Commercial loan structure There are four basic loan structures--seasonal, term, bridge, and permanent capital.

Each has its own particular characteristics of analysis, loan facilities, collateral, risks, and opportunities and needs to be priced, documented, and monitored accordingly. The process of loan structuring begins by identifying the financing requirement. With new loan requests, the first of a series of pro forma balance sheets takes into account all of the uses of the proceeds of the loan and computes the requirement. With existing loans subject to periodic review or renewal, the bank's outstanding loans and perhaps other debt as well constitute the requirement. Existing loans should be reexamined periodically as the original assumptions may have changed. Loan structuring is then the process of breaking down the financing requirement in terms of repayment--seasonal, term, bridge, and permanent capital loans--and analyzing, approving, pricing, documenting, and monitoring each component accordingly. Each type of loan has its own particular characteristics of analysis, loan facilities, collateral, risks, and opportunities. Seasonal Loans The seasonal loan generally funds an increase in inventories, such as purchases of Christmas wares by retailers or the manufacture of seasonal items like toys or snowmobiles. The cash created by the loan is disbursed to suppliers and labor, the inventory is sold, receivables are collected, and the bank is repaid over what should be a relatively well-understood schedule. However, things rarely work with such well-defined precision. Retailers may have several overlapping seasons, such as Easter sales, back-to-school, and Christmas. The trick is to not still be financing Easter inventories while advancing for Christmas wares. A farmer will have highly predictable cash needs until after harvest, when the seasonal loan should be at its peak. Repayment will then depend on the marketing plan--which is when and how the farmer will sell. The prior year's seasonal loan may well be paid in the first and second quarter of the current year or even further out, resulting in the bank having to maintain and monitor two separate seasonal loans simultaneously. Such service businesses as accounting firms may collect the bulk of their receivables at one time. The bank will probably be funding expenses, resulting in losses until the second and third quarter of the year, when billings are collected and the loan repaid. Some businesses will have unpredictable or occasional spikes in current assets that need financing. An investment bank completing an underwriting would advance funds at closing for the purchase of securities and would be repaid as they are sold or distributed. A number of these "seasonal" loans could be outstanding at once and might be handled as individual seasonal loans. At the same time, the bank might be extending the investment bank a permanent capital loan to finance securities inventory and margin loans. Even companies with adequate working capital and sales that are distributed fairly evenly throughout the year might have occasional short-term requirements. A company might temporarily deplete the cash account for an advantageous bulk inventory purchase, a payment on a term loan, or a capital expenditure. Loans to cover such disbursements will pay out as receivables are collected, and there should be several cleanups annually.

Although most seasonal loans are fairly straightforward, the situation becomes more complex with overlapping seasons and concurrent permanent capital or term loans. The analyst must have a very good understanding of the borrower's working capital components and how they function at different times in the cycle. Analysis. The point at which the bank has the most risk is usually when the inventory is at its peak and the seasonal loan is fully disbursed. The analyst must reach a comfort level with the inventory at that point and with the bank's position relative to other creditors, primarily trade vendors, perhaps through a historical pattern of similar peaks and the ability to convert them into cash. If there is a pattern of seasonality, the analyst might focus on what, if anything, is different about this year. For example, are projected sales volumes significantly higher or is the product mix different? At the point of peak risk, the analyst should make a thorough examination of the projected inventory and any obstacles to its conversion into cash. A toy manufacturer will normally have a number of products with a very stable history of sales. It will also have a number of faddish items that, it hopes, will mean blockbuster sales. Toy buyers are quite fickle, so the risk is high. The analyst must decide if the mix between stable and faddish products is appropriate at the peak. Inventory is normally the biggest risk to the lender, but occasionally the receivables portfolio is riskier than inventory. A lumberyard may have palletized lumber with a known commodity value while the receivables portfolio contains extended terms to contractors. A distributor of agricultural chemicals may have less risk in warehoused commodities than in the receivables portfolio. Receivables risk points out that the analyst must understand and be comfortable with the borrower's credit policies. Such policies include investigations, approvals, limits, datings, collection procedures, guarantees, and letters of credit. Meanwhile, on the other side of the balance sheet, the bank has competitors for cash. Will trade debt still be outstanding at the point of peak debt, and will there be any purchase money security interests? Will any cash be disbursed for term loan payments, capital expenditures, dividends, or treasury stock while the bank's debt is outstanding? Company-prepared projections of balance sheets, income statements, and cash flow statements on a monthly or quarterly basis are the best tools for analyzing a seasonal loan. The projections can help the analyst determine 1) the amount and timing of peak credit needs; 2) the degree of inventory reliance; 3) the bank's relative priority with the trade and other competitors for cash; and 4) disbursements for capital expenditures, other indebtedness, dividends, and treasury stock. If company-prepared statements are unavailable, the analyst must discuss the most recent balance sheet with the borrower and determine the amount and timing of current asset buildup and contraction. Prior years' disbursements to the trade or estimates for the current year might be helpful. These mutually derived estimates can be summarized in a credit file comment, but are no substitute for borrower-prepared projections. Facilities. The seasonal loan is often advanced under an advised, revocable line of credit sufficient to take care of the peak borrowing need while granting some leeway for additional requirements or timing differences. Many seasonal borrowers will have other loan facilities, such as term loans, with the bank, so all facilities should be reviewed at the time the seasonal loan is paid out and the next season is being considered. This timing may or may not coincide with the borrower's fiscal year.

