The Law of Unintended Consequences

 

Nearly all of us have heard the term “unintended consequences”, but we often do not have the temperament or sufficient experience to avoid them.

We certainly saw examples of that this month where the unintended consequences led to not only an attack on the United States capitol, but also leading to federal criminal charges, significant losses of political contribution and loss of business for certain organizations.

In 2018, in the publication The Library of Economics and Liberty, Robert Norton wrote, “The law of unintended consequences, often cited, but rarely defined, is that actions of people, and especially of government, always have effects that are unanticipated or unintended.”

 

IN THE PAST FEW WEEKS …

We have seen in recent weeks, just a few of the unintended consequences of the activity related to the attack on the US capitol:

The second impeachment of the President
• The loss by the Trump Corporation of contracts with New York City of contracts generating $17 million per year.
• The loss of most, if not all, banking relations of the Trump Corporation
• Hundreds of Federal charges and potential charges related to the mob at the Capital
• Job losses for participants ranging from blue collar jobs to attorneys and college professors. Politicians have lost book contracts and large campaign donations.
• Loss of access to social media platforms.
• A move to disbar the former Mayor of New York and another prominent attorney, accompany by significant lawsuits.

 

THIS DOESN’T INVOLVE ME …

But, you say, what does that have to do with me? Particularly if you manage a mid-size business, not at all connected with these larger political issues. However, in the article quoted above, the same type of thinking that led to these unintended consequences in government, also affects business in numerous ways.

When the unintended consequence of a decision is favorable, there is never an issue. The favorable outcome is usually considered a bonus. But when the unintended consequence is adverse, depending on the impact, the decision process is questioned as is the individual who made the decision.

In the article, Norton focused on the causes of unintended consequences, three of these which are in the control of the decision maker. These are ignorance, error, and immediacy of interest.

In both ignorance and error, leaders make decisions on issues without considering the unintended consequences, or before needed information is obtained. These are decisions that are not well thought out nor operationalized.

 

HOW WILL COMPETITORS RESPOND?

Consider a company in which the management of a business unit presented their plan to enter a new market without any consideration of the unintended consequence of a competitive response and how it would impact the company’s market entry.

A question to ask: Is the market growing at a sufficient rate to absorb a new supplier without a competitive response? Will competitors respond by price cutting, or in a different way?

What differentiates this new product in the marketplace to limit a competitive response? Why would customers switch buying from their incumbent supplier and decide to buy from the company?

How competitors might respond to a new market entry is unknown. A leader will often need to make a decision, but the information desired to make a fully informed decision is not available.

Before making that decision, effective leaders listen to the opinions of their experts and they fall back on their own experience, common sense, and good critical judgment.

This is how they de-risk a decision and minimize the chance of unintended consequences.

 

THE CHALLENGER DISASTER …

Immediacy of interest describes the type of decision where “someone wants the intended consequence of an action so much that he purposefully chooses to ignore any unintended effects,” to the peril of the decision maker and the organization.

NASA’s decision to launch the space shuttle Challenger on Jan. 28, 1986 against the advice of the Thiokol engineers is an example of a decision driven by immediacy of interest. NASA had promised Congress a too aggressive and unrealistic launch frequency.

The pressure to meet this schedule resulted in a catastrophic decision to launch the Challenger in adverse temperature conditions, well below the ambient temperature for which the solid rocket booster O-rings were designed.

Upon hearing Thiokol’s recommendation to delay the launch due to risks to the astronauts and the shuttle, one of the NASA officials stated, “I am appalled by your recommendation.”

Another NASA official stated, “My God, Thiokol, when do you want me to launch – next April?” NASA launched Challenger, and shortly after the launch the O-rings failed, resulting in an explosion and the catastrophic deaths of seven astronauts and loss of the shuttle.

 

WHAT CAUSES SUCH DECISIONS?

What is the cause of immediacy of interest type decisions? Certainly, hubris is one cause. Dictionary.com defines hubris as “excessive pride or self-confidence, arrogance. Arrogant leaders are rarely if ever successful over the long term.

