There have been some signs and indicators recently that the economy may finally be turning the corner. But many cash-strapped businesses will be unable to take advantage of a possible recovery because they are stuck in a kind of bank purgatory known as the “special assets group.”

Many banks make the mistake of lumping all problem loans that have been assigned to special assets into one big bucket and applying the same plan of action: reduce exposure to the point the bank can liquidate with little or minimal loss. The bank has one goal in mind: grind the debt obligation down, with little or no focus on whether or not there is a viable business model that just may be caught up in a bad set of circumstances.

Broken … and Not Broken

There tend to be two different types of businesses in the special assets group: those that really are broken and will eventually be liquidated, and those that are still viable, but have an inadequate capital structure. With some debt restructuring, these businesses can often be turned around and made successful again.

Businesses in this second category may still be making payments on their loan, but they have landed in special assets because they ran afoul of bank covenants for one reason or another. They might still have a workable business model, solid sales, loyal customers and even positive cash flow and profits.

As cash flow lenders, however, banks may not be able to underwrite financing to these businesses. Banks are primarily focused on the income statement and the cash flow statement, both of which are lagging indicators of future cash flow. Neither do banks have the collateral controls to mitigate the risk involved in commercial and industrial (C&I) lending. As a result, some companies are unable to obtain the appropriate capital structure needed to turn the business around. 

For example, one business owner we worked with funneled profits out of a successful venture to fund growth on a new venture. Unfortunately, he did not discuss this action with his bank. The new venture failed, leaving the successful one with too much debt, which tripped a covenant violation with the bank. So the bank froze its financing and placed it in special assets. Meanwhile, the business had strong sales and purchase orders it couldn’t fill due to a lack of capital.

We were referred to the business and quickly saw its potential for strong growth if its debt and capital were properly restructured. We provided them with a working capital line of credit that was structured so that it could fund future growth, and reworked the term structure to allocate a portion of excess cash flow toward paying down its bank term loan. The result was a true win-win: the business had growth capital without raising equity, and the bank reduced its exposure and has a performing loan.

In another instance, a tool and die manufacturer spent two years in special assets, during which time it was able to shave a $500,000 debt down to just $50,000. Purchase orders for new business were stacking up, but it couldn’t fill them because all of its excess cash was going toward paying down the bank debt. We stepped in and paid off the remaining $50,000 to the bank and provided a working capital line of credit that enabled the $3 million business to fill its orders and keep growing.

Balance Sheet Lending

As balance sheet lenders, rather than cash-flow lenders, asset-based lenders underwrite loans differently than banks do. We look primarily at a business’ ability to generate future sales and receivables, and to management’s ability to navigate the company through the challenging waters of this economy. We examine the business model of a company (both current and future) and ascertain its viability, and then we base our debt capacity on the assets of the business, not its lagging cash flow.

We also have more advanced and stringent controls in place, which can provide for a greater amount of debt than a bank can typically provide for. This is due to our systems and our ability to monitor collateral and work through challenging times with our clients. Together, these components enable asset-based lenders to provide financing solutions to many viable businesses in special assets that banks can’t help.

Given all of this, it wouldn’t be a bad idea for asset-based lenders to talk to local bankers about businesses in their special assets group that still have strong sales and cash flow, but an inadequate capital structure. Then explain to them how as an asset-based lender, you may be able to provide a financing solution that improves the bank’s exposure and gives the business a new lease on life.