As the economy continues to improve and commercial loan volume rebounds, community banks are making an increased number of loans to service businesses such as medical practices, nursing homes and hotels.

Lending to these types of businesses poses unique risks and requires a special type of underwriting. Service businesses usually do not have hard assets like equipment and inventory that manufacturers and retailers do that can be pledged, and more easily valued, as a secondary source of repayment.

Because of this, community banks are being asked to consider total enterprise value, or TEV, when underwriting loans to service businesses. The tricky thing about using an enterprise value as collateral is the fact that it is going to be negatively impacted if the business isn’t generating enough cash flow to service its debt, which places both your primary and secondary source of repayments in jeopardy as they are so closely related.

While this kind of lending is generally considered of higher risk for community banks, bank management can expect that heightened attention will be paid by examiners to these types of credit facilities. Regulators issued guidance in 2013 to assist lenders in the underwriting of this kind of leveraged lending. The guidance notes particular concern for the following areas:

  • The absence of meaningful covenants in loan agreements, specifically for debt service coverage and maintenance of loan to values in collateral
  • The aggressive nature of capital structures and repayment assumptions for some transactions
  • Reliance on enterprise value without adequate independent validation of the value

Leveraged Lending Best Practices
With these concerns in mind, some best practices that bank management should consider before underwriting loans to service businesses using TEV as collateral are:

  1. Make sure the business currently has, and has historically had, strong cash flow. Service businesses should be able to demonstrate a reliable, consistent source of recurring cash flow to service the debt. This, after all, will be your primary source of repayment for the loan.
  2. Underwrite the loan using a higher debt service coverage ratio. This will give you more leverage to act quickly, if necessary. If you would normally underwrite a loan at a debt service coverage ratio of 1.25, for example, increase it to 1.5.
  3. Utilize minimum debt service coverage and liquidity covenants. Not only is it important to utilize the aforementioned covenants in loan agreements, it is equally important to monitor them on a regular basis. Through monitoring, management will be able to detect trends, whether positive or negative, which could open up conversations with the borrower regarding their operations. This would allow the lender to make suggestions for improvements before ratios fall below the minimum required by the covenants.
  4. Stress test business operations both for debt service coverage and enterprise value. Utilizing these stress tests as a part of the initial credit proposal gives those in management a clear picture of the “what if” scenarios, and also gives them an idea of how much flexibility the business has in their operations to maintain the required debt service coverage ratio and enterprise value for loan to value calculations.
  5. Scrutinize the management team. The company’s management team should have a proven track record and high level of competence in the industry in which it operates.
  6. Carefully examine the owner’s personal finances. The owner needs to have some of his or her own money in the business – or some “skin in the game” – as well as a highly liquid and marketable net worth.

Please contact us if you have questions about Leveraged Lending 417-881-0145.