + 1) (or deploying debt carefully to fund asset growth) 

Hence, you can maximize or increase returns, in part, by assuming more debt and taking on more leverage. This certainly explains why some investors and managers can be more comfortable with leveraged finance or with restructuring the balance sheet to absorb more debt and reduce equity (where new debt buys back equity capital). When revenues are flat, companies sometimes will find ways to generate higher returns on equity by engaging in "financial engineering" by changing the capital structure (or increasing debt and buying back stock). 

Debt usually has another obvious advantage. The company can fund operations and fixed assets from the cheaper cost of debt and by using "other people's money." Large global companies over the past decade in a low-interest-rate environment took advantage of low rates and recapitalized their balance sheets and bolstered their returns on equity.  Investors benefit from the company deploying less capital than otherwise necessary to generate a similar level of operating income.

Re-engineering the balance sheet by taking on more debt works well if the company is generating positive operating cash flows. Debt must be serviced if used. Thus, the company must generate steady cash flows from period to period to make principal and interest payments.

Bankers involved in leveraged finance rationalize structures if the company is generating steady, predictable, certain streams of cash flow from operations to pay the much higher levels of debt.

Negative earnings, negative cash flows and/or downturns in performance and revenues jeopardize the company's ability to meet these payments and can put the company in default (which can lead to acceleration, insolvency and bankruptcy). Hence, debt is optimal and ideal, but up to a certain point, the point at which it becomes too much of a service burden. 

Financial and credit analysis must also attempt to determine the level of debt for a company for which it can become a problem. 

4. In the assessment of debt on corporate balance sheets, how important is the popular and conventional Debt/Ebitda ratio? 

How much of a factor is it in determining whether the company can take on more debt?

The Debt/Ebitda ratio is important because it is widely discussed and widely used as a first-approach method to determine how much is too much debt on the company's balance sheet. It is supposed to tell us how many years it may take for the company to pay down all outstanding debt. The higher the number, the longer it takes, and the more risks there are the company may not be able to make long-term payments. Time means uncertainty and risks.

But it should not be used as a single measure. It should be used as a starting point to determine whether debt is a burden.

Of course, higher ratios will always imply higher debt burdens. Yet some companies with high Debt/Ebitda ratios (say, Debt/Ebitda= 5) can handle and service debt without difficulty. In those cases, they have high-probability (highly certain) cash flows and bankers approve and execute new transactions aware that company is generating high-probability cash flows. Debt/Ebitda = 5 is acceptable, therefore, when cash flows are much better assured.

In many ways, the ratio is flawed, because it doesn't account for Ebitda ("Earnings before interest, taxes, depreciation and amortization") being a mere approximation of annual cash flows. Ebitda also disregards other essential, required cash outflows to support an ongoing business operation. Operating cash flows from period to period must account for required payments for taxes, new investments and capital expenditures (especially for maintenance).

The ratio is flawed, too, because Ebitda changes from period to period and, thus, the ratio can change significantly. 

Too much focus on the metric itself might be misleading, as it presumes all cash generated will be used to pay debt principal and interest. The ratio doesn't account, too, for the likelihood large, public companies will try to ensure they can use operating cash to pay the dividend streams many of its investors are accustomed to.

But we still use the ratio as an initial benchmark to start the assessment of how much is too much debt--especially when the bank gets the initial request from a company interested in borrowing more money or while the investment bank works with investors and ratings agencies to determine whether it can underwrite a new bond issue successfully.

Let's suppose we use Debt/Ebitda = 3 as that benchmark (which is often the case in many transactions in many corporate industries). If higher than 3, then there could be risks and uncertainties related to time to pay debt. If less than 3, we gain more comfort, although it doesn't guarantee the company can pay debt without difficulty.

From there, a financial analyst must perform the conventional analysis of reviewing historical information, assessing the operating environment, and projecting performance and cash flows into the future.

When bankers, debt investors and borrowers negotiate financial covenants, the ratio comes in handy. In such structuring, the ratio is often used to establish debt limits with companies. Lenders are comfortable with current credit exposures, but want to ensure the borrower will not go elsewhere and add mountains of more debt. They may require (in documentation) that debt not grow at a rate such that Debt/Ebitda exceeds a certain benchmark (say, Debt/Ebitda= 4). 

As a covenant, the ratio is useful because for the parties involved, it is not difficult to measure from period to period. And something (its definition) the parties involved can agree on quickly. 

Tracy Williams

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