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Pros and Cons of Different Types of Lenders: Which Lender is Best?

Date: Feb 17, 2015 @ 07:00 AM
Filed Under: Turnaround Management

In any case, the asset-based lender focuses on the assets being pledged and is constantly and consistently verifying the existence of those assets. Regular field examinations will be required. These examinations are typically every quarter, and work to verify the assets pledged as collateral – the accounts receivable, inventory and/or equipment of the company. The borrower is responsible for the additional costs of monitoring the collateral and will pay field examination fees to the lender.

The borrower will be required to submit detailed borrowing base certificates on a regular basis. Often the submission schedule is weekly, but the schedule could be monthly or daily. The borrower will need to devote internal resources to the preparation and submission of the borrowing base certificates, and to the required monthly reporting, and the field examinations.

The asset-based lender will generally require dominion over cash in the form of a lock box, cash accounts maintained at the lender, or cash accounts maintained at a mutually agreed upon lender with a third party agreement allowing the lender to sweep cash under certain circumstances.  

The interest rate and fee structure will typically result in a higher annual lending cost.

Recently a company had experienced two years of substantial losses.   Although the company had returned to interim profitability, the traditional lender was concerned because the equity of the company had eroded.   From a “capacity” perspective, the traditional lender felt the profitability and the equity position were unacceptable.   However, the company’s accounts receivable and inventory could be readily verified and showed a strong collateral position for an asset-based lender.   Although the company paid a higher interest rate to the asset based lender, and would be paying collateral audit fees, the asset based lender considered the company to be a very good credit risk and was excited to have the opportunity to build a relationship with the company for the long term.

Using private equity as a lender will provide more flexibility in the structure and account management because these lenders are not regulated in the same way banks are regulated. However, higher returns are required by the investors in the private equity firm.  

This type of lender will accept more risk, and charge higher rates and fees in exchange for the risk profile. This class of lender may also require less monitoring; for example, field exams may not be required or may be required less frequently.

A borrower should expect that this lender will ask for a structure that allows warrants, or an alternative ability to convert to equity if loan conditions are not met.

Private equity firms can differentiate themselves from each other by their experience in specific industries, their experience with specific collateral types, and their experience with different types of structures.  

In another example, a company had been reporting break even performance, but had good prospects for the future. Accounts receivable, inventory and equipment were solid assets, but insufficient to fund the cash needs associated with growth. From the asset-based lender’s perspective, the “capacity” and the “capital” were not strong enough to support the entire debt needs. A private equity firm combined an asset-based line of credit tied to the accounts receivable and inventory with an equipment loan, and then overlaid an eighteen month fully amortizing term loan to fund the additional cash needs. As the company’s sales grew, the collateral base for the line of credit grew and provided a source of repayment of the term debt. The profitability of the company provided the remaining term debt repayment.

Private equity as an investor is a good opportunity for borrowers who are willing to give upside potential to an investor in exchange for the investor’s willingness to accept more risk. As an investor, there will be an expectation of some combination of input on management roles, the ability to place personnel the investor selects in key roles, and/or board seats.  

This investor may be willing to wait longer for a financial recovery. Alternately, this investor could move faster to act on warrants, board seats, etc. if there are performance problems. There may be pressure to “fix and sell” to maximize the investor’s return.

Once example of using private equity as an investor would be in agriculture, when a borrower needs to acquire land to support its operations, but will need a longer loan commitment than a traditional lender would find acceptable, and does not have sufficient accounts receivable and inventory to support the land purchase. In this case the private equity investor saw land as a good long term asset to hold either as collateral, or if necessary, an asset to convert to cash via sale.  

In another example, the private equity investor was interested in funding merger and acquisition activity other lenders would not have considered. In exchange for this funding, the equity investor received two board seats, and was able to serve on the committee that selected the CFO.  

Which Lender is Best for a Company?

There is no one size fits all for borrowers and lenders. Within each of these lender categories you will find lending partners that move closer to the lower and higher risk entities they compete with. Lending works in cycles, with looser credit and tighter credit alternating over time.  The same circumstances private equity as a lender will accept at one point in time, an asset-based lender will be comfortable with at another point.

It is important for a borrower to objectively review its own Capacity, Character and Capital from the perspective of an outsider. And then use that analysis to determine the best group of lenders to pursue. Often that means looking at several lenders in at least two categories to determine the options available – and the risk and reward for both the lender and the borrower – as expressed in the final structure of the lending relationship.

Juanita Schwartzkopf
Managing Director | Focus Management Group
Juanita Schwartzkopf has over 25 years experience in commercial banking, business management, and financial and management consulting. During her career, she has handled projects involving financing strategies, strategic planning, forecasting, cash management, creditor relationships, information management, bankruptcy, crisis management and business plan development.

Schwartzkopf held key operating and management positions in many types of companies, from start-up to mature businesses. Throughout her career, she has worked on improving performance in severely troubled and stable, healthy companies. She has negotiated lending arrangements on behalf of both creditors and debtors.

Schwartzkopf was awarded an M.B.A from the University of Wisconsin and a Bachelor of Arts degree in Accounting from Carthage College. She is a Certified Public Accountant (“CPA”) and Certified Fraud Examiner (“CFE”).
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