Another cause of immediacy of interest decisions is the pressure to act, which in and of itself is a way of achieving results. However, at what risk and at what cost?

How many times do we read in the press about unethical or illegal acts that were committed due to the pressure to get something done? These situations eventually almost always become public, adversely impacting the reputations of the individuals and organizations involved.

The reputations of organizations may recover over time. Those of the individuals never do.

 

HOW TO AVOID SUCH DISASTERS …

How can you avoid immediacy of interest decisions.

Surround yourself with people who will tell you what they think, not what you believe you want to hear.

Have experts that both have the expertise to advise, but do not have the same vested interest in the decision.

They know more about the unintended consequences than you do.

And remember, what you do reflects not only on you, but on your organization and your colleagues as well.

Revitalization Partners specializes in improving the operational and financial results of companies and providing hands-on expertise in virtually every circumstance, with a focus on small and mid-market organizations. Whether your requirement is Interim Management, a Business Assessment, Revitalization and Reengineering or Receivership/Bankruptcy Support, we focus on giving you the best resolution in the fastest time with the highest possible return.

Time Is Running Out

 

There is growing evidence of a soon-to-be reported spike in the number of non-performing loans in lender portfolios, and time is running out to take the difficult but necessary measures to mitigate their risk.

The question isn’t whether or not that intervention will or won’t be required, it’s when it will be.

Since the beginning of the COVID-19 crisis, the Federal Reserve has taken swift action to provide a number of tools to help banks cope with this anticipated increase in non-performing loans.

 

DEFERRED PAYMENT PROGRAMS …

One of the most sweeping programs, which was aimed at helping small- to medium-sized businesses early in the COVID crisis, was the deferred payment program. If borrowers could not make monthly loan payments, lenders were allowed to initially defer those obligations for a three-month period. The deferral period ultimately could be extended to six months or longer based on the lender’s discretion.

While the program was responsible for saving thousands of businesses in the short term, its continuation has created significantly increased exposure for participating lenders. According to an American Banker article from August, as borrowers struggled with the effects of the first few months of the COVID-19 pandemic, the amount of deferred loans at Bank of America, Citigroup, JPMorgan Chase and Wells Fargo exceeded $150 million.

 

RELIEF PROGRAMS NOT ENOUGH …

Further, the same banks set aside more than $32 billion for loan losses in the second quarter of this year, which indicates they have a high degree of uncertainty about the length of the pandemic and the resulting economic crisis.

The towering number of deferred loan payments, combined with the near record level of increased loan loss reserves in a single quarter, signal that relief programs may not be enough to deal with the tsunami that is forming.

Domestic banks’ concerns over the threat was initially revealed in a survey taken in May by the Federal Reserve Bank of Dallas.

Findings showed that 83% of financial institutions expected an increase in non-performing loans within six months while 27% reported an increase in non-performing loans during the preceding six weeks.

Data from their recent November 2020 survey confirmed those threats by reporting an alarming increase in current and future nonperforming loans.

 

THESE COLLECTIVE FEARS …

The continued concern related to the projected increase in nonperforming loans is based in part on a heightened sense of uncertainty around the political landscape, the second wave of COVID-19 outbreaks and economic downturn, and federal spending.

These collective fears are heightened by the number of businesses that may not have the financial or operational expertise to rapidly respond to swift declines in revenue.

While many companies have taken immediate steps to downsize their business and generate positive cash flow, there are also many operators, particularly in the lower middle market, that do not have the management skills or experience in dealing with dramatic business downturns.

 

COMMERCIAL LENDERS SHOULD BE …

Because of the magnitude of troubled credits, commercial lenders should be extra vigilant and not wait for loan deferral programs to end before taking action to mitigate loan write-downs. All lenders have tools to continually evaluate and score the creditworthiness of their commercial borrowers.

However, there is a risk that the usual warning signs raised by these methods will be somewhat neutralized or minimized by the availability of the current loan deferral programs.