The maturity on the note under the seasonal line should correspond with the low point in current assets, when both the bank and the trade should be paid out. When advancing under a seasonal line of credit, the bank and the borrower should agree on the use of the proceeds, which will normally go toward paying expenses and suppliers for inventory. Any payments for term debt, dividends, treasury stock, or capital expenditures should be agreed upon. Instead of advancing under an advised, revocable line of credit, the bank might extend a commitment that is a contractual obligation to advance funds under agreed-upon terms and conditions up to a specified amount and prior to an expiry date. A commitment fee is normally charged. Inexperienced lenders occasionally get themselves into a situation where the borrower hears "commitment" when the lender actually intended "revocable line of credit." This misunderstanding can result in serious lender liability issues. To avoid misunderstandings, the bank must carefully analyze the seasonal loan request and ensure a reasonable comfort level. The bank must then agree on the timing and amount of peak debt, when the debt will be repaid, the uses of loan proceeds, and what other payments, if any, are permitted for capital expenditures, term debt, dividends, or treasury stock purchases. These issues can be spelled out in a simple letter of agreement. The lender must understand that if the bank stops funding as the season builds, the borrower may go out of business. This situation can be avoided with a thorough and frank understanding with the borrower. Collateral considerations. Normally, the bank is secured by a perfected security interest in accounts receivable, inventory, and equipment. Exceptions can occur with well-capitalized companies having minimal other debt and a history of seasonal payout. An annual lien search should be made to detect other security interests, such as purchase money security interests. With a seasonal loan, a traditional borrowing base, as used in permanent capital lending, is unworkable. At the beginning of current asset expansion, the bank is exposed to inventory much more heavily than it would ever be in permanent capital lending. Receivables at this point would be minimal, so the normal eligibility requirements used in asset-based lending do not work with seasonal loans. The bank would be better off agreeing to an inventory cap with the borrower. In a seasonal lending situation, the bank can derive very little comfort from the collateral of the current assets. After all, if the borrower cannot sell the inventory or collect the receivables, will the bank be able to do a better job of it? Highly unlikely. (1) Analysts should focus on other collateral, such as real estate or personal guarantees. What else can go wrong? Problems that are generally associated with seasonal loans include: * At the end of the cycle, the bank may be paid out, while the trade is not. The company may not be able to get the same terms for the next buildup of inventory, which increases the bank's exposure. Therefore, even if paid off as agreed, the bank should run a trade check to ensure suppliers are paid as well. * At the end of the cycle, the bank may not be completely paid. If the trade is unpaid as well, the problem is compounded. This should be reported immediately to bank management, as the bank will soon be asked to finance the upcoming season. If the current assets still have value and the company is generating cash from operations, a term loan might be the answer. If not, the options become less attractive (another lender, an infusion of equity, or liquidation). * Many business owners dislike seasonal production problems. If a manufacturer of snowmobiles starts producing watercraft, a seasonal loan could turn into a permanent capital loan.

* Problems with raw materials, labor, machinery costs, or force majeure may hamper production of the product or services. * Style, demand, obsolescence, contamination, or recall may limit sales. * It may not be possible to collect receivables. * Cash may be used for purposes other than current assets or liabilities, such as fixed assets, other debt, dividends, or treasury stock. Common lender errors. * The lender fails to react immediately to a lack of cleanup. * The lender "terms out" the carryover debt that is not cleaned up, but the cash flow from operations is insufficient to amortize the debt. This situation just postpones the problem. * The lender overestimates the expansion and contraction of current assets and structures a seasonal loan that is too large and will not pay out completely. If the seasonal loan is too big, the debt should be restructured by transferring enough to the term loan to ensure a cleanup. