Bar Bulletin

Bar Bulletin

The Distressed Loan Dilemma: Are We Acting Fast Enough to Mitigate Risk?

December 2022 Bar Bulletin

By Bill Lawrence

A recent survey conducted by SRS Acquiom in late September 2022 reveals that lenders are becoming increasingly concerned about the impact of higher interest rates on their portfolio. The survey included bank and non-bank lenders, investment banks as well as law firms. The research asked participants for their views on the impact of the five interest rate increases made by the Federal Reserve in 2022, as well as perspectives on the economy, lender loan activity and their own portfolios.

Key takeaways from the survey include:

• At least one-third of the respondents indicate that more debt facilities are becoming distressed as a result of interest rate increases;

• The Federal Reserve’s actions have also increased the risk profile of many debt facilities, resulting in nearly 60% of respondents finding it more difficult to assess risk;

• One-third of respondents (33%) indicate that they have some, but not many, credit facilities that require loan restructuring. Almost a quarter (24%) state that some loans in their portfolio require restructuring review; and

• Lenders are exploring a wide array of options with their borrowers to avoid bankruptcy filings, with most (69%) looking at multiple approaches including covenant revisions, more flexibility in payment options, rate adjustments and more

The Bias of Past Performance

While lenders are becoming increasingly concerned about the potential for rising loan losses, it can be argued that many are not acting fast enough to mitigate current risk. The reason: Banks and other asset-based lenders (ABL’s) typically view their borrower’s performance based on past results. While lenders receive borrower’s financial statements on a monthly or quarterly basis, the numbers often do not fully reflect current or — more critically, forecasted — future performance. They are largely a snapshot of what has transpired to date. With the pace and size of the Fed’s interest rate increases, along with the anticipation of additional rate increases to come, there is no question that the negative impacts will only accelerate and put pressure on future earnings.

In order to get a better handle on borrower performance, it is prudent to consider asking for financial projections that not only include the income statement, but also for the balance sheet and cash-flow statements. Some lenders receive annual financial projections at the beginning of each year. However, in the current environment, it’s critical to discuss the borrower’s performance with management on a quarterly basis. Updated projections should also be requested frequently for companies that are starting to show signs of stress. If lenders are not receiving financial projections, it’s time to request them, especially for companies that are showing year over year declines.

The lender’s attorneys can play a valuable role in the risk management process. They are typically involved in creating loan documentation as well as preparing forbearance agreements when borrowers violate their financial covenants. However, attorneys can also suggest that lenders have the right to request financial projections in the initial loan documents. Ultimately, if an attorney is asked to prepare a forbearance agreement, particularly when there is a history of multiple forbearance agreements, they can provide insight into what the lenders might do in the future to mitigate risk if covenant violations continue.

Getting Real About the Road Ahead

Lenders can use these projections to track current performance compared to what the borrower had anticipated and use them as a basis for a frank conversation about what is being done to improve performance. Experienced lenders understand that borrowers tend to put a positive spin on the future regardless of what the numbers suggest. Accordingly, there should be concern when a borrower’s response suggests that business will improve soon. This typically indicates that management is not taking the operational problems seriously enough and it’s important to dig deeper. If the borrower does not provide adequate answers consistently, it may be time to bring in a third-party professional to help assess the situation.

Now is the time for lenders to be more cautious as interest rates increase and the high rate of inflation continues to take its toll on companies. Taking a proactive approach in dealing with potential risk will help mitigate future loan losses and allow the lenders to retain borrowers instead of asking them to find a new lender. 

Bill Lawrence is a Principal at Seattle-based restructuring and corporate advisory firm Revitalization Partners, which has served as a receiver in more than 30 cases in the Pacific Northwest. He and his partners write regularly about the operational and financial challenges in successfully restructuring companies. Learn more in the firm’s blog as well as its e-book, “Insights to Grow, Build or Save Your Business!”

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