While actions may be taken to exit or foreclose on the worst of the worst loans in a lender’s deferred payment program, this represents a small fraction of the loans.

The majority of businesses in the portfolio, however, will likely continue to operate, and if appropriate action to mitigate cash flow losses is not taken, they will reach a point of no return.

At that juncture, they will never be able to repay the loan in full and the lender will be faced with writing off a portion – if not the entire loan – as a loss.

 

QUARTERLY FINANCIAL REPORTING …

Most commercial credit loans require at least quarterly financial statement reporting along with covenant testing.

As a condition to approve a deferred loan, lenders should require increased financial reporting, including monthly profit and loss and balance sheet, 13- week cash flow projections in addition to monthly documentation describing where a business stands against cash flow forecasts.

Revitalization Partners specializes in improving the operational and financial results of companies and providing hands-on expertise in virtually every circumstance, with a focus on small and mid-market organizations. Whether your requirement is Interim Management, a Business Assessment, Revitalization and Reengineering or Receivership/Bankruptcy Support, we focus on giving you the best resolution in the fastest time with the highest possible return.

Happy Holidays


During a wacky and challenging year, we’ve all had to adjust to our ways of working, communicating and staying in touch.

As always, we’ve appreciated your readership and comments on our blog throughout the year.

All of us at Revitalization Partners hope that you and yours are staying safe and healthy. We’re looking forward to 2021 to see how all of you successfully blend the old and new normal. We’ll be resuming our blog after the new year.

Happy Holidays!!

Revitalization Partners specializes in improving the operational and financial results of companies and providing hands-on expertise in virtually every circumstance, with a focus on small and mid-market organizations. Whether your requirement is Interim Management, a Business Assessment, Revitalization and Reengineering or Receivership/Bankruptcy Support, we focus on giving you the best resolution in the fastest time with the highest possible return.

An Approach to Business Litigation

 

We’ve all been following the incredible number of lawsuits that have been filed in conjunction with the last election.

And in listening to the plaintiffs and their attorneys, we’re not nearly finished. But remember, for each plaintiff and attorney, there is a defendant and another attorney or set of attorneys.

And while you’re unlikely to make the press with a lawsuit related to your business, the financial cost and emotional stress can take a toll on any entrepreneur or company executive.

 

IN THIS POLITICAL CLIMATE …

In this political climate, it is difficult to get everyone to agree on anything. We do not think we would get objection, however, to describing the legal environment for many businesses as somewhere between challenging and hostile. And a large and growing part of that environment, unfortunately, is the complex civil suit.

Complex actions are on the rise everywhere. Fair Labor Standards Act class action filings, for example, keep breaking records every year, not in a good way. Plaintiffs’ counsel have become more aggressive as they see their brethren make exorbitant fees in class action settlements on some cases with – to be kind ? questionable merit.

And if a Plaintiff’s attorney can turn what would have been a single civil lawsuit into a class action instead, why not? Prosecution of the modern class action, at least to settlement, does not require much if any more resources than some “standard” lawsuits. Despite some effort by the United States Supreme Court, there has been no slowing this trend.

 

A BIGGER TARGET …

Some businesses are more of a target for some actions. For instance, the relatively high number of independent contractors in the transportation industry makes those companies a target for employee reclassification class-actions, regardless of the facts in any particular case.

But any executive in a mid-sized company or larger should expect a near “bet the business” type lawsuit at some point in his or her career, be it based in contract, consumer protection, employment law, or a myriad of other state and federal private actions.

We understand some companies feel their contracts, policies and people are invulnerable to legal critique. Our experience is, where there is a willing plaintiff’s attorney, there is a way. The way to deal with this is get way ahead of it, and the time to start doing that is before any complaint is filed or served.

The one bright spot in this piece: there are a few preliminary, straightforward and relatively inexpensive steps you can take.

 

TAKE THESE SIMPLE STEPS …

First, just like you would with a bank, build a relationship with litigation counsel before you have an immediate need. You can do this through your corporate attorney or business advisor, but make sure it is someone with the ability to handle the probable worst-case scenario.

