Help in Reaching the Middle Market
The single most significant challenge to the banking industry's survivors is how they are going to fund asset growth -- and at what margins.
Historically, consumers -- net savers -- have loaned through financial intermediaries to businesses, which are net users of funds. Today, however, consumer debt is at an all-time high and maturing baby boomers simply have been spenders, without much in the way of deposits to offer. They are credit-driven.
Banks are under increased pressure, therefore, not only for liquidity, but to monitor their asset mix in terms of both amount and quality.
Loans are the lifeblood of commercial banks. They produce the highest return and are also the assets with the highest risk. An aggressive bank attempting to maximize the return to shareholders by increasing profits after taxes has every incentive to lend money, rather than running a large investment portfolio.
Solving Rate Risk Problem
It is incumbent on bank management, however, to manage the interest rate risk of a loan portfolio on a constant basis. Business loans obviously have a proper place on a commercial bank's balance sheet for the good of the bank and its shareholders, for the business as a source of funds, and the economy as a source of growth.
Because of all this, the increased sophistication of Fortune 500 companies in seeking and getting capital, and their emphasis on cash management, commercial bankers have targeted the so-called middle-market company.
We define the middle market here as companies whose annual sales are between $5 million and $100 million. These companies have several unique characteristics:
* They tend to be family owned or closely-held.
* They are the growth companies of tomorrow.
* They pay higher rates for their money than do the Fortune 500 companies.
* They lack in-depth sophistication on their internal staff.
* They rely, or should rely, more heavily on their "outside staff," which would include bankers, lawyers, accountants, and -- something of a new breed in the middle market -- the consultant.
It seems that 70% of family-owned and/or closely held businesses do not make it to the second generation.
Relatively few middle-market companies have any kind of formal planning activity. In fact, they lack the capability of doing it in-house. They spend the vast majority of their time on day-to-day activities, with no focus on the future.
While the banks have targeted middle-market companies for reasons of profitability and spread of risk, these are the companies that have very high volatility and mortality. They cannot make more than one strategic decision that is wrong. Otherwise, they wind up as a workout loan.
They also have all the complications of a family-owned business. Management succession is often a major consideration of a lending bank when viewing a middle-market credit.
A Need to Let Go
Since many middle-market companies are family-owned, the challenge, therefore, is even greater. Often family CEOs tend to be very strong-willed, dominating individuals, who find it most difficult to "let go" and allow other family members in the business to make decisions.
A relatively new member is beginning to appear in the middle-market company's outside staff: the middle-market consultant. The first indication of this is the expansion of accounting firms into what they call management advisory services.
In many cases, however, the people who head these consulting divisions of accounting firms are converted CPAs, whose focus to date has been on history and whose firm is already doing the audit. Therefore, they have a difficult time being objective.
What Consultants Aren't
The other side of the coin is that all the people who have ever been fired from jobs, and are in the process of looking for other ones, term themselves "consultants."
Consulting, therefore, in the popular use of the term, does not have a particularly good image, especially in the middle market.
Banks want middle-market companies to borrow, but they also want strong credits at good margins.
And they need to be concerned that the middle-market company has a good focus on the functions of human resources, operations, marketing, and finance.
Tracking the Glide Path
If the bank credit officers or loan officers could receive an updated copy of a middle-market corporation's business plan each year, they could track the company's glide path and monitor the attainment of the company's objectives, along with the soundness of the strategies, what a benefit it would be.
There are consultants in the middle market who are qualified and objective, whose interests are very similar to the bank's: They are looking for long-term relationships.
These consultants are capable of doing strategic planning over three to five years, with updates possible on a quarterly basis, and formal updates on an annual basis.
A number of these consultants have in-depth financial and planning experience, coming from such backgrounds as large corporations, large consulting companies, and the banking community.
As a banker for 18 years, my experience with consultants was not always favorable. I found some to be self-serving, biased, and little more than loan brokers.
The success ratio will certainly be less than 100%. But, with careful selection, it should be decidedly on the positive side.
The middle-market company can now have, as part of its management team, a sophisticated consultant, on a fee basis. The consultant can afford to be objective and offer assistance in planning and sourcing capital.
Capital, in this case, may go beyond bank loans to include bank loans and perhaps some subordinated debt.
