Banks more willing to lend as private equity capital increases

September 18, 2011
| By Pete Daly |
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A partner in the local office of BDO USA said that firm is seeing “that banks are once again willing to lend and that the pricing on loans has actually gotten fairly competitive again.”

“The difference is,” added Matthew K. Becker, “all banks are generally only willing to loan to customers who are extraordinarily creditworthy.”

At the same time, Becker said BDO is seeing an increase in investments by private equity firms “because there is a lot of capital available in the private equity markets.”

BDO USA LLP is one of the nation’s largest professional services firms providing tax, financial advice and consulting to business.

“What we find is that private equity funds tend to raise capital on a fairly uniform basis,” said Becker, “(but) over the past couple of years, they raised capital that they haven’t deployed.”

Equity funds are getting more aggressive in seeking investments now because “fund managers realize the capital committed to them (by private investors) has a limited life.”

He explained that the capital isn’t actually turned over to the equity firm. The owner of the capital commits to investing it if the fund manager can find a good investment for it, but the commitment is usually a limited time ranging from two to four years, and if the fund manager doesn’t find a worthy investment, the availability of that capital is liable to disappear, he said.

One of the results of that trend in the private equity markets is a lowering of the cost of borrowing that capital, said Becker.

“We’ve seen an uptick in private equity acquisition activity in West Michigan over the last six to 12 months,” he said. He said the West Michigan economy isn’t necessarily an indicator for the economy as a whole, “but it’s starting to feel like private equity firms are interested in West Michigan businesses again.”

One strength of private equity as a capital source is that it can come from anywhere in the world — and does. Becker said they are seeing “an increase in foreign investment in the U.S. auto industry,” including in West Michigan, generally from those countries that already have or are growing a vibrant auto industry of their own, such as China, Germany and Japan.

But banks are what business owners generally think of first when there is a need for capital.

“It used to be banks loaned to a broader range of creditworthy (businesses),” said Becker. Then they adjusted their loan prices based on the creditworthiness of each particular customer.

“Now it’s only the most creditworthy customers the banks are willing to lend to, and pricing on loans tends to be very competitive,” he said. “If there is any risk to a loan at all, most banks will walk away.”

A limited amount of capital and stricter regulation of lending are driving the banks, he said. “So banks are much, much more conscious of the covenants that get written into their credit agreements, and they are also more conscious of enforcement of those covenants.”

The most common covenant stipulation is a limit to the amount of debt the borrower can have, in relation to the company’s EBITDA — earnings before interest, taxes, depreciation and amortization.

Becker said some banks require their borrowers to evaluate their EBITDA quarterly to make sure they are still within that debt limitation contained in the loan agreement. And, he added, the calculation often includes debt from other sources beyond that particular bank.

“I think there is still a high level of skepticism with respect to bank credit. Banks tend to be very leery, especially of organizations that don’t have a proven track record,” said Becker. “Before the issues that we had with bank capital over the past two or three years, banks would be willing to loan to business, perhaps only on an EBITDA performance basis, without reference to the underlying assets. And now banks tend to focus both on a multiple of EBITDA but also on the underlying collateral,” he said.

“Requirements on companies who borrow from banks have increased,” said Becker. “Instead of a financial statement review, banks are often asking for financial statement audits, and in addition to those audits, they’re also performing their own audit-type procedures on a sporadic basis to make sure that the information that the customer has reported to the bank is accurate.”

In Becker’s experience, banks are “very leery” of two specific types of business: “The first is auto and the second is real estate. I think those two industries are still viewed by the banking community as being very high risk.”

Companies involved in the auto industry have “actually started to improve in terms of financial performance, and it seems like the industry is headed in a positive direction. I think it’s taking the banks and the individuals (within the banks) making credit decisions a little while to catch up with that trend,” he said.

The auto industry traditionally has faced a lot of demand for up-front investment in tooling by the lower-level suppliers that have bid successfully on parts for a new product.

“If you can’t find a bank to front that tooling cost, a lot of times that prohibits that organization from entering into the program, which limits growth and future profitability,” said Becker.

In his line of work, Becker said it is not uncommon to encounter a manufacturing company that actually has orders in hand from the automobile or appliance industries, “but because of slowing demand at the OEM level, those purchase orders get put on hold. So that leaves the suppliers carrying the upfront tooling cost, and then facing delay in revenue associated with the program, which crunches their credit and makes expansion more difficult.”

Manufacturing for the auto industry and office furniture industry are still probably the largest chunks of the West Michigan economy, said Becker, and that’s where the private equity investments are going.

Becker said he personally sees conflicting signs of the overall direction the U.S. economy is taking, with most indicators good — except unemployment numbers.

“I think the biggest sign of struggle is we can’t seem to get the unemployment numbers any lower. They’ve been stagnant for the last year or so. It would be nice to get below 6 percent, but we’re still a long way from that.”

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