Significant disruptions in credit quality have facilitated the need for field examiners to be on alert for situations that are generally not prevalent in a more stable environment.  A borrower and their employees’ lives and livelihood have suffered material impact during the COVID-19 crisis between those forced into unemployment or for those forced to significantly alter the way in which they fulfill their job duties.  Business owners that might never have been considered a credit risk now face the prospect of having to consume current profits to pay off mounting obligations that accrued when their revenue stream dropped to zero.  The retail recovery from this crisis will likely be slow as consumer attitudes will have been significantly altered.  That slow recovery will impact commercial businesses and service companies that serve those outlets as well as energy and infrastructure companies through lower demand.

Field examiners and the commercial lenders have an opportunity to embrace new effective guidance while addressing key areas of concern in this new lending environment. 

An Assessment of “Collateral” Damage Sustained by the Lender

For a field examiner in the post-crisis environment, the need to assess the lender’s current collateral position is vital.  The field examiner should also pay close attention to the level of current activity at a borrower’s location and relay any concerns to the lender.  While analysts will be keenly focused on financial performance and covenant compliance, it is the field examiner’s responsibility to offer a sound evaluation of the quality and performance of what could likely be the lender’s primary means of repayment in a liquidation.  This is true even for credits that were previously deemed “cash flow” borrowers.

With regards to accounts receivable (A/R), extensive testing and analysis should be performed to ascertain the quality of the asset and accuracy of the reporting document.  There is likely to have been deterioration due to trade accounts slowing down payment.  There is also a risk of extensive credit activity as purchases are returned and customer allowances are pushed forward.  Are invoices well supported?  Are cash receipts being posted timely and correctly?  In a time of financial stress, even good people make bad decisions and the easiest method to clean up ineligibles in a formula- driven line of credit is via misapplication of cash receipts. 

A close review of past due accounts with a focus on the critical column is essential.  The field examiner should identify accounts that are newly past due, or larger accounts that might be encroaching on cross aging parameters.  Potential write-offs should be determined not only for the negative earnings impact but also for the dilutive impact in a liquidation.  An analysis to identify concentrations of exposure to industries related to travel, hospitality, those tied directly to the shutdown or of businesses deemed “non-essential” is very important.

The field examiner should analyze A/R turnover and dilution in comparison to prior periods pre-crisis.  A marked deterioration would likely be accompanied with an increased borrowing need.  Increased line utilization in conjunction with a deteriorating collateral matrix could be an early indication that the lender runs the risk of funding heavily into a future overadvance.  Increases in dilution could also indicate that the current structure is no longer aligned with the borrower’s collateral performance.  

For loan facilities where the lender has dominion of funds, a complete review of all non-lender inflows is key to ascertain if a borrower is depositing funds out of trust.  If A/R remittances are being directly received, they should be forwarded to the lender in a timely manner.  They should also not represent a significant percentage of total proceeds or the lender should be notified.  Should a facility be purchased based and not a loan, out-of-trust deposits can be highly damaging as the financer’s only recourse would fall to the customer unless an account debtor was previously notified as to the nature of the transaction.

The propensity for a company to overutilize inventory availability now is high even if their deal was not previously inventory-intensive, as the A/R base deteriorates.  In the absence of a field examination, fraud risk significantly intensifies as inventory is the one borrowing component that can’t easily be reconciled utilizing third-party documentation.  Financial stress can be easily buried in inventory.  It could be that the company recently purchased a large amount of inventory in advance of a project that failed to materialize or was cancelled.  This is a distinct probability for items that are longer lead time and is also a concern given the abrupt nature of the recent business interruption.

These questions should be on every field examiner’s list with regards to inventory.  Is the company managing inventory levels to match post-crisis sales trends?  Are payments timely to critical vendors?  Has there been a marked increase in inventory turnover? Is slow moving inventory increasing since the crisis and how is the company managing this?  If turnover is increasing, is it due to a recent buildup or simply a falloff of sales activity.

