Recently, media has increasingly reported of challenges experienced by small and medium enterprises (SME) to secure bank loans.
Banks put the blame on increased capital demands and the macro economic climate. Irrespective of the underlying cause, access to borrowing for SMEs have lessened and the cost of debt increased during the last quarters.
Support schemes exist for venture companies. Larger corporations have access to financing from bond and stock markets, in addition to bank lending. Companies in between have more restricted availability of capital.
In order to improve the likelihood of a positive outcome on loan applications it is important to structure an organized application process. This will improve the odds of securing the necessary capital resources to facilitate for the company’s operational and investment plans.
Norwegian lending market
We will here focus on debt financing for enterprises in the form of bank lending. The lending market for private persons and enterprises in Norway today is centred around four large banks which control ~55% of total lending.
At the end of 2018 loans from financial undertakings amounted to NOK 5 079bn and total domestic bonds outstanding were NOK 1 971bn. Only a few, large issuers dominate the bond market.
Capital demands and regulation
In 2011 the Basel committee put forth revised capital- and liquidity standards, Basel III. CRD IV is the EU Commission’s adaption of this framework. The intention behind the tightening the revisions entailed is to secure a more robust financial sector on the back of the credit crunch of 2008-09. Amongst other factors, this is achieved through elevated demands for equity to be put aside to fund the bank’s lending. Particularly lending to enterprises has seen increased demands.
In addition to increased capital demands, the macro economic climate has considerably worsened. The resulting effect of these issues is the reduced availability of capital, which has had media focus as of late.
Fintech and crowdfunding
The Fintech market is a relatively new phenomenon in Scandinavia. In Europe on the other hand this market gathered 1.5 bn dollars of funding during 2015. This market place has then grown by more than 150% p.a. the last years.
The British company Funding Circle has seen an enormous growth in its lending volumes. During the first half of 2015, it lent out more than 200 million pounds, growing from the 2012 level by more than 1,100 %, as seen in Figure 1.
This market is not yet active in Norway. In the meantime, SMEs are at the benevolence of getting funding from the banks. Thus, it is important for management to know what to focus on when approaching these to secure necessary funding.
What is important for the banks?
Bank lending discussions can arise from various circumstances. For example in connection with new ventures, acquisition financing, restructurings, and renegotiations, etc.
Independent of the cause it is vital for the loan applicant to understand that credit assessments have a different focus from those of equity investments. This is because the lender’s potential return is capped. Hence, risk assessments become relatively more important. From the bank’s perspective, the total capital cash flow is there with the sole purpose of servicing debt and not for distribution to equity holders.
Figure 2 portrays some factors affecting the lender’s perception of credit risk in any lending arrangement. In addition to this, lending margins, loan size and duration are of importance in determining how attractive a prospective loan is.
Loan applications over a certain size, both for new endeavours and in renegotiations, will typically need approval by bank’s credit committees. It is important not to underestimate the banks’ informational need in this process, especially not in refinancing situations. It is not so that all decision makers know the company’s background and circumstances in detail. Preparing a detailed information package will lay the ground for an easier credit approval process.
Debt servicing capacity
Primarily banks will assess the cash flow outlook of the loan applicant. Will the business be able to honour their interest and amortization payments as they fall due? Large and stable cash flows allow for faster redemption and thus lower credit risk.
The business plan must clarify the enterprise’s EBITDA outlook, and be founded on relevant market analysis. In addition to this, it should spell out working capital and investment needs.
Pledges & guarantees
By pledging assets or posting guarantees, the loan applicant can reduce the credit risk exposure absorbed by the bank. Pledges can tie to real estate, company assets, invoices, shares, etc. Guarantees can be cross guarantees from companies within the same group, from physical persons or other companies.
Covenants, information undertakings & other restrictions
Strict covenants, in combination with broad and frequent reporting duties can likewise act as risk reducing measures. Whilst this allows the bank to more rapidly, take charge in lending situations that turn bad.
Other restrictions to the company’s manoeuvrability can yield similar effects. Typically, these can involve «Cash sweeps» or limitations on investments. It is commonplace with restrictions on Mergers & Acquisitions, since such transactions can put the immediate debt servicing capacity of the borrower at risk, at least temporarily.
The bank’s aim is to ensure that there are no major changes made to the underlying business model that they first set out to fund, without credit approval. In some instances, loan agreements can be quite comprehensive and will often demand elaborate legal opinions.
What can the loan applicant do?
The formal loan application is only a part of the grounds for decision-making for the bank. Confidence in management is key. It is therefore vital that management is present throughout the application process.
The terms and conditions, which the bank put forward, is subject to negotiation. For negotiation purposes, it might make sense to replace or modify any of the discussed elements with others to achieve more appropriate borrowing conditions. This could be to achieve lower lending margins, larger size loans, higher duration, greater flexibility, etc.
Large loan processes have similarities with divestiture processes of companies to external investors. In the same fashion as these it may also here be appropriate to draw up a “vendor due diligence ” report presenting the company’s strategy, business plan and debt servicing capacity.
“credit assessments have a different focus from those of equity investments ”
Highlight debt-servicing capacity
Information presented to the bank in the loan application should give a presentation of management. Complementary to this an analysis of prevailing and outlook for market and the competitive situation will be of interest to the lender. Presentation material should high light existing order books and any existing long-term contracts. Customer dependencies or lock-in periods will similarly contribute to increase the robustness of earnings projections.
Complete business plan with long-term budgets and any associated “Key Performance Indicators ” are central. Including, underlying assumptions for price and cost outlook.
Investment needs going forward is of particular relevance to the bank. It might be sensible to separate the investment plan into two tranches, maintenance and new investments. Wherein the former says something about investment needs in order to maintain the prevailing EBITDA-level. The latter, new investments, is typically undertaken to achieve long-term growth. This will be of minor importance to credit suppliers relative to equity holders. The latter group would have long-term dividend potential as their main objective.
The submitted business plan will be subject to covenants. How strict they will be, and how demanding the information undertakings will be, depends on how the banks perceive the credit risk.
This article was written to offer some thoughts and suggestions that may be relevant for companies discussing financing alternatives with their banking partner. How the individual factors weigh, and whether there are other more important considerations to focus on, will depend on the specific case.
Mimir Consulting has experience from financing negotiations, and other financing matters, from both very large as well as smaller.
We work closely with management to ensure that we have sufficient information about the company and its industry.
When all significant issues are mapped, management leads the process towards the bank, whilst we can assist as sparring partner where appropriate.
We aid companies with:
Mapping out the company’s market situation, market analysis, etc
Prepare business plans and model debt servicing capacity
Prepare presentations, build «storyline», assessment of strategy and business model
Assist in negotiations