ABL Advisor spends time with Tim Eichenlaub, Chief Credit Officer at AloStar Business Credit, to discuss topics ranging from external risks brought about by regulatory changes to striking the right balance in building a healthy sales and credit culture.
ABL Advisor: We note that you have worked in commercial finance shops of all sizes. Could you share what you see are the three major distinctions between credit functions at ABL providers to larger middle-market borrowers compared to those providers to middle to smaller borrowers?
Tim Eichenlaub: Yes, I have had the opportunity to work at Heller Financial, GE Capital, CIT Group and two newer lending platforms over my career, providing both asset-based and cash flow loans.
The most obvious difference is the size of the company you are financing and the size of the loan. Larger mid-market companies typically have a larger revenue base, more staying power, better access to capital markets and greater options in a distressed or workout scenario. This has a big impact on how the deals are structured, priced, and monitored.
Larger middle-market deals may have springing covenants and springing dominion of cash based on an availability trigger. Deals in the lower end of the middle-market tend to have more covenants and dominion of cash in effect at the inception and throughout the life of the loan.
In general, I think you have seen pricing for larger middle-market deals come down faster than for smaller ABL transactions. Lenders need a certain level of income dollars to cover the overhead of running an ABL shop and if you are focused on smaller transactions you need higher spreads to generate those dollars. For larger transactions, lower pricing can also be justified by the lower default risk of the borrower and the ability of the bank to provide ancillary fee based services such as cash management or bond underwriting. There is generally more consistency around larger market pricing as these deals tend to be syndicated facilities that require a number of participants due to size and therefore has to be a market deal. Smaller deals tend to have more variability on pricing as the loan can be held by one or a small club of lenders who may view the risk differently or have another reason to be particular aggressive on that specific transaction.
Related to monitoring, smaller middle-market companies tend to be subject to higher levels of collateral monitoring and control. Oftentimes the liquidity of smaller borrowers is tighter than larger companies who may have an asset-based working capital facility that is largely undrawn. Also, the systems and books and records of the smaller companies are generally not as sophisticated as for larger businesses and this usually results in the need for dominion of cash and more frequent field exams and appraisals.
ABL Advisor: The term enterprise risk management can be defined by different parameters depending on the lending institution. How do you define it and how do you manage enterprise risk management at AloStar Business Credit? In other words, what’s the scope and what are the “hot spots” given AloStar’s definition?
Eichenlaub: Enterprise Risk Management (ERM) to us is a formal approach to the challenge of understanding and dealing with the risks that endanger our institution as a whole. The basic purpose of any ERM framework is to prioritize risks and define mitigation strategies. Also, it should be more strategic and forward looking, while most loan reviews and internal audit processes are based on historical data.
In the past, most lenders focused primarily on credit and operational risks. As a regulated institution, we look at enterprise risk management in part from the bank regulator perspective. In addition to credit and operational risk, regulators focus on interest rate, liquidity, market, compliance, strategic, and reputation risk. In discussions with regulators and other banks, compliance risks will be getting much more focus this year and going forward. As the non-performing asset problems at most banks have lessened over the last couple of years and balance sheets are in better shapes, compliance risks have moved up the priority scale significantly. You are seeing some very large fines levied against certain institutions for Bank Secrecy Act and Anti-Money Laundering violations. With more external risks due to regulatory changes from Dodd Frank, Basel III, and Consumer Financial Protection Bureau coming down the road, I don’t look for this to change any time in the near future and will likely only increase.
ABL Advisor: How closely do you watch the economic data on both a regional and sector-by-sector level? Is that an integral part of what you do?
Eichenlaub: Our asset-based lending business is national in scope so we do pay close attention to what is happening nationally, regionally, and by industry sector. As a generalist lender, we have portfolio accounts in a broad range of industries.
When underwriting new transactions, we spend significant time analyzing both the company and the industry in which it competes. What are the industry trends? What will be the impact of another downturn in the industry on our borrower? We also spend a lot of time on the question of how am I going to get out of the deal if things don’t go right? What is my first, and second, way out of the credit? What is my downside? How do we quantify it? The good news is that given the recentness of the last downturn, we have relevant data points on how the borrower and industry will perform in a downturn. The further we get into a recovery, the more we as lenders tend to lose sight of those data points however.