For a manufacturer, an analysis of the accuracy of work-in-process is essential to determine if inventory listed as raw materials is in an interim stage of fabrication.  The field examiner should also determine if liquidation value has deteriorated with reductions to input costs that will almost certainly exist as suppliers offer incentives to bolster their own businesses.  Supply chains will inevitably be affected by the crisis.  Is the ability to get goods or required components adversely impacting production and thus sales.

To conclude, the need for a field examiner to understand the increased risks in a deteriorating credit environment is essential.  Vital is an awareness for the increased potential of fraud or reporting manipulation to facilitate a borrower’s short-term liquidity needs.  As previously stated, in periods of financial stress, even good people make bad decisions.

Formal Operating Procedures for “Virtual” Field Examinations

In an environment where continued travel restrictions or social distancing are the norm, what is the lender’s tolerance for a full desktop review?  This largely has to do with internal credit policy or a decision maker’s attitude towards remote examinations.  In situations where remote examinations are permitted, the field examiner and the lending contact need to be educated as to the potential shortcomings of the process.  

In this field examiner’s mind, the most significant shortcoming is the inability to utilize the office environment for clues as to what might really be occurring with the credit.  Simply listening to banter between employees is an excellent source of information as well as an observation of activity at the company.  Is it neat and well maintained?  Is a professional demeanor exhibited?  Are employees disgruntled?

While the mechanics of a remote field examination are essentially the same, a “how to” guide for the examiners should be authored.  Lenders are going to expect the same product to a large extent even if the field examination is remote.  Increased communication and greater understanding on how the field examination is being re-engineered and the limitations will be a critical element to the successful outcome and report delivery.

Inventory transactions present a significant hurdle to a remote field examination.  While cost testing, perpetual breakdowns, location breakdowns and gross margin analysis are relatively simple in a remote environment, performing test counts and analysis on the overall operations and facility conditions are limited.  If the field examiner chooses to do test counting via some manner of video platform, attention should be paid to the randomness and spontaneity of the process which should be dictated by the field examiner.  The field examiner should also include standard test counting checks and balances such as having company participants open random boxes for view.

Fluid and constant communication with the borrower is key to facilitate timeliness. The field examiner’s ability to re-think their process to align with how documentation is being provided is also essential.  Learning to work with what is being given to you when you get it and not sticking to your standard order of procedures is important.

The field examiner should also be mindful that consistent communication with the lender can allay concerns about the remote nature of the field examination.

Performing Triage on the Dying and Dead

As the coronavirus continues to impact businesses all around, it is important for lenders to consider which borrowers will be able to survive the downfall and which ones are probably not going to make it. The lender must assess the borrower’s cash flow and determine to what extent there is ability to pivot to new markets. Key considerations: Is the borrower selling to a few select customers in an industry that may take longer to recover such as transportation, retail and hospitality? Is the borrower able to diversify their customer base so they can look for more profitable opportunities? Communication and ongoing monitoring will be key. The lender should consider having more frequent portfolio meetings with their underwriting team to determine where they stand and what action plans to take in order to prevent any major losses.

For lenders that want to trim their portfolio, they may want to consider having discussions with other nontraditional lenders or finance companies and factoring organizations that are willing to take on more risk. Many of these lenders rely less on cash flow and more on collateral as a form of repayment. The legal team should review loan documentation with respect to collateral access rights, guarantors, signers etc. so the lender can be well prepared for a liquidation-type scenario.

Prop Up Borrowers and Bring Them Back to Health

Bring a borrower back to normalcy will be a challenging task. Due to the greater risk of debtor insolvency, lenders are not afforded the luxury of cherry picking the traditionally safer blue-chip receivables for funding. In such circumstances, the lender may consider applying pre-emptive reserves to specific customers, industries or geographic locations or designating debts owed by those riskier debtors simply as ineligible for funding.  Increasing reporting requirements is key. Borrowers that are expected to recover should provide a forecast and financial plan to determine the probability that they can turn around their business and improve their cash flow situation. If a borrower is in default, the lender may want to require borrowers to reduce or eliminate shareholder distributions and/or salaries for higher paying executives to generate additional cash flow. Lenders should also review any federal government aid that was provided and determine how sufficient this will be in the short run and how much borrowings will be needed as a result.