Even before a filing, litigation counsel can help you place, develop and refine processes for routing, handling and responding to a new lawsuit, combating the impact on operations, and the smooth collection, review and production of business records – one of the most expensive parts of any litigation. Plus, it is just a confidence builder to have the number of someone you know you can call if there’s trouble.

Second, start budgeting annually for some defense costs. And if you do not end up using that reserve, carry it over. No one relishes the idea of standing up in an executive meeting and projecting attorney’s fees up on the screen, associated with some as of yet undefined litigation.

But dealing with any significant lawsuit gets immeasurably harder if you are at the same time trying to “find” the initial defense costs somewhere. And no matter how much insurance coverage you buy, there will still be breaks in coverage or coverage disputes.

Finally, discuss with your management team what general approach the company would take to threatened litigation, assuming it is without merit. This may sound less important or productive. It is not. The day a big lawsuit is filed against the company is not the day to find out you disagree with your Chief Financial Officer on whether to pursue early settlement.

 

“GOING TO THE MAT” …

Some businesses have the resources, attitude, and risk tolerance for going to the mat, so to speak. Some do not.

Neither company is good or bad, but it is important to know the one you have.

Of course, counsel should be present for any meeting to clarify and protect confidentiality.

 

DON’T UNDERESTIMATE THE …

Do not underestimate the power and confidence that comes from foresight, planning, and smooth execution.

There is utility in correctly anticipating a bad situation and knowing exactly who to call and how to respond.

That is why we have fire drills. Otherwise, people would just run around in a panic not knowing what to do, which by the way, is the worst environment for litigation.

And if you’re not sure what attorney to call or how to approach them, feel free to give us, at Revitalization Partners, a call. (206) 903-1855

We’ve worked with many attorneys and companies on both sides of legal disputes.

 

Revitalization Partners specializes in improving the operational and financial results of companies and providing hands-on expertise in virtually every circumstance, with a focus on small and mid-market organizations. Whether your requirement is Interim Management, a Business Assessment, Revitalization and Reengineering or Receivership/Bankruptcy Support, we focus on giving you the best resolution in the fastest time with the highest possible return.

Where is the Liquidity During the Pandemic?

 

Despite the fact that there appears to be substantial debt and investment money available, small business loan approval percentages from large banks dropped from 13.5% in September to 13.3% in October while small banks approved 18.4% of funding requests, down .1% from September.

These changes highlight the challenges of small business owners searching for capital during the pandemic. “Securing small business funding remains challenging at the moment.” states Rohit Arora, CEO of Biz2Credit.

Many business owners are refraining from applying for credit because they are unsure if their “forgivable” PPP loans are going to be forgiven. This is a time of great uncertainty for companies from sole proprietors to firms with millions in gross sales. Many companies are struggling to just hang on and are likely to go under if they don’t receive a financial lifeline to survive until the pandemic ends.

 

SMALL BIZ OWNERS ARE …

The US Bureau of Labor Statistics report of early November found that non-farm payroll employment rose by 638,000 in October dropping the unemployment rate to 6.9%.

Despite these figures, small business owners are still very worried. Many states are considering new restrictions due to the cresting wave of Covid 19 creating a state of limbo for all sized companies.

Despite the declining rates of loan approval in banking, two categories of lenders rose slightly: Institutional lenders approved 22.2 percent of loans in September with alternative lenders approved 23.3% of loans in the same month.

For these lenders, loan activity is starting to come back. Since banks have been more cautious, borrowers looked to other sources. Since institutional lenders and alternative lenders are seeking yields, they are willing to continue to provide funding in these uncertain times.

 

PRIVATE LENDING THRIVES IN …

Private money lending has always thrived during economic downturns. While the coronavirus pandemic and its widespread economic effects are historically unprecedented, tightening standards and restricted liquidity in the conventional lending space are not new. During cycles when conventional lending opportunities contract, private lending expands, as borrowers and investors alike look for new options.

