Asset-Based Lending: The Post-Crisis Landscape

Many lenders today may feel a little bit like Max, Mel Gibson's iconic character in the 1980s futuristic sci-fi movie trilogy Mad Max. In the same way that the post-apocalyptic landscape faced by Max was a far different world than existed before, the post-financial crisis lending landscape is far different from what existed before 2008.

This is true for all types of lenders, including both commercial banks and asset-based lenders. Since the onset of the financial crisis more than three years ago, virtually everything about commercial lending has changed. This includes much stricter credit criteria and more risk aversion on the part of lenders, as well as enhanced regulatory scrutiny on lenders.

In particular, federal regulators now require that commercial banks' loan portfolios be more diversified. Specifically, regulatory guidance now caps the amount of capital that can be invested in commercial real estate (CRE) and acquisition, development and construction (ADC) loans as a percentage of total capital. A natural result of this has been a renewed emphasis by banks on commercial and industrial (C&I) loans.

"C&I loans are replacing CRE and ADC loans in our portfolio—we're slowly shrinking that bucket," says David Wooding, a senior vice president with The Columbia Bank, a commercial bank in Columbia, Md., with $2 billion in assets. "While there is definitely pressure to grow our C&I loan base, it's a longer sales cycle. Banks in general are scrutinizing credits more closely today in light of the underlying weaknesses in the economy."

"Most banks are in the ‘stealing' business right now when it comes to C&I loans," says Jeffrey Covington, senior vice president with NewDominion Bank, a community bank in Charlotte, N.C. with $400 million in assets. "It's no secret that CRE loans are passé and C&I is the way to go for the foreseeable future. All the banks here in Charlotte, from the big mega-banks to the small community banks, are out trying to find good manufacturing and distribution companies and business services and professional firms that need owner-occupied real estate loans, equipment loans and lines of credit."

However, with little credit demand among these segments for new buildings and equipment or expanded credit lines, Covington says he and most other bankers are trying to woo clients from each other based almost exclusively on service and rate. "While the turmoil in the banking industry can sometimes expose holes in service, it's much harder to gain the favor of a new client without a fresh credit need to help pry them away."

Unforeseen Consequences

While certainly welcome given what has happened with both residential and commercial real estate over the past few years, this shift in emphasis to C&I loans could lead to some unforeseen consequences.

John Barrickman has worked in commercial lending for more than 40 years, during which time he has served as a front-line commercial lender and as a bank CEO. As the president of New Horizons Financial Group, a financial services industry consulting firm headquartered in Atlanta, he has a unique perspective on today's commercial lending landscape in light of not only the past three years' developments, but developments over the past 30+ years.

"Most banks, and community banks in particular, traditionally focused on CRE and ADC loans," says Barrickman. "With what has happened in real estate and the new regulatory guidelines, many are now starting to migrate back to C&I loans. What I'm seeing, however, is that many bankers' C&I lending skills have deteriorated and many CRE lenders are having a hard time making the transition. I'm getting lots of calls from banks saying they need to grow their C&I loans and their lenders need more training."

"There's no question that fewer bankers today are formally credit trained like those of us who've been making commercial loans for 20 to 30 years or longer are," notes Covington. "Lots of commercial bankers can do a loan on a building, but the advantage today goes to the lender who really understands what C&I lending is all about."

A Familiar Scenario

The scenario Barrickman often sees looks like this: A bank has a long-time customer that has survived the recession and financial crisis, but it can no longer lend to the business using traditional C&I lending techniques because the leverage is too high, liquidity is strained, etc. "From the banker's perspective, the business is no longer creditworthy."

In this situation, banks need to exercise more control over the collateral, but they often don't have the staff, infrastructure or systems required. "Banks need to properly monitor and manage these types of loans, which includes having systems for understanding and controlling the collateral and monitoring the borrowing base," Barrickman adds. "And they need lenders that can go out and look at the collateral periodically to make sure it's actually there and is of the quality it's supposed to be. There's more to it than just counting boxes."

Look familiar? Of course it does. As Barrickman notes, "This is the classic case where an asset-based lender can come in and help both the borrower and the bank. Therefore, asset-based lenders should make a concerted effort to partner with banks. The bank can maintain the primary relationship with the customer and still meet the customer's credit needs responsibly by engaging the asset-based lender as a partner—either to issue the credit or help monitor the collateral."

Getting Back to Lending Basics

Covington notes that many banks lost sight of how lines of credit are supposed to work and, as a result, ended up backing themselves into an asset-based lending corner. "If $900,000 is outstanding on a $1 million line of credit, you've essentially got an asset-based loan, with long-term repayment based on short-term assets, which is very risky. As banks realize this, some are starting to get back to the proper use of lines of credit for temporary working capital, with companies in and out of the line on a normal monthly cycle.

"If we saw that a business was going to be heavy into its line right from the start, or we expected this to happen soon, we might call in an asset-based lender to either take the whole lending relationship or help out with underwriting and monitoring," Covington adds. "In this case, the credit position would still be ours."

Unlike asset-based lenders, Covington says banks tend to focus less on how quickly receivables and inventory turn or whether inventory is in boxes or work in process. "At the end of the day, our underwriting is based more on company performance: Is there a strong balance sheet? Are there consistent trends in earnings and equity?

"If receivables and inventory monitoring requires more than a casual glance, that's when I believe banks should bring in an asset-based lender that specializes in this," he says. "Either let them take the credit, or have them confirm that the receivables and inventory are as strong as you think they are."

Wooding believes commercial banks are well equipped to do what he calls "asset-based lite: a company that's strong with good assets, for which you just need to put together a line of credit with a borrowing base certificate monitored monthly." A loan like this can typically be monitored through monthly financial statements, receivable and payable aging schedules and an inventory report, Wooding notes.

"But most banks aren't set up to do heavy-duty asset-based lending—and, in fact, most have gotten away from it," he adds. "We have looked into it in the past, but have decided there are too many other opportunities to pursue without taking on that level of risk exposure, monitoring and expense. Instead, we refer intensive asset-based lending out to asset-based lenders, but hold onto the deposits and the rest of the banking relationship."

Filling the Gap

According to Wooding, there's a gap in the market right now for asset-based loans of $1 million or less. "I don't know where a business turns that needs a less-than-$1 million ABL-monitored line of credit. Most commercial banks want to do larger deals."

This represents a tremendous opportunity for small and mid-sized asset-based lenders, for whom this size loan is usually a home run. Such a loan can be a stepping stone to help a business through a financing transitional period until it once again qualifies for traditional bank financing.

The bottom line: There are many nuances to C&I lending that not all bankers are familiar with. Tremendous opportunity currently exists for asset-based lenders and banks to team up and, working together, deliver the kinds of financing solutions that are desperately needed by many business borrowers today.