The Five Rules of Workout

Because last year’s recession caused such a sudden depression in demand, some middle-market businesses have seen revenue declines of as much as 30-35%. Many of these businesses are still losing money and are close to exhausting their financial reserves. These companies’ banks are receiving the end-of-year financial reports and deciding whether the results meet contractual performance targets known as covenants.

Covenants are key tools for banks to determine continued creditworthiness. It doesn’t matter if you have made every payment … if your loan agreement contains ratio covenants that you have violated (i.e., limiting debt to net worth), the bank has legal rights to restrict additional borrowing … or worse, to accelerate payments of your loans.

After violating a financial covenant, a borrower is typically introduced to a new bank professional know as “the workout officer.” The workout officer’s job is to ensure collectability and also to improve the risk characteristics of the loans on the bank’s books. This means altering the existing loan agreement in ways that accomplish those goals, but which are often painful for the borrower.

If you find that your loan has been transferred to the Aloha Room, don’t panic. Properly administered, workout will only be a brief and relatively painless episode. Improperly administered … and by this I mean by the borrower … it can actually imperil the company’s financial future.

Here are five elementary rules of workout:

  1. Covenants count. Yes, these are essentially backward-looking and do not reflect the long-term prospects of a firm. And some borrowers argue that the ratios are essentially meaningless tests that just strain the company’s financial picture, and that they stress already-busy management with essentially non-market tasks. This is a one-sided view of a contractual undertaking made in better times.

    Ann Ustad Smith, a partner practicing in the restructuring group of law firm Michael Best & Friedrich, LLP said in a recent e-mail, “Covenant requirements are not just a periodic math exercise. Noncompliance with covenants is a signal that the borrower’s ability to repay the bank’s loan is in doubt.”

    Ann strikes a hopeful tone, however, finding that covenants can help a borrower rehabilitate and refinance: “The sooner the change in the borrower’s financial situation is detected, the more likely the loan can be renegotiated or the borrower can find new financing — before business deterioration makes establishing a new banking relationship unlikely.”

  2. Interest rates don’t count. You get a call from the lender. He says the interest rate on your loan is going up due to the violation of a term of your agreement. At this point, most CFO’s go ballistic. The interest rate is a visible and costly, and to the company and its board, a change feels capricious and punitive.

    But interest rate does not matter. If the company has violated the covenants, the change in interest is the symptom of the violation, not a “gotcha” move on the part of the lender. A cardiac patient does not yell at the doctor because of chest pain. He enters a rehab program to get healthy. As a painful signal, interest rates perform much the same function. The company risks not having enough bank capital at any price … when there is a shortage, don’t focus on the price, focus on the availability.

    In saying this, I am neither defending bad behavior on the part of the banks nor encouraging heart attacks: I am simply urging that the patient focus all energy on getting better.

  3. The third rule is easy to say, hard to do: improve the performance of the company. Find where you are making money and where you are losing money — then promote one and end the other.

    This is hard because it requires an operating mindset that is so different from “normal” business. Among other things, it means challenging the ambitions of the company. If you are a retailer who has traditionally found growth through aggressive new-store openings, it means now managing the existing stores more closely. If you are a manufacturer, you need to ensure your reported profitability numbers by customer, product and even factory add up. You need to ensure they reflect the current costs and revenue prospects.

    As it happens, this is very hard for management to do. The process involves both personal soul-searching by the CEO and new processes at the financial and operating levels. That’s why there are turnaround consultants out there … to shore up the organization and help decision-making.

  4. Planning: do it once. Many companies will go through a cost-cutting exercise, tell the bank how much better things will be, and then are surprised when the promised numbers don’t come to pass. So they take another stab at a performance program, and again declare victory. If the second program doesn’t work out, it is fair to say that management will find itself suffering from two deficits: not enough financing, and not enough credibility. Of the two, credibility is the more precious resource.

    And remember, the plan must not only pass muster with the officer you are accustomed to meeting, but to her bosses and bank management generally. Workouts get a lot of attention, and the bankers are smart enough, and experienced enough, to ask tough questions and expect the answers to be readily apparent.

  5. Report often. Banks like to have follow-up meetings to see how the plan is going. It is tempting to view this as a waste of time. On the other hand, what if you viewed the obligation to report your financial results as a timely opportunity to review your internal progress?

    In this, the key word is “internal.” Bankers are not management experts, and their role is to protect the value of the loan … not to improve your fortunes. So bankers should not provide management advice if for no other reason than it could get them in legal trouble later on. That being said, the periodic meeting of every six, eight or 12 weeks is a signal that your team has limited time to set the targets, generate a plan, and live up to its promise.

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