Thursday, April 2, 2009

We're All Cash Flow Lenders Now

Loans to non-investment grade and middle-market companies are typically secured by the borrower’s receivables, inventory, and fixed assets. Pledging this collateral, however, does not reduce the borrower’s likelihood of default. Security should reduce the loan’s loss given default, but not necessarily in the way you expect. Here’s how.

How Are Loans Repaid?
Banks that make secured loans do not expect to foreclose on the collateral to repay the loans. Loans are typically repaid from cash flow from operations or by refinancing with new debt. Foreclosing on collateral is a last resort. Some lenders, such as those that provide asset based loans, equipment finance, or mortgages, are expert in disposing of foreclosed assets, but most banks are ill-prepared to seize assets and sell them.

So Why Take Collateral?
Most secured lenders to bankrupt large corporate and middle-market companies never take possession of their collateral. Instead, the companies are reorganized or sold using the bankruptcy system (e.g. Chapter 11 or Chapter 7 in the U.S.). Proceeds from the bankruptcy, either cash or new securities, are then distributed to creditors. Secured creditors have a higher priority when these proceeds are distributed, giving them lower losses than unsecured creditors.

Does Collateral Mean the Loan Will Be Repaid?
Unfortunately not. Even if the value of the collateral exceeds the amount of the loan when it is made, it is likely that the value of the pledged assets will be substantially lower when the borrower is in financial distress. After all, an asset is only worth what someone will pay for it, and, as we’ve seen, many assets decline in value in a recession.

What’s the Lesson?
As a lender, by all means take collateral when you can get it - just don’t rely on the collateral as your primary (or even secondary) source of repayment. Instead, analyze the company’s ability to generate cash flow to repay its debt. Remember, taking collateral doesn’t mean the company or its assets will retain their values. Unless you are an asset based lender, the biggest benefit you get from collateral is that it moves you to the front of the line in a bankruptcy.


Chris Janc said...

The main reason a cash flow lender wants a perfected lien on the assets is i) to prevent the granting of such a lien to another party and ii) to ensure the usability of the asset in the event he has to take over the business. Cash flow lenders always view second way out as the sale of the business as a going concern (as opposed to the liquidation of the business, as might be the case with an asset based lender). If the lender has to take over the business, he needs to know that he will be able to take everything that is integral to running the business. In the hundreds of cash flow loans I have done, I never did one without collateral.

Ron Carleton said...

For large-corporate loans to investment grade companies, the market standard is that all debt is unsecured. To Chris's point, most loans have a "negative pledge" covenant saying that the borrower can't pledge assets to anyone else. Then, if the company starts getting into trouble, the bank lenders can get some collateral (usually in exchange for waiving covenant defaults).

Think it Through said...

I ran across a blog that read and commented on your blog. You guys might fin it interesing.

Think it Through said...

Sorry, hit the pblish too soon. It is

SO there you go.

Peter Webb said...

What is the priority of repayment in a liquidation scenario in the US?

Ron Carleton said...

In a liquidation (in almost all countries), secured creditors are paid from the proceeds of their collateral. If the secured creditor's claim is greater than the value of the collateral (i.e. they are undersecured), their deficiency claim becomes a general unsecured claim and gets paid (along with all the other unsecured claims) from proceeds of the sale of the debtor's unpledged assets, if any.

So taking collateral gives the lender priority over other creditors, but only to the extent the collateral has value. For this reason, many lenders get a blanket lien on all of the borrower's assets - this way, they get paid before any other creditors (except for certain classes of creditors that are granted statutory seniority, like mechanics liens and some payroll and tax claims).

Peter Webb said...

Thanks Ron. So what are your thoughts on Chrysler and the controversy around the UAW getting some priority over secured creditors?

Ron Carleton said...

Well, under the bankruptcy code, you can't "cram down" on secured creditors (i.e. force them to accept a deal for less than the value of the collateral). So the bankruptcy judge couldn't force them to take the deal, but the Treasury Department could. Note that the few holdouts among the secured creditors were institutional investors who hadn't taken TARP money. These holdouts will be forced to take the deal because they will get outvoted by the other creditors in their class.

tom said...

Very relevant topic and good discussion! To get a feel for value of a lender's security, I can say that 5-10% of asset book value is a realistic number. I recently analysed a US Automotive supplier with fixed assets of $600m on its balance sheet whereby expected proceeds from fire sale is $40-50m. These are 2009 figures and show that investors in secured High Yield loans are in for a surprise if they expect to foreclose on their collateral. And that might even me worse for other industries. Many large cable operators in Europe for example have justified their extortionate leverage levels to investors with the fact that they own the actual cable infrastructure in their countries. we are talking millions of miles of copper cable or fiber optics. This wsa used as collateral for billions of high yield loans. But in case of a foreclosure, who is going to buy anything for these cables which are dug into the ground? So in a climate like the current, any secured lender trying to foreclose on its collateral can realistically write-off most of its money. The better option is of course to consent to a restructuring and swap debt for equity, which is I believe the best option in many cases.

Arthur James said...

There was recently a great article in the FT on distressed debt investors and how they decide on which tranches of debt to buy in order to benefit from debt for equity swaps.