ABL Advisor: In today’s economic environment, are you are noticing any emerging trends that require a more creative approach to underwriting?
Eichenlaub: The one area that we have found that requires a more creative approach to underwriting is around add-backs to EBITDA. A lot have companies made hard decisions during the recent economic downturn to improve their cost structures through layoffs, facility closures, productivity enhancements, etc. The decrease is overhead expenses is starting to show in improved financial performance for a lot of companies and resulting in stronger debt service coverages. The challenge is to make sure you are convinced the changes you are giving credit for are permanent changes to the cost structure are not giving credit to the improved financial performance for items that are more revenue related that are at risk of going away when we have the next downturn and revenue declines.
ABL Advisor: We’ve heard a great deal with regard to the need of building a healthy credit and sales culture within a lending institution. In a recent article on our sister site, Equipment Finance Advisor, one senior credit manager advocates strongly for a top down approach in creating such a culture. Do you agree to the premises of this article? If so, how do you go about creating that culture?
Eichenlaub: I agree that you need to have a healthy credit and sales culture. There is a natural tension between sales and credit in any lending organization. The business development side is correct in the view that if you are not making new loans and getting money out the door, you aren’t going to grow the income statement. The credit side is also correct in the view that you don’t make money by the making of loans; you make money by getting all of your principal back at some point in the future. Credit losses will kill you. Both perspectives are valid and the source of potential conflict between sales and credit that needs to be managed.
Any successful lending organization has found a way to manage this tension and I do think it comes from the top. It starts with defining risk parameters and how much risk you are willing to take as an organization. The sales side needs to be able to accurately represent in the marketplace the credit appetite of the institution and types of deals that they can get done. It is very unproductive and frustrating for both sales and underwriting to be spending time on deals that will ultimately not be approved. The art is to have a credit box that is thoroughly understood by both sales and credit, but not to have such rigid parameters that you are missing otherwise good opportunities where the overall strength of the transaction makes up for a shortcoming or exception to policy in a specific area.
At the end of the day, it’s all about balance. Credit guys don’t get paid for saying no and need to find a way to do business as opposed to finding reasons not to. On the flip side, sometimes in the heat of a competitive battle for a particular transaction we need to maintain discipline and just step away. Longer term success in the lending business does not rely on the approval of any single transaction.
ABL Advisor: As we begin the new year, is there anything that’s top of mind for you personally as a chief credit officer that might surprise our readers who aren’t on the credit side or your peers at other institutions? What do you think is top of mind for them aside from the obvious concerns?
Eichenlaub: Top of mind for me and I would guess for a lot of credit peers at other organizations is how we are going to meet aggressive growth targets and new business budgets without stretching on credit. I think 2013 will be a very competitive year to book assets for all C&I lending, including asset based. There is a huge amount of liquidity looking for a home and it feels like deal flow is getting off to somewhat of a slow start.
In any credit cycle, pricing is the first thing to give way and we have clearly seen lower pricing in the ABL marketplace over the last couple of years. So far, credit parameters don’t seem to have changed much in the asset-based market, at least relative to the larger cash flow financing market. My big concern is that although the asset-based industry has a terrific track record of low losses even through down cycles as the result of maintaining lending discipline, in 2013 we start to see underwriting standards loosening up appreciably as we all look to make aggressive new business budgets.
The other thing that we are starting to focus on more is the impact of higher interest rates. I think we have all been somewhat lulled into thinking rates are going to be low forever. Given a lot of asset-based loans no longer have LIBOR floors, these borrowers will feel the effect of increases in rates earlier compared to cash flow borrowers who may be subject to a 100 to 150 basis point floor. If you run interest rate sensitivities for borrowers that have drawn facilities and project rates to increase a couple hundred basis points over the next 18-24 months, a lot of asset-based deals get much tighter on debt service coverage ratios.