The Real Cost of Chapter 11 Bankruptcy

 

During 2020 Chapter 11 business bankruptcy filings were up 29% over 2019.

In the second half of 2021, bankruptcy filings are expected to increase dramatically as the economic impact of Covid -19 becomes clearer and as the various stimulus packages come to an end.

The projected increase in bankruptcies means that both lenders and companies will require a laser focus on two key items: Funding Issues for the process and the End Game, which may involve the sale of the company or a liquidation of its assets.

In August 2019, a group of small creditors made an appeal to the court overseeing the Sears Holdings’ bankruptcy, to reexamine professional fees that were previously allowed by the court. This was a little less than a year after the company filed its Chapter 11 and several months after the remaining stores were bundled and sold to the company’s former CEO.

 

SIMPLY A “CORPORATE HUSK” …

At this point, Sears Holding was simply a corporate husk, a party to litigation and the holder of a massive legal bill. The fees that Sears Holdings owed its lawyers and advisors for the Chapter 11 filing had reached nearly $170 million. Some creditors, which included suppliers, argued that this left Sears Holdings administratively insolvent.

They worried that the company owed more in administrative claims, including both fees to its advisors as well as post-petition payments to vendors, than it could possibly pay. Creditors asked the court to limit how much would be paid to Sears’ hired advisors as a way to balance the interests of lawyers and other advisors with creditors “who may be staring down the barrel” of big financial losses.

 

A HEAVY WIND SPREADING THE FIRE …

If Chapter 11 expenses are a fire, time and complications are like a heavy wind that can spread them out of control.

There is a hard to miss irony to the formidable expenses piled onto a company going through a legal process meant to protect it from financial implosion.

And yet professional fees paid by the company are also a source of profit for others.

Regardless of the size of the company entering a Chapter 11, the costs of the company’s attorneys and advisors are easily exceeded by the cost of attorneys and advisors for the creditors’ committee, any secured lenders and often the company’s executives themselves.

 

EXORBITANT LOAN RATES …

In addition to these expenses, finance providers often charge exorbitant rates for bankruptcy loans that have been proven to be remarkably safe from payment defaults. The combination of all these costs places a heavy burden on the company and significantly impacts its ability to successfully emerge from Chapter 11.

Historically, only 10-12% of Chapter 11 filings are ultimately successful by emerging from Chapter 11 with an approved reorganization.

Not only are companies responsible for the costs for all parties during the Chapter XI process, they are also responsible for their legal and financial costs of preparing to file for bankruptcy paid out prior to file for Chapter XI.

These expenses typically are equal to the costs incurred during the bankruptcy filing, so the total cost is extremely burdensome and frequently makes it impossible to reorganize.

 

PREPLANNING IS CRITICAL …

Given that difficulty in emerging from Chapter 11, preplanning is critical to minimize the costs incurred during the Chapter 11 process. There are a number of almost fatal problems that could occur if proper pre-planning does not take place, prior to the Chapter 11 filing.

For example, if a solid financial plan is not developed the company may not have the finances to continue to operate. The company needs adequate time to make arrangements for debtor in possession (DIP) financing to manage through the entire process, if required.

In addition, the 13-week cash flow plan must be sufficient to allow for a delay of accounts receivable payments as well as anticipating that vendors may stop providing credit and insisting on COD payments for critical supplies.

Secured creditors are often asked to fund operations leading up to a Chapter 11 filing in order to assure the possibility of a going concern offer should a sale be necessary. This is often more comfortable for the debtor, but not so for the lender. Absent a substantial equity cushion, a lengthy sales process that results in the identification of a buyer is not in the favor of the lender unless collateral values are increasing.

 

A BETTER ALTERNATIVE …

While Chapter 11 provides the greatest opportunity for a creditor to maintain control of their company, the odds of a successful outcome are small, and the costs are high. There are other alternatives such as a Sub-Chapter 5 of the bankruptcy code, providing the company meets certain criteria.

