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One Deal Can Seriously Impair Your Portfolio -- Understanding Collateral

Date: Aug 18, 2015 @ 07:00 AM
Filed Under: Asset Management

The abundance of competition in the lending world is well known. Asset-based lenders are competing aggressively for a limited number of deals. Commercial lenders are building asset-based structures with a lower level of due diligence. In light of growing competition for deals, the urgency to cut costs and close loans increases. In response to this competitive landscape, we have seen more and more lenders omit the requirement for initial inventory appraisals or reduce the required number of collateral monitoring engagements after an initial inventory appraisal is completed.

Rather than actually being engaged for an appraisal, we are often asked general questions about how well a particular industry is performing in the market. The problem with this approach is that poor performing outliers exist within high performing industries. In fact, we often see poorly managed companies faltering despite their bustling industry or companies laden with obsolete products after being outpaced by competitors.

As the economy has strengthened in the United States, risks of lending on inventory may seem limited. However, those risks still exist and without appropriate scrutiny and understanding of your collateral options, one deal can seriously impair your portfolio. Outlined here are several reasons why inventory appraisals are critical to understanding your collateral and ultimately ensuring that you are making the best possible lending decisions.

Collateral Mix Changes

Inventory provides a lender with an ever-changing collateral base. Inventory mix changes constantly and what was hot a year ago may simply be scrap today. We regularly see businesses that initially appear to be in good shape with sales and inventory levels staying consistently in balance overall. The problem lies much deeper, however, as sales may be driven by a small number of items that are rarely in stock. Meanwhile, the rest of the finished goods may sit on the shelves collecting dust. Simply examining financial metrics from forty thousand feet may give you the impression that you have sufficient collateral, but in the event of liquidation you could be well underwater.

For example, when dealing with apparel you can see the mix in sizes change rapidly, and without close monitoring this inventory might become seriously unbalanced with a bias towards smalls and double extra-large. Recovery values diminish substantially when you lose the standard sizes that customer’s desire. Changes in color mix can also negatively affect value. When the appraiser did his initial inspection and analysis, the tee shirts may have been mostly the more desirable white and black colors, but three months later the inventory could be made up of orange and green tee shirts that do not have the same rate of sell through. During times of company distress sub-par purchasing choices are frequently made to save cash while staying in stock, resulting in an even further disconnect between what the market desires and what the company has on hand. The sizes and colors that are easily sold with limited discounts may be sold during a period of decline and by the time the lender realizes a problem exists with the company the inventory might be seriously out of balance.

The same thing can happen with commodity raw materials as inventory quantities diminish. The plastic resin market may be robust, but trying to sell an opened 25 kilogram bag can be difficult and require more discounting than an untapped rail car or unopened bag of the same resin product. It is often assumed that metal goods are a basic commodity and therefore have easy channels of sale; but quite often the size, cut or grade can be very specific leaving a limited number of buyers outside of scrap dealers.

Inventory Age vs. Usage

Most ABL lenders send out field exam teams to help establish a borrowing base. One of the first things that is done during the field exam process is that inventory age is determined and all items over one or two years old are excluded from eligibility. This methodology makes sense as a good first step, particularly when evaluating food or other inventory with a shelf life.

However, age is rarely the most critical piece of information when determining the recovery value in a liquidation. The most telling piece of information for inventory is always going to be product usage. If your appraiser has the ability to do analysis at an item and category level, looking deeply into weeks of supply, you will get a much better understanding of the inventory. The weeks of supply analysis delivers the most realistic picture of how an advisor or liquidator will be able to move the product in a wind down scenario. If the company data does not allow for this level of analysis, the appraisal should be read with additional scrutiny in mind.

Oftentimes we encounter CEOs and CFOs filled with enthusiasm about their great new product. They believe that it will sell like hotcakes once it hits the market, but what they fail to realize is that their product may not achieve its anticipated market penetration. The company may have stocked up for the wave of sales they were anticipating. But what happens if the wave does not materialize or it takes longer than expected? The risk for the lender lies not just in the old product, but also the new -- making the inventory appraisal a key tool in the lender’s underwriting process.

Markets Change

Market conditions change constantly. We completed an orderly liquidation of oil field service components related to “traditional” well finishing in early 2015. The recoveries were very low for two main reasons. Just three months prior to the sale when oil prices were nearly $30 more a barrel than when the liquidation was completed, it is believed that the sale values would not have been so depressed. Additionally, this product did not service the horizontal (fracking) drilling process, but instead the vertical which has taken a significant back seat in the United States in the last three years. Therefore, two very significant market changes -- one being more macro in nature -- had a serious impact on recovery values. Values change constantly, particularly in markets driven by commodity prices. Therefore, collateral monitoring is critical to ensure a sufficient understanding of its current collateral position.

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