Navigating Wall Street After the Meltdown
In seeking capital main street middle market company CEOs will need to “think like a lender” in their fight to get access. Here’s how
March 12 2010 by Robert F. Mancuso
Main Street America’s relationship with Wall Street ended with the financial crisis, and while certain financial institutions over the past year have recovered and even prospered, Main Street America has not.Â In many ways, and for many reasons, the relationship that existed as recently as two years ago cannot return to the way it was.
The old relationship
So what happened?Â Instead of providing the economically productive service of allocating capital to companies that deserved it (and withholding it from those that did not), Wall Street provided capital indiscriminately.Â Years will pass before Main Street begins to view Wall Street as its ally.Â In its wake, CEOs of small and middle-market companies have been left stranded, with seemingly little recourse to replace the access to capital that Wall Street provided.Â As a new Wall Street emerges, it is imperative that the CEOs and management teams of Main Street businesses realize that perhaps for the first time in decades all forms of capital have become scarce and will likely remain so for years.Â Equity capital was historically the most difficult to secure and the most expensive.Â However, in today’s new Wall Street, what had been the most abundant type of capital – that provided by banks – has become just as difficult to obtain.Â Since that capital is the means by which companies pay their bills and purchase their raw materials, an inability to borrow such short-term capital has dire consequences, particularly for growth and middle-market companies.Â The CEOs of these companies need to fight for capital.Â In short, they need to learn how to “think like a lender.”Â The transformation to thinking like a lender starts with taking clear, concrete steps in four critical areas.
1)Â Reassess your capital structure.
Small and middle-market companies are the backbone of America but the tailbone of the lending community.Â In good times, banks view these businesses as more risky than comparably-sized big-cap, publicly traded companies.Â Why?Â Financial opacity.Â Particularly among small and family-owned businesses, financial statements are not always audited, and so “reviewed” statements are often questioned as unreliable.Â As a result, banks demand additional collateral or security, which typically means a personal guarantee of a portion of the loan by major shareholders.Â That guarantee is often enhanced by the creation of an account set up at the bank which consists of cash or readily marketable securities owned by the shareholders but pledged to the bank, which the bank can access if there is a default. All this collateral is in addition to the typical security interest the bank takes in all the company’s inventory and receivables.
In normal times banks view small companies as manageable risks.Â In bad times, when credit is tight, banks will do just about anything they can to back away from lending to these companies.Â If they renew an existing line of credit, it will be on much more restrictive terms – shortening the maturity, reducing advance rates, demanding that a higher percent of the loan be supported by additional personal guarantees, increasing the interest rate charges, and even demanding a co-lender.Â These terms are quite common for family-held companies, especially those still managed by the founder.
I am currently working with a family-held specialty retailer located in the Northeast, with approximately $75 million in annual sales.Â The company was founded almost 50 years ago by the current CEO.Â For decades, the CEO managed to avoid borrowing. Â However, a few years ago, in order to finance an expensive store expansion, he borrowed $10 million dollars on terms then considered attractive.Â The recession hit and the new store performed badly, dragging down the entire company’s profitability.Â As a condition to renewing the loan, the owner had to personally guarantee the bank’s entire loan to the company.Â As onerous as that appears, the owner is fortunate the bank even renewed the loan.
Senior management and shareholders of growing businesses need to accept these facts and analyze – and, if necessary, restructure – their capitalization accordingly.Â With the U.S. banking industry in a continuing state of uncertainty, shareholders of these companies should consider tapping alternative sources of capital, such as mezzanine funds and private equity.Â They should consider divesting non-essential assets to increase liquidity and prepaying bank loans with the proceeds of asset sales. They also need to examine all capital expenditures, especially in assets located outside the bank’s reach – for example, foreign subsidiaries, for which the bank gives no credit.Â
Two U.S.-based companies that illustrate these points are practicing what I call “offensive” lending.Â They are going into the long-term capital markets to tap fixed-rate senior debt provided by highly regarded insurance companies rather than relying onÂ the generosity of fickle banks.Â Both of these companies are family-held, each with more than $250 million in sales.Â In both cases, the companies are studying how best to tap the long-term debt market to provide capital for acquisitions even before a purchase has been negotiated.Â This type of forward thinking will be rewarded in the market. With the capital on the balance sheet, the company will be able to negotiate better terms from the seller and not be required to negotiate a deal which is “subject to financing.”
2)Â Invest in good governance
Poor corporate governance, leading to inadequate sharing of information, is a common ailment.Â Both of these characteristics – poor governance and information opacity – are especially prevalent at companies in the earlier stages of the corporate lifecycle.Â Problems that would otherwise seem straightforward can be compounded by not having a well-rounded board of directors.Â If you haven’t already done so, it is imperative that you make your board stronger and more effective by adding outsiders who will consistently question and challenge the CEO’s and the CFO’s decisions.
A privately-held Â textile manufacturer with around $50 million in sales has learned this lesson the hard way.Â The current CEO inherited the business from his father and has never instituted a board of directors.Â Over the past six years, he has become progressively removed from day-to-day affairs, delegating much of the responsibility for running the company to senior managers.Â Recently, it was discovered that an overseas raw materials vendor may have been overcharging the company for goods and that this may have gone on for years.Â Without a board of directors to oversee the company’s activities, the CEO had no one to help him discover the truth or figure out what to do.Â An active and informed board likely would have caught the problem before it became a crisis.
3)Â Apply merit-based standards
Too many businesses continue to promote executives based on relationships rather than purely merit.Â In good times, sub-par performance can be overlooked.Â In bad times or in the current crisis, such practices applied to promotion and CEO succession can’t be tolerated.Â Lenders are under enormous pressure to scale back their commitments to all but the most important and best customers.Â Every decision a borrower makes must be scrutinized from the perspective of the key question, “How will this appear to our bank?” This perspective may be new and even uncomfortable but the approach will serve companies well.Â Even though a bank can’t cross the line and manage the borrower’s business, it can and will carefully consider actions taken by a borrower when determining whether to renew an existing line of credit, for example.Â
Promoting an individual into a key position because of a relationship rather than accomplishment casts doubt on the standards a company applies in building its business. Adopting a higher standard than many other growth-phase or middle-market businesses – that is, approaching the standards for promotion and CEO succession used by public companies – will likely enhance the credit worthiness of a borrower in the eyes of its lender.
4)Â Implement financial transparency
Treating your bankers on a need-to-know basis is unquestionably a fatal error.Â Because old practices die hard, many young businesses view their bank lenders in an almost adversarial light when performance falls short of budget.Â “Tell the bank loan officer as little as you can,” is often the instruction given by the CEO.Â Rather than hide and hope the problem will go away, distinguish yourself by doing the unexpected: share, rather than stonewall.Â The reaction will almost always be an enhanced debtor/creditor relationship.Â
In today’s highly competitive world, a more transparent approach may be a deciding factor in whether a business languishesÂ or flourishes.Â Customers need to know about their suppliers and vice versa.Â Particularly during the current hard economic times every business is facing, withholding information about your financial affairs from key suppliers will only encourage them to suspect the worst.Â That presumption could lead to a tightening of vendor credit, compounding other business problems. Additionally, companies that practice excessive secrecy suffer when problems arise since too few people know how to unlock all the gates that exist between the critical information and a solution.
Management and shareholders of companies who understand how their lenders view them are better prepared to adjust to the changing rules that the current financial crisis has produced.Â By objectively assessing and upgrading your capital structure, adopting best-practices based corporate governance, adhering to merit-based standards for promotion and succession, and fostering consistent financial transparency, shareholders and management of these companies will reduce many of the risks that will materialize in any given business structure.Â As the adage goes, what you don’t know can absolutely hurt you.
Robert F. Mancuso, a 35 year veteran in private equity and capital markets, is founder and managing partner of The Dellacorte Group, a New York-based, middle-market focused merchant bank active in corporate advisory services and private equity.