Given that a number of Chapter 11 bankruptcies end in a sale of the company or its assets, a better alternative may be to file for a receivership in a state court. In the state of Washington and Oregon.

This is the fastest and most cost-effective method of a sale of the assets of a company or as a going concern. It is less costly as the company only pays for their own professional expenses.

Other parties must pay their own expenses, unlike in the bankruptcy process where the company pays everyone’s expenses.

Prior to making a decision to enter a Chapter 11, a company should retain both an insolvency attorney and a financial advisor to examine all of the alternatives.

As those who have experienced unsuccessful Chapter 11 filings have found, it’s often easy to get in and difficult or impossible to get out.

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.

Why Small Businesses Fail

 

As we’ve learned throughout the pandemic, the small business failure rate has increased dramatically. And yet, even in the most challenging industries such as consumer-related companies, while many have failed others have adapted and even thrived.

Revitalization Partners over the last eighteen years has worked with many distressed companies. As we begin to become involved with a company, one of the first questions we ask the owner or entrepreneur is:

What do you believe happened?

The responses are often very different from the reality that we discover as we get further into our understanding of the company. The observations of the owners are frequently very off point, which makes sense if you think about it.

If the owners knew what they were doing wrong, they might have been able to fix the problems. Often, it’s simply a matter of denial or not knowing what you don’t know. So, let’s look at some of the reasons small businesses fail.

 

THE MATH DOESN’T WORK …

Sometimes the math just doesn’t work. There is not enough demand for the product or service at a price that will produce a profit for the company.

This happened to a lot of companies during the pandemic where the customers could not or would not materialize. Many of these companies are still going, kept alive by PPP loans or other government programs.

But these programs will come to an end and if the company was beginning to see revenue and profit declines pre-pandemic, management has to question the viability of the company when the government aid ends.

 

WHO IS AT FAULT?

Another problem we see are owners that can’t get out of their own way. They may be stubborn, risk averse, or conflict averse – meaning that they need to be liked by everyone.

They can be perfectionist, paranoid, or insecure. But in most cases, the owner tends to blame the bank, government, the idiot partner, anyone but themselves.

Even when we explain the problem, they may even recognize that we’re correct, yet continue to make the same mistakes until the company fails.

 

DON’T KNOW THE NUMBERS …

One of the most common reasons for business failures is poor accounting or computer systems. You simply cannot be in control of a business if you don’t know what’s going on.

With bad numbers, or even worse, no numbers, a company is flying blind. It happens all the time. It is a common and disastrous misconception that an outside accounting firm, hired to do the taxes, will also take responsibility for the financial condition of the company.

In reality, that’s the job of the owner and/or the management of the company. Revitalization Partners recently had a receivership case where the owner did not even know which receivables were due and which had been paid.

Most of the “receivables” that were being used as collateral for a bank loan were non-existent, having been paid long ago.

 

NO CASH CUSHION …

Another reason for a business failure is the lack of a cash cushion. It is often said that “cash is king.”

It’s especially true that business is cyclical, and problems can and will occur. Some of our clients have experienced the loss of a key customer, loss of critical employees, lawsuits, and now a pandemic. If a company is out of cash, or more importantly, maxed out on it credit line borrowing capacity, it may not be able to recover.

We have never met a business owner or entrepreneur who has described their business as mediocre. And yet every business can’t be above average.

This mediocracy often applies to operational inefficiencies and sometimes dysfunctional management. The inefficiencies often include paying too much for rent, labor and materials. Or not having a marketing or sales plan.

We often hear from managers and owners that “If only that next big order will come in” or “if only we could reduce our product cost to X then everything will be fine”. The dysfunctional management team believes that, yet it is not true and has never been true.

 

IT TAKES COURAGE TO ASK FOR …

The saddest reason for business failures is a successful business that is destroyed by its own success and over-expansion.

This includes experiencing growing pains that damage the business, borrowing too much money in an attempt to keep growing at a particular rate, or moving into new markets that are not fully understood and may not be as profitable. It is true that sometimes less really is more.