The Field Examination Scheduling Paradigm

Field examinations are generally considered just that; Field Examinations.  Examiners have always been considered the eyes and ears of the lender.  The new field examination scheduling paradigm in the short run will be somewhat chaotic for managers primarily due to travel restrictions as the “reopening hurdles” defined by the CDC to phase into re-opening vary by state and region across the nation.  Borrowers and physical examiners located across state lines or in and around hot spots will face a number of challenges.

Adhering to a strict criterion by the lender’s field examination scheduler, that the lender must have a field examiner on site just hasn’t been possible in the early stages of the CVD-19 restriction period.  These lenders in particular are challenged with considering engaging a firm to conduct desktop-type examinations whereas prior, a field examiner was physically on-site throughout the field work.  Technologyadvances have made borrowers able to live up to much of the standards, though the scheduling paradigm has to balance time it takes to perform each field examination within the portfolio, as well as the nuances with each credit.  Examiners that are not physically on-site are primarily considered “out of sight, out of mind” and therefore second on the company contact’s list of priorities.  The field examination information flow or drag often plays into the time to completion and this will extend the field examination time regardless of the client’s ability to convert all documentation to soft copy and comply with the remote field examination.  In addition to this delicate balance, the deferred inventory test counts not waived and the scheduling of them will be challenging and therefore must consider the extent to which each jurisdiction, and office within each jurisdiction, is open for business and available to accommodate a field examiner’s physical presence.

Post-Pandemic and the Field Examiner’s “new” Skillset

Lenders may consider committing to an internal team comprised of A/R verification specialists and collateral analysts. These will be crucial roles due to the closer monitoring that may be required due to collateral and financial deterioration.  Constant review of ineligible calculations and a new pivoted focus on trends for accuracy is key here since borrower cash flow will seemingly have tightened. This should also include a bank statement review as the propensity for borrowers to be out of trust is high in this environment especially for dominion of funds (DOF) borrowers.  Advanced review of the BBC submission in terms of cash reporting could be worthwhile rather than just month end cut offs. A borrower can potentially divert a month of collections before the lender knows what is happening.  

The post-pandemic world of asset-based lending may not so much require new skill sets but the re-allocation of existing resources to catch the trending on the front end.  The lender is no longer in a position to just wait for the field examination to expose results.  Lenders now will cope with a high volume of covenant breaches, forbearance, requests, line limit increases and over advances.  Resources additives, so to speak, will need to catch the collateral and financial deteriorations on the front end and act rapidly to address any issues.   The addition of more or astute operational staff to handle these issues and rapidly respond will be imperative.

Post-COVID-19 – Will there be Meaningful
Comparisons of Data

The field examiner should include an evaluation of the borrower’s technological abilities in this process and encourage the necessity of maintaining historical documentation, as many systems do not facilitate the re-creation of such for key lookback components.   This should include a client’s ability to soft-copy and archive account data, maintain support documentation for testing purposes and maintaining reference documents such as loan agreements, landlord waivers, guarantor information, etc. 

The valid comparisons to pre-crisis periods is more a timing issue than technological ability.  Until such time as a standard review period has lapsed, which can be a year or more, comparing current and prior data is not meaningful as indicators will generally be negative by default.  Even comparing periods up to two prior years may not be valid, depending on the speed of the recovery.  Avoid the temptation to extrapolate or common-size one dataset to the other as you might be comparing apples to oranges depending on individual industry trends.  Facts are facts when comparing financial data.  The underlying cause of a deteriorated trend will be well known.  A focus on management’s outlook as to where they can or will be and when is likely more valuable to a credit officer.   Understanding that these parameters exist will allow the field examiner to offer more meaningful interpretation of what is being presented.    

Dopkins ABL Consulting Services is in the business of helping its clients improve the profitability of their loan portfolio through effective risk evaluation, collateral monitoring, and reliable and accurate field examinations. For more than 30 years, it has assisted commercial lenders with research and risk evaluation of a credit decision, and with continued monitoring of loans once granted. Its underlying objective is to improve the profitability of clients’ loan portfolio while being a trusted advisor to their important prospective and existing client relationships.