It is important to note, however, that private debt is not fully immune to the damage caused by the severe economic impact of COVID-19. In the last couple of months, a number of private debt funds and capital providers either temporarily or permanently shuttered their operations due to a freeze of their capital sources, poor underwriting practices, and/or non-performing loans, resulting from a coronavirus-related forbearance or default.

For those that are fortunate to be actively lending today in the private debt environment, the landscape is riddled with market delays, stemming from rate renegotiations, expanded due diligence, short- term extensions on maturing debt, re-underwriting loans, and arbitraging greater spreads for investors. In addition, since private money – perhaps wrongfully so – tends to be the choice of last resort, there is the continual shopping for cheaper debt from traditional lenders.

Despite those unavoidable delays, most purchases and refinancing’s currently in the market require the execution speed that only private lending can deliver- agility that is proving quite beneficial.

For example, there are a significant number of cash-out transactions, as some borrowers seek to inoculate their operating businesses with cash infusions to get them through the current economic hurdle.

 

SHOPPING SPREE OPPORTUNITIES …

Some borrowers are looking at this time to expand their financial coffers in anticipation of ready-made, perhaps even unprecedented, shopping spree opportunities of distressed, but quality, real estate and other assets.

Other borrowers may be preparing for what they believe could be a slow reopening and reintegration process, or another wave of reinfection and more closures in the coming fall or winter seasons.

Private lenders are approaching the new market challenges in new and different ways. Some private lenders are pressing the pause button to focus on managing their existing portfolios and negotiating workouts on any non-performing loans.

 

TODAY’S NEW NORMAL INCLUDES …

Others are actively transacting, but they are implementing modifications to their existing guidelines. Today’s “new normal” in commercial loans and real estate lending may include all or a combination of the following:

• Price increases
• Reduced loan-to-value thresholds
• Removal of vulnerable property types, such as retail and hospitality from their pipelines
• Reduced or eliminated subordinate financing
• Requiring or increasing interest reserves
• Applying full recourse in instances where non-recourse was the normal

 

MOVING FORWARD …

Prudent private lenders aren’t standing by to see what happens.

They are adjusting their valuation methodologies and underwriting standards to ensure that there is ample equity coverage to account for the new economic, political and societal stresses on collateral.

With the inertia-busting agility of private capital along with the guidance of trusted advisors, investors and lenders can continue to move forward and thrive, even in the midst of a global pandemic.

 

Revitalization Partners specializes in improving the operational and financial results of companies and providing hands-on expertise in virtually every circumstance, with a focus on small and mid-market organizations. Whether your requirement is Interim Management, a Business Assessment, Revitalization and Reengineering or Receivership/Bankruptcy Support, we focus on giving you the best resolution in the fastest time with the highest possible return.

How Credit Insurance Impacts Liquidity

 

Our appreciation to the Calibre Group, a Pittsburgh, PA private equity group providing advisory services and direct investment, specializing in manufacturing and metals, for providing much of the information in this blog.

As we all know, companies have been hit hard by the economic downturn caused by the global health pandemic and subsequent nationwide shutdowns.

During this downturn there has been a lot of focus on weak demand and labor issues. But one issue that deems to have gotten less focus is trade credit insurance or lack thereof.

Many companies directly and indirectly rely on trade credit insurance to support operations. It is an insurance product that is vital in helping buyers and sellers conduct transactions in a smooth and efficient manner. Without trade credit insurance, the flow of goods between buyers and sellers could be restricted by a lack of confidence and liquidity.

 

ACCESS TO LIQUIDITY …

As the prices of goods continue to rise, the access to liquidity becomes more important for companies. The increase in prices combined with poor financial results during the pandemic, will lead banks to become more wary in extending credit to their borrowers.

As such, banks are going to be more focused on the collateral value of the borrowers.

For companies that have struggled during the pandemic, banks may be inclined to require inventory appraisals. And the banks may lean on appraisal companies to find reasons to recommend lowering advance rates. One way to do this is appraisers estimating longer liquidation times due to real sales volumes.

