The market has seen a steady rise in the number of troubled commercial loans over the last few months. Consequently, companies and their financial officers who previously had minimal experience with loan workouts are faced with varying proposals from their lenders on how to restructure credit facilities and operations. Many companies will go through this process and emerge better disciplined and more focused on their core businesses, while others won’t survive. Whether a company survives and thrives may depend entirely on how well its executives understand the options and strategies available to them.
Once an event of default occurs under a loan facility and the loan-workout process starts, lenders will often take one of the following remedial approaches:
- Do Nothing: This may surprise some companies, but lenders often take a patient wait-and-see approach to troubled credits. After an intensive review of the loan documentation and collateral package, the lender may issue a reservation of rights letter, notifying the company of all of the known events of default and informing the company whether the lender intends to exercise any initial remedies, like imposing a default rate of interest or charging other fees and penalties. In certain loan facilities, this step will also trigger increased reporting requirements. Note that even at this stage, institutional lenders will often have handed the loan package off to an internal restructuring department, which means that company representatives should expect to become acquainted with new bank relationship and credit officers (and possibly lender’s counsel engaged specifically for workout transactions).
- Restructuring and Forbearance Agreements: Forbearance agreements are often a hybrid between the reservation of rights letter and a standard amendment to the loan facility. Under the forbearance agreement, lenders will agree not to exercise certain remedies for a set period of time in exchange for modifications to the loan or the collection of waiver and other fees. These modifications may entail introducing additional collateral or guarantor support, amending loan covenants to increase reporting, adding new financial covenants or requiring the engagement of outside consulting firms. This stage also allows lenders to correct deficiencies in the original loan documentation; a company’s default may motivate lenders to enhance the substance of the “remedies” provisions (for example, ensuring that the facility is cross-collateralized and cross-defaulted with other facilities or the facilities currently extended to affiliated parties). Lenders may also ask principals to provide a capital infusion large enough to give the company the necessary liquidity to resolve its current issues. The goal of the forbearance agreement is to give a company the time it needs to alter performance enough to convince the lender that there is a path to repayment or, alternatively, the time it needs to find a new lender that will refinance the existing loan.
- Alternative Types of Financing: An almost infinite number of loan structures are available to companies. In addition to standard mortgages and revolving lines of credit, companies might consider equipment term loans, cash flow term loans, subordinated loans, mezzanine loans and asset-based lending (ABL) lines of credit, to name a few. Companies with a standard cash flow revolving line of credit may be required to obtain additional or alternative types of financing. One alternative is subordinated debt. This may come from business owners or other non-bank lenders willing to make riskier loans in exchange for higher interest rates and other compensation. Another asset-intensive business option is obtaining a new ABL facility. ABL loans adjust the size of the loan facility periodically to a percentage of the company’s assets, most often accounts receivable and inventory. This provides benefits to both the lender and the company: The lender can control the loan’s balance to what it reasonably thinks it can fully recover in the event of a future bankruptcy or other liquidation while often providing a company with larger availability than a traditional cash-flow deal may offer. ABL loans involve additional reporting requirements, but the benefits of additional liquidity may greatly outweigh the costs of satisfying those requirements. Finally, a lender may be willing to “term out” some existing lines of credit in exchange for a lien on previously excluded collateral (for example, a lien on real property that a revolving loan lender decided to forgo at the original closing). By providing this additional support, the lender may allow the company to repay the outstanding balance over time in exchange for immediately providing additional working capital availability.
- Accelerate and Liquidate: At a certain point, not all businesses can be saved, and a lender’s priority is always loan repayment. The lender and the company will often have worked through at least one of the preceding options before reaching this point. If a lender does not see a viable option for repayment, it will be forced to foreclose on the collateral and/or exercise its rights to collect from the company’s guarantors. Because liquidating and collecting on collateral is costly and time-consuming, lenders will often decide to either sell the loan or the business as a going concern.
It is important to remember that lenders are not necessarily the enemy. Lenders often benefit more from helping a company correct its course and overcome the fundamental issues that led to the events of default rather than simply foreclosing on the collateral and shutting down the business. Companies and finance executives who prioritize working with their lenders may see profound benefits in both the short and long term as a result of the workout. Navigating the initial hurdles of increased reporting and tighter financial covenants may be difficult, but a company’s cooperation and compliance with the redesigned covenants will give the lender greater incentive and visibility into a rehabilitative path forward.
Meet the Authors
Peter Brockmeyer represents commercial banks, investment funds, private equity sponsors, non-bank lenders and public and private corporations in structuring secured and unsecured credit facilities, including acquisition financings, syndicated loans, asset-based loans, real estate-secured transactions, and debtor-in-possession facilities.
Katherine Durr focuses her practice on structuring secured and unsecured financing, including syndicated credit facilities, acquisition financings, and asset-based and real estate loans for commercial banks, investment funds, and public and private companies.