Q: I have a deal that is like spaghetti because affiliated entities are all tied up in accounts receivable and accounts payable. The borrower’s biggest customers are affiliated entities with due to and due from accounts…and so on.
The borrower, however, is unwilling to produce the financials for all affiliated companies because the affiliated companies will not be a borrower or a corporate guarantor. Given these circumstances, what tools can we use to determine credit worthiness or is this enough to turn it down? I am just confused as what to base my decision on and am reluctant to move forward. What is your advice?
A: This is a common borrower response to the lender’s initial requests for related entity financial statements and tax returns, especially if you are prospecting a new borrower. From a prudent commercial underwriting perspective, you need to sort out the “spaghetti” on a global basis to determine if these affiliated entities are a potential cash source or a potential cash drain. In other words, it is critical to understand the global picture.
The borrower’s reluctance to share this information may be a potential red flag, especially given the intercompany activity you describe. As a next step, it seems logical and prudent to have a further discussion with the potential borrower to explain why these affiliated entity financial statements are absolutely necessary to evaluate the borrower’s credit request. Absent this information, it is impossible to assess the borrower’s dependence on the cash flow and financial condition of the affiliated entities, which is necessary before making a credit recommendation. Such a follow up can sometimes change the borrower’s initial position regarding sharing of related entity financial statements and tax returns.
Our case in point in the Commercial Real Estate Underwriting series was a great example of the importance of global analysis. If we had failed to complete the global analysis on Mr. Schumacher’s entities, we are very likely to have recommended approval of a loan request with Shadelands Glen LP as the Single Asset Entity borrower. Our global analysis highlighted one of the key weaknesses in this credit request, identifying some financial red flags. Applying the global perspective – as highlighted on Slide 54 of this final session – in the event of default for any credit facility in the Schumacher group of affiliates, we determined that there would be ripple effects felt by the other entities which may include the diversion of management’s focus and attention, diversion of cash resources, legal ramifications, and rising legal and accounting costs which can put a strain on global cash flow and impact all related entities.
Please keep in mind that these are suggestions only from our perspective. Your institution’s policies, procedures and guidelines for such an issue should certainly prevail.
Q: When you are looking at structuring a maximum leverage ratio, does the resulting leverage ratio include global debt, i.e., debt for all related parties as well as guarantor debt?
A: While you can certainly calculate and apply a covenant based on a global leverage ratio of all related entities, the most commonly used maximum leverage ratio covenant is applied at the borrower level. Most spreading software generates two or three versions of a borrower’s leverage ratio. The most useful is one that computes senior debt divided by tangible net worth.
- Senior debt is usually defined as all debt less subordinated debt.
- Tangible net worth is usually defined as net worth less intangible assets plus subordinated debt.
The corelated covenant used for a guarantor is a debt-to-income ratio, which is designed to contain guarantor spending.