In the middle market, the company often has no formal written plan for bank loans, and has inadequate funding. If the funding is adequate in amount, it may not be appropriate as to term or purpose.
Other problems include the availability of collateral, personal guarantees -- always a controversial subject -- and not only the ability, but also the willingness to supply the lender with timely information on a regular basis.
Covenants Enter the Picture
Often the company requires term debt rather than total reliance on short-term credit lines. In this case, not only is adequate collateral and the value and liquidity of collateral an open question, but loan covenants are necessary.
Reasonable covenants require negotiation. If they are too strict, the company has a difficult time running their business and must often ask for waivers. If they are too liberal, the bank may find problems after the fact.
Consultants who approach lenders on behalf of or with clients may be perceived, perhaps with some justification, with skepticism by the existing or potential lender.
There may be concern on the part of some bankers that a consultant is acting as a loan broker and, therefore, will always recommend the cheapest deal to the client and/or may threaten to move the bank relationship for whatever reason. If true, the consultant is, in fact, a bank antagonist.
Both Sides Must Benefit
To be successful over time, the consultant needs to build these relationships with lenders and borrowers alike. No funding package that is not for the mutual benefit of both lender and borrower will endure.
There are times, however, when middle-market companies need a secondary bank relationship, and there are times when the relationship needs to be on a different basis.
One example that illustrates this point is a large regional corporation with $40 million in annual sales, three years of losses and $12 million in borrowings, all at a floating rate of interest with no floor or ceiling.
The corporation then needed to borrow additional funds during the fourth year; the bank, and rightly so, becoming very nervous.
With the help of a middle-market consultant, the corporation constructed its first three-year strategic plan, prepared a specific version for the bank and refinanced the entire company during the fourth year at the existing bank for $19 million. The additional $7 million was on a fixed rate, secured by both equipment and real property.
An Interest Collar
The consultant then advised the corporation to purchase interest rate protection in the form of a collar (a floor and a ceiling) on the company's average line borrowing from the bank's money management division. This recommendation literally removed interest rate risk from both the company's and the bank's concern.
As a result, the bank is much more comfortable with the credit. The company showed about an $800,000 turnaround during the first year in profit before tax.
The bank is now aware of the company's glide path, and can monitor goals and objectives on a quarterly basis.
Constructing the plan took about five months. Several informational meetings were held including senior company management, the bank, the attorneys, the accountants, and the consultant. Surprises were negated.
The company made excellent use of its "external staff." As a result, the bank relationship was strengthened and increased. That may sound like a textbook case, but it is a real-world case from 1988.
Beyond Internal Capabilities
The fixed-rate money was on a term basis and included a term loan agreement with positive and negative covenants and appropriate guarantees. The company did not have the capability on its internal staff to do the plan, negotiate the loan agreement, and get a good focus on their requirements over the following three years.
A significant impediment to any middle-market company doing its own planning is interruptions. Once they are committed to retaining a consultant and paying a fee, meeting times are set aside and agendas are established with specific objectives for each meeting.
The net result should be a benefit to the company. the bank, the accountants, the attorney -- and the consultant.
The target is for banks who wish to lend to the middle market and consultants who wish to build their practice in the middle market.
There is no way the bank can literally manage the company or spend the time necessary to make sure the company is on track with its plan. A bank cannot and should not construct the company's plan.
They all want the middle market: banks, accountants, lawyers, and consultants.
Banks generally do not regard accountants and lawyers as adversaries, nor should they so regard consultants. Consultants are not a panacea for all middle-market problems.
A proper selection process, however, can find an effective consultant. That means, doing business with someone who has a permanent office, educational qualifications, experience qualifications, and an established track record.
References should be required and checked. The obvious benefit to the corporation is that it may become one of the 30% who does make it to the second generation. The bank may have a stronger credit.
The accountants and lawyers may have a repeat client. The consultant generates not only fee income but, hopefully, an on-going relationship.
It is more cost-effective for the middle-market company to use an external staff than permanently hiring a number of specialists. Outside staff, when efficiently used, are cost-effective compared with salaries, fringe benefits, and perks. So, the economics work.
Mr. Hitselberger is managing director of Professional Consulting Associates, Timonium, Md., and a visiting professor in the Graduate School of Business at Loyola College in Baltimore.