This means higher liquidation costs and net liquidation values. In order to accommodate the reduction in net orderly liquidation value as a percentage of cost, lenders will lower inventory advance rates.

 

AS ADVANCE RATES GET LOWERED …

As inventory advance rates get lowered, it will be critical for companies to continue to receive high advance rates on their accounts receivable, while also being able to extract longer terms on their accounts payable.

In many cases, AR advance rates and terms on AP are driven in part by trade credit insurance.

Banks will provide higher advance rates on insured receivables. Likewise, if a vendor can get higher advance rates, they will be more lightly to provide extended payment terms.

However, what we are hearing from contacts at banks and insurance brokers, is that in this time of need, trade credit insurers have declined to issue new policies or have tightened coverage significantly. Some insurers that are offering coverage are reducing coverage limits.

 

SENIOR LENDERS GET NERVOUS …

In times of turbulence and uncertainty, senior lenders tend to get nervous. When they get nervous, they almost immediately focus on downside protection. This typically results in increasing blockers/reserves and finding reasons to lower implied advance rates. Lower implied advance rates come in two forms: (i) lower advance rate percentage, and (ii) changes to “eligible” collateral.

With regard to accounts receivable, banks traditionally have standard definitions of what constitutes an ineligible receivable. These are typically receivables from offshore customers, contras/receivables subject to set-offs, cross-aged, significantly past due, and concentration.

Occasionally banks may also restrict advance rates on customers with deemed credit risk. However, in some cases borrowers can get their banks to advance on certain “ineligible” receivables if they have credit insurance (effectively converting ineligible collateral to eligible collateral). Additionally, there are many instances where uninsured receivables may get an 80-85% advance rate, while insured receivables may get a 90% advance rate. Depending on the premium cost of the insurance, this can be attractive to certain companies.

 

TRADE CREDIT INSURANCE DRYING-UP …

With trade credit insurance drying up, there are many companies, particularly those with high customer concentration or international customer and/or vendor exposure that may see their liquidity evaporate in the near-term. A company that typically carries $10 million of receivables, of which 25% are insured, could see its borrowing base decline by between $250 thousand and $2.25 million. In normal circumstances this would be problematic, but it is exacerbated when liquidity is already weak, inventory advance rates are being reduced, and prices are on the rise.

In addition to lower implied AR advance rates, the lack of trade credit insurance is also detrimental on the purchasing side. Just like you are concerned about your customers, your suppliers are concerned about you. If you are normally able to get 60-day terms from your material vendors, you may find those being reduced to 30 days in the absence of their ability to get insurance on you. A company that makes $50 million of material purchases per annum, would see its liquidity reduced by $4.1 million in that scenario.

 

IMPERATIVE TO MAINTAIN …

As a company owner or executive, it will be imperative to maintain excess liquidity given the uncertain times, and the potential reduction in advance rates from inventory appraisals and lack of trade credit insurance, coupled with a need to increase inventory purchases.

For opportunistic companies with ample liquidity, the next few months may present an opportunity to acquire competitors that run into liquidity issues or acquire assets from companies that need the capital to survive a liquidity squeeze.

 

CONTINUING TIGHTENING …

Lastly, we do not believe banks have fully countenanced the impact of the pandemic on their performance. There have been prohibitions on residential real estate foreclosures and landlords have not been allowed to evict delinquent tenants.

Building owners have foregone rental payments across all sectors including retail while the work from home initiative stands to leave swaths of commercial office space barren.

Banks anxiety to control loss is likely increasing, with continuing tightening of liquidity requirements.

 

Revitalization Partners specializes in improving the operational and financial results of companies and providing hands-on expertise in virtually every circumstance, with a focus on small and mid-market organizations. Whether your requirement is Interim Management, a Business Assessment, Revitalization and Reengineering or Receivership/Bankruptcy Support, we focus on giving you the best resolution in the fastest time with the highest possible return.