Commercial Loans
General
Loans to business enterprises for commercial or industrial purposes, whether proprietorships, partnerships or corporations, are commonly described as commercial loans. In asset distribution, commercial or business loans frequently comprise one of the most important assets of a bank. They may be secured or unsecured and have short or long-term maturities. Such loans include working capital advances, term loans and loans to individuals for business purposes.
Short-term working capital and seasonal loans provide temporary capital in excess of normal needs. They are used to finance seasonal requirements and are repaid at the end of the cycle by converting inventory and accounts receivable into cash. Such loans may be unsecured; however, many working capital loans are advanced with accounts receivable and/or inventory as collateral. Firms engaged in manufacturing, distribution, retailing and service-oriented businesses use short-term working capital loans.
Term business loans have assumed increasing importance. Such loans normally are granted for the purpose of acquiring capital assets, such as plant and equipment. Term loans may involve a greater Risk than do short-term advances, because of the length of time the credit is outstanding. Because of the potential for greater risk, term loans are usually secured and generally require regular amortization. Loan agreements on such credits may contain restrictive covenants during the life of the loan. In some instances, term loans may be used as a means of liquidating, over a period of time, the accumulated and unpaid balance of credits originally advanced for seasonal needs. While such loans may reflect a borrower's past operational problems, they may well prove to be the most viable means of salvaging a problem situation and effecting orderly debt collection.
At a minimum, commercial lending policies should address acquisition of credit information, such as property, operating and cash flow statements; factors that might determine the need for collateral acquisition; acceptable collateral margins; perfecting liens on collateral; lending terms, and charge-offs.
Accounts Receivable Financing
Accounts receivable financing is a specialized area of commercial lending in which borrowers assign their interests in accounts receivable to the lender as collateral. Typical characteristics of accounts receivable borrowers are those businesses that are growing rapidly and need year-round financing in amounts too large to justify unsecured credit, those that are nonseasonal and need year-round financing because working capital and profits are insufficient to permit periodic cleanups, those whose working capital is inadequate for the volume of sales and type of operation, and those whose previous unsecured borrowings are no longer warranted because of various credit factors.
Several advantages of accounts receivable financing from the borrower's viewpoint are: it is an efficient way to finance an expanding operation because borrowing capacity expands as sales increase; it permits the borrower to take advantage of purchase discounts because the company receives immediate cash on its sales and is able to pay trade creditors on a satisfactory basis; it insures a revolving, expanding line of credit; and actual interest paid may be no more than that for a fixed amount unsecured loan.
Advantages from the bank's viewpoint are: it generates a relatively high yield loan, new business, and a depository relationship; permits continuing banking relationships with long-standing customers whose financial conditions no longer warrant unsecured credit; and minimizes potential loss when the loan is geared to a percentage of the accounts receivable collateral. Although accounts receivable loans are collateralized, it is important to analyze the borrower's financial statements. Even if the collateral is of good quality and in excess of the loan, the borrower must demonstrate financial progress. Full repayment through collateral liquidation is normally a solution of last resort.
Banks use two basic methods to make accounts receivable advances. First, blanket assignment, wherein the borrower periodically informs the bank of the amount of receivables outstanding on its books. Based on this information, the bank advances the agreed percentage of the outstanding receivables. The receivables are usually pledged on a non-notification basis and payments on receivables are made directly to the borrower who then remits them to the bank. The bank applies all or a portion of such funds to the borrower's loan. Second, ledgering the accounts, wherein the lender receives duplicate copies of the invoices together with the shipping documents and/or delivery receipts. Upon receipt of satisfactory information, the bank advances the agreed percentage of the outstanding receivables. The receivables are usually pledged on a notification basis. Under this method, the bank maintains complete control of the funds paid on all accounts pledged by requiring the borrower's customer to remit directly to the bank.
In the area of accounts receivable financing, a bank's lending policy should address at least the acquisition of credit information such as property, operating and cash flow statements. It should also address maintenance of an accounts receivable loan agreement that establishes a percentage advance against acceptable receivables, a maximum dollar amount due from any one account debtor, financial strength of debtor accounts, insurance that "acceptable receivables" are defined in light of the turnover of receivables pledged, aging of accounts receivable, and concentrations of debtor accounts.
Risk Management Framework
Given the high risk profile of leveraged transactions, financial institutions engaged in leveraged lending should adopt a risk management framework that has an intensive and frequent review and monitoring process. The framework should have as its foundation written risk objectives, risk acceptance criteria, and risk controls. A lack of robust risk management processes and controls at a financial institution with significant leveraged lending activities could contribute to supervisory findings that the financial institution is engaged in unsafe-and-unsound banking practices.
General Policy Expectations
A financial institution’s credit policies and procedures for leveraged lending should address the following:
• Identification of the financial institution’s risk appetite including clearly defined amounts of leveraged lending that the institution is willing to underwrite (for example, pipeline limits) and is willing to retain (for example, transaction and aggregate hold levels). The institution’s designated risk appetite should be supported by an analysis of the potential effect on earnings, capital, liquidity, and other risks that result from these positions, and should be approved by its board of directors;
• A limit framework that includes limits or guidelines for single obligors and transactions, aggregate hold
portfolio, aggregate pipeline exposure, and industry and geographic concentrations. The limit framework should identify the related management approval authorities and exception tracking provisions. In addition to notional pipeline limits, the agencies expect that financial institutions with significant leveraged transactions will implement underwriting limit frameworks that assess stress losses, flex terms, economic capital usage, and earnings at risk or that otherwise provide a more nuanced view of potential risk;
• Procedures for ensuring the risks of leveraged lending activities are appropriately reflected in an institution’s allowance for loan and lease losses (ALLL) and capital adequacy analyses;
• Credit and underwriting approval authorities, including the procedures for approving and documenting changes to approved transaction structures and terms;
• Guidelines for appropriate oversight by senior management, including adequate and timely reporting to the board of directors;
• Expected risk-adjusted returns for leveraged transactions;
• Minimum underwriting standards (see “Underwriting Standards” section below); and,
• Effective underwriting practices for primary loan origination and secondary loan acquisition
Participations Purchased
Financial institutions purchasing participations and assignments in leveraged lending transactions should make a thorough, independent evaluation of the transaction and the risks involved before committing any funds. They should apply the same standards of prudence, credit assessment and approval criteria, and in-house limits that would be employed if the purchasing organization were originating the loan. At a minimum, policies should include requirements for:
• Obtaining and independently analyzing full credit information both before the participation is purchased and on a timely basis thereafter;
• Obtaining from the lead lender copies of all executed and proposed loan documents, legal opinions, title insurance policies, Uniform Commercial Code (UCC) searches, and other relevant documents;
• Carefully monitoring the borrower’s performance throughout the life of the loan; and,
• Establishing appropriate risk management guidelines as described in this document.
Underwriting Standards
A financial institution’s underwriting standards should be clear, written and measurable, and should accurately reflect the institution’s risk appetite for leveraged lending transactions.a financial institution should have clear underwriting limits regarding leveraged transactions, including the size that the institution will arrange both individually and in the aggregate for distribution. the originating institution should be mindful of reputational risks associated with poorly underwritten transactions, as these risks may find their way into a wide variety of investment instruments and exacerbate systemic risks within the general economy at a minimum an institution’s underwriting standards should consider the following:
• Whether the business premise for each transaction is sound and the borrower’s capital structure is sustainable regardless of whether the transaction is underwritten for the institution’s own portfolio or with the intent to distribute.
• A borrower’s capacity to repay and ability to de-lever to a sustainable level over a reasonable period.
• Expectations for the depth and breadth of due diligence on leveraged transactions.
• Standards for evaluating expected risk-adjusted returns.
• The degree of reliance on enterprise value and other intangible assets for loan repayment, along with acceptable valuation methodologies, and guidelines for the frequency of periodic reviews of those values;
• Expectations for the degree of support provided by the sponsor (if any), taking into consideration the sponsor’s financial capacity, the extent of its capital contribution at inception, and other motivating factors.
• Whether credit agreement terms allow for the material dilution, sale, or exchange of collateral or cash flow-producing assets without lender approval;
• Credit agreement covenant protections, including financial performance (such as debt-to-cash flow, interest coverage, or fixed charge coverage), reporting requirements, and compliance monitoring.
• Collateral requirements in credit agreements that specify acceptable collateral and risk-appropriate measures and controls, including acceptable collateral types, loan-to-value guidelines, and appropriate collateral valuation methodologies. Standards for asset-based loans that are part of the entire debt structure also should outline expectations for the use of collateral controls (for example, inspections, independent valuations, and payment lockbox), other types of collateral and account maintenance agreements, and periodic reporting requirements; and, Whether loan agreements provide for distribution of ongoing financial and other relevant credit information to all participants and investors.
Credit Analysis
Effective underwriting and management of leveraged lending risk is highly dependent on the quality of analysis employed during the approval process as well as ongoing monitoring. at a minimum analysis of leveraged lending transactions should ensure that:
• Cash flow analyses do not rely on overly optimistic or unsubstantiated projections of sales, margins, and merger and acquisition synergies,
• Liquidity analyses include performance metrics appropriate for the borrower’s industry, predictability of the borrower’s cash flow, measurement of the borrower’s operating cash needs and ability to meet debt maturities,
• Projections exhibit an adequate margin for unanticipated merger-related integration costs,
• Projections are stress tested for one or two downside scenarios, including a covenant breach,
• Transactions are reviewed at least quarterly to determine variance from plan, the related risk implications, and the accuracy of risk ratings and accrual status,
• Enterprise and collateral valuations are independently derived or validated outside of the origination function, are timely, and consider potential value erosion ,
• Collateral liquidation and asset sale estimates are based on current market conditions and trends,
• Potential collateral shortfalls are identified and factored into risk rating and accrual decisions,
• Contingency plans anticipate changing conditions in debt or equity markets when exposures rely on refinancing or the issuance of new equity, and
• The borrower is adequately protected from interest rate and foreign exchange risk.
Valuation Standards
Institutions often rely on enterprise value and other intangibles when (1) evaluating the feasibility of a loan request, (2) determining the debt reduction potential of planned asset sales, (3) assessing a borrower’s ability to access the capital markets, and, (4) estimating the strength of a secondary source of repayment. institutions may also view enterprise value as a useful benchmark for assessing a sponsor’s economic incentive to provide financial support. given the specialized knowledge needed for the development of a credible enterprise valuation and the importance of enterprise valuations in the underwriting and ongoing risk assessment processes, enterprise valuations should be performed by qualified persons independent of an institution’s origination function.
There are several methods used for valuing businesses. the most common valuation methods are assets, income, and market. asset valuation methods consider an enterprise’s underlying assets in terms of its net going-concern or liquidation value. income valuation methods consider an enterprise’s ongoing cash flows or earnings and apply appropriate capitalization or discounting techniques.market valuation methods derive value multiples from comparable company data or sales transactions.however, final value estimates should be based on the method or methods that give supportable and credible results. In many cases, the income method is generally considered the most reliable.
There are two common approaches employed when using the income method. The “capitalized cash flow” method determines the value of a company as the present value of all future cash flows the business can generate in perpetuity. an appropriate cash flow is determined and then divided by a risk-adjusted capitalization rate, most commonly the weighted average cost of capital. this method is most appropriate when cash flows are predictable and stable. the “discounted cash flow” method is a multiple-period valuation model that converts a future series of cash flows into current value by discounting those cash flows at a rate of return (referred to as the “discount rate”) that reflects the risk inherent therein. This method is most appropriate when future cash flows are cyclical or variable over time. Both income methods involve numerous assumptions, and therefore, supporting documentation should fully explain the evaluator’s reasoning and conclusions.
When a borrower is experiencing a financial downturn or facing adverse market conditions, a lender should reflect those adverse conditions in its assumptions for key variables such as cash flow, earnings, and sales multiples when assessing enterprise value as a potential source of repayment. changes in the value of a borrower’s assets should be tested under a range of stress scenarios, including business conditions more adverse than the base case scenario. stress tests of enterprise values and their underlying assumptions should be conducted and documented at origination of the transaction and periodically thereafter, incorporating the actual performance of the borrower and any adjustments to projections. The institution should perform its own discounted cash flow analysis to validate the enterprise value implied by proxy measures such as multiples of cash flow, earnings, or sales.
Enterprise value estimates derived from even the most rigorous procedures are imprecise and ultimately may not be realized.therefore, institutions relying on enterprise value or illiquid and hard-to-value collateral should have policies that provide for appropriate loan-to-value ratios, discount rates, and collateral margins. Based on the nature of an institution’s leveraged lending activities, the institution should establish limits for the proportion of individual transactions and the total portfolio that are supported by enterprise value. regardless of the methodology used, the assumptions underlying enterprise-value estimates should be clearly documented, well supported, and understood by the institution’s appropriate decision-makers and risk oversight units.further,an institution’s valuation methods should be appropriate for the borrower’s industry and condition.
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Risk Rating Leveraged Loans
The risk rating of leveraged loans involves the use of realistic repayment assumptions to determine a borrower’s ability to de-lever to a sustainable level within a reasonable period of time.for example, supervisors commonly assume that the ability to fully amortize senior secured debt or the ability to repay at least 50 percent of total debt over a five-to-seven year period provides evidence of adequate repayment capacity.if the projected capacity to pay down debt from cash flow is nominal with refinancing the only viable option, the credit will usually be adversely rated even if it has been recently underwritten. In cases when leveraged loan transactions have no reasonable or realistic prospects to de-lever, a substandard rating is likely.furthermore, when assessing debt service capacity, extensions and restructures should be scrutinized to ensure that the institution is not merely masking repayment capacity problems by extending or restructuring the loan.
If the primary source of repayment becomes inadequate, it would generally be inappropriate for an institution to consider enterprise value as a secondary source of repayment unless that value is well supported. Evidence of well-supported value may include binding purchase and sale agreements with qualified third parties or thorough asset valuations that fully consider the effect of the borrower’s distressed circumstances and potential changes in business and market conditions.for such borrowers, when a portion of the loan may not be protected by pledged assets or a well-supported enterprise value, examiners generally will rate that portion doubtful or loss and place the loan on nonaccrual status. In addition, institutions need to ensure that the risks in leveraged lending activities are fully incorporated in the all and capital adequacy analysis.for allowance
purposes, leverage exposures should be taken into account either through analysis of the expected losses from the discrete portfolio or as part of an overall analysis of the portfolio utilizing the institution's internal risk grades or other factors. At the transaction level, exposures heavily reliant on enterprise value as a secondary source of repayment should be scrutinized to determine the need for and adequacy of specific allocations.