It is said that it takes courage to ask for help. If you are a business owner or entrepreneur that sees, even the beginning of some of the problems outlined, ask for help early. While you are seeing your own business, those of us in the restructuring business have seen and helped many businesses with similar difficulties. While we can’t speak for everyone in the business, at Revitalization Partners …

… it costs nothing to have a discussion.

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.

The Housing Market and Credit

 

We all know that house prices are increasing while the availability of inventory of houses is shrinking around the country; while at the same time, unemployment remains at a high level with pandemic-related unemployment driving both the economy and political policymaking.

The article below was written by Glen Weinberg of Fairview Commercial Lending, a leading hard money, non-bank lender in residential and commercial investment real estate. Glen can be reached at: info@fairviewlending.com.

10 MILLION AMERICANS …

10 million Americans are behind on their mortgage payments, with the majority of these late payments occurring in FHA loans. At the same time, Millions are out of work, yet house prices are increasing in most markets. What was in the new forbearance agreement? How does a Forbearance impact credit? Why are forbearance agreements the leading driver of increasing house prices?

The White House said that it would extend a ban on home foreclosures for federally backed mortgages through June 30. President Biden had earlier extended the moratorium, which had been set to expire at the end of January, until the end of March in a series of executive actions on his first day in office.

 

BIDEN GIVES EVEN MORE TIME …

The Biden administration also said it would give homeowners more time-through June 30-to enroll in a program to request a pause or a reduction in mortgage payments. The federal Cares Act signed into law last March by former President Donald Trump let borrowers postpone payments on federally backed mortgages for as long as 12 months.

Homeowners will now be able to receive up to six months of additional mortgage payment forbearance, in increments of three months, for those borrowers who entered forbearance before June 30, the White House said. Borrowers who enter into such plans can skip payments if they suffer a pandemic-related hardship but have to make them up later.

In essence, borrowers could refrain from paying a mortgage / making payments for almost two years as the new order allows borrowers up to 6 months of additional forbearance as long as they enter into the agreement before June.

 

WHAT’S FORBEARANCE?

Forbearance is when your mortgage servicer or lender allows you to pause (suspend), or reduce your mortgage payments for a limited period of time while you regain your financial footing. The CARES Act provides many homeowners with the right to have all mortgage payments completely paused for a period of time.

Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, and guidance from federal agencies and the GSEs, there are two protections for homeowners with federally or GSE-backed (Fannie Mae or Freddie Mac) or funded mortgages:

• First, your lender or loan servicer may not foreclose on you until at least June 30, 2021. Specifically, the CARES Act and the guidance from the GSEs, the FHA, the VA, and the USDA, prohibit lenders and servicers from beginning a judicial or non-judicial foreclosure against you, or from finalizing a foreclosure judgment or sale. This protection began on March 18, 2020, and now extends through at least June 30, 2021.

• Second, if you experience financial hardship due to the coronavirus pandemic, you have a right to request and obtain a forbearance for up to 180 days. You also have the right to request and obtain an extension for up to another 180 days (for a total of up to 360 days). You must contact your loan servicer to request this forbearance. There will be no additional fees, penalties or additional interest (beyond scheduled amounts) added to your account. You do not need to submit additional documentation to qualify other than your claim to have a pandemic-related financial hardship.

 

MANY LENDERS OFFER RELIEF

Credit card companies, auto lenders, and other lenders are providing similar relief to their clients via forbearance or modification plans. Over 100 million borrowers are in some type of forbearance on an account. About 10 million borrowers have missed mortgage payments.

The Cares act prohibits lenders from reporting the payments as missed payments and therefore loans put into Forbearance do not affect your credit score. Unfortunately, what is happening in the marketplace is drastically different.

Banks have pulled back sharply on lending to U.S. consumers during the coronavirus crisis. One reason: They can’t tell who is creditworthy anymore. By early April, 33% of banks that responded to the Federal Reserve’s senior loan officer survey said they had increased their minimum credit-score requirements for credit cards over the previous three months, up from 14% in January. Bank respondents tightened lending standards for all consumer-loan categories tracked by the survey.

Furthermore, TransUnion recently began selling data to help lenders determine whether consumers have been affected by the pandemic, including data on people who have received a deferment or other assistance. According to the legislation, a forbearance can’t be used to deny credit to someone, but there are loopholes. For example, a lender in their underwriting might require the last 6 months of paystubs, mortgage statements, etc… and use this information to deny the borrower.

 

NOBODY IS TALKING …

Nobody is publicly talking about it, but a forbearance is a red X mark for lenders and will prohibit, in many cases, any additional advance of credit. For example, a bank is not going to give someone a new home loan if their existing mortgage is in forbearance. This is, in essence, keeping borrower’s stuck in their existing houses because without the ability to get a new loan, why would someone sell their existing house?

10 million houses have essentially been taken off the market as the owners are financially stuck as they cannot get new credit. Furthermore, 106 million borrowers are unable to do anything due to the red mark on their credit from the forbearance. Many of these borrowers might have deferred a credit card payment as opposed to their mortgage so the true number of homes off the market is exponentially greater than 10 million.

This drastically reduces inventory and will keep a large quantity of properties off the market for some time. The reduction in inventory in already tight markets will lead to price increases as demand has stayed relatively constant and supply has been constrained further.

A large number of the loans in Forbearance are FHA loans which are low down payment loans focusing on the first time buyer and lower price points. The majority of defaults will occur in FHA loans as we saw during the last recession. The number one driver of default is equity. The more equity is in a property, regardless of other variables, the less likely the property will go into foreclosure. With very little equity in most FHA loans over the last several years there will be a plethora of defaults.

 

THE NEXT QUESTION IS …

The next question is how many of the borrowers in forbearance will ultimately default? Nobody really knows, but if we assume that 40% end up defaulting (the rate we saw in the last recession on subprime loans like FHA) after the forbearance runs out, this will amount to roughly 4 million houses in foreclosure; to put it in perspective in 2008 3.1 million foreclosure filings were made.

This leads to the next question; how will the market react to the large increase in new inventory? The majority of properties entering foreclosure should be at the lower price points where there is a huge demand for houses as building costs have risen faster than incomes making it almost impossible to drastically increase inventory to meet the demand.

In solid markets like Denver or Atlanta the market should be able to absorb this inventory either through end users or corporate housing companies that buy suburban houses for long term rentals.

Continuing forbearances now for over 18 months is merely delaying the impending problem that 10 million plus are experiencing. There have been fundamental changes in the economy and many sectors are not coming back anytime soon if ever. Unfortunately, the economy is not like a light switch will turn on and miraculously everyone gets current again and is able to make up the missed payments.

There is no doubt there will be millions of foreclosures soon (how soon depends on the moratoriums). The only question that is outstanding is how each market will absorb this inventory and what impact there will be on prices. In most cities there will be little impact, but we suspect there will be many markets that will struggle with the inventory leading to market declines. We will get to see how this unfolds sometime later this year.

 

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.

 

Selling a Small or Mid-Sized Enterprise

 

Experts predict that 2021 will be a year where M&A activity will increase, particularly with privately owned companies and family businesses.

This increase is expected to be fueled by business owners who are looking to monetize their businesses for retirement. One of the key questions they ask Is “What is my business worth”?

 

COMMON VALUATION METHODS …

Depending on the size of the business the most common method is to value them based on a multiple of earnings. There are several ways to look at multiples when valuing a business. And there are also mistakes to avoid in the process of determining what a business is worth.

When we examine a multiple of earnings, which earnings number do we use? For a small business, it is common to use a method called Sellers Discretionary Earnings (SDE).

For larger businesses, most buyers use Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).

For purposes of differentiating both methods, generally the SDE method is used for earnings of $1,000,000 or less.

The SDE method is an effort to identify all owner’s benefits available to the new owner of the business. A similar effort with a larger business is Adjusted EBITDA. Adjusted EBITDA adds back expenses such as owner’s compensation above market, higher rent paid to a facility owned by the business owner, or non-recurring expenses. There are many other adjustments that should be made depending on the circumstances, prior to arriving at the value of the business.

 

IS THE BUSINESS DESIRABLE?

Once you have an idea of the approach to valuation and the multiples used in your industry, it’s time to look at the points that make your business most desirable to a purchaser.

Desirability factors such as a consistent history of growth and profitability, a broad and diverse customer base, multi-year contracts with recurring revenue and proprietary products or technology all contribute to adding to value at the higher end of the multiple range.

 

SOME COMMON MISTAKES …

And yet, even with all of the data available, business owners make drastic mistakes every day when selling their businesses. Some of the common errors made in a business sale are:

1. FAILING TO PLAN: Failing to adequately plan in advance for the sale of a business may significantly impact the valuation. The owner succeeding you needs to be set up for success. This means running the business as if you are going to own it forever and not giving a prospective purchaser the feeling that it’s a quick “I’ve had enough” decision.

2. THE BEST PROMOTER IS: Remember, in the end, you are the best promoter for your business. While a broker or an investment bank may help identify potential purchasers, you are the individual that is in the best position to explain why your business has the unique customer base or proprietary products or technology that will drive the value of the sale.

3. FULLY UNDERSTAND WHAT’S INVOLVED: You need to make sure that you thoroughly understand what is involved in selling a business. The standard process begins with a person or entity that approaches an owner and is interested in purchasing the business. That is typically followed by a confidentiality agreement which leads to informal due diligence to determine the buyer’s level of interest. If the prospective buyer is interested, this usually leads to a letter of intent (LOI). The LOI summarizes the terms of the proposed deal and will include such terms as the purchase price, method of payment, deadlines, exclusivity, and how the business will continue to be run during the process. You will want your attorney and/or advisor to review the LOI carefully to ensure you best interests are represented. Most LOI’s, are non-binding, so it’s important to make sure it does not represent a binding contract without the ability to renegotiate as the process develops.

 

4. CHOOSE WISELY, NOT QUICKLY: There are business brokers for smaller businesses and investment banks for larger ones. Who you get to assist you in the sale is an incredibly important decision. Frequently, inexperienced owners go with the first broker or investment bank they meet just to get the process started. Using the wrong group could delay a sale by pricing a business too high or worse, they could be looking for a fast commission by pricing it too low. Knowing both the proper range of valuation and having confidence in your representative is vital.

 

 

WHAT CAN GO WRONG?

As an example of what can happen if you have the wrong advisors or worse, no advisors, Revitalization Partners is serving as a court appointed receiver for a company that was sold by the long-term owners to two employees. The sale was done as a stock sale and financed by the owners as an unsecured note. In addition, the former owners guaranteed a bank loan and several credit cards on behalf of the company.

As the new owners lacked sufficient business experience and the company was impacted by the pandemic, the company ended up in receivership. The owners became unsecured creditors and were also held liable by the banks and credit card companies for their personal guarantees.

In another case, several owners of a small technology company ended up in a lawsuit amongst themselves. During the process, the owners attempted to sell the company by using an investment bank. Despite the fact that the investment bank assured the judge in the lawsuit that they could sell the company, after a year of effort the company remained unsold due to pricing and contract issues and the company was eventually placed in receivership for a sale.

 

GET EXPERIENCED HELP …

There are many aspects to consider when contemplating either buying or selling a business.

It’s really important to have an experienced independent advisor to help business owners ensure the process is professionally managed and their interests are represented.

Both sellers and buyers with no frame of reference or prior experience are frequently misled, being told what they want to hear rather than the facts.

Some brokers or investment banks make statements supported by a lack of facts.

Be certain that your advisor works for you, not a commission on the sale. Be careful and smart!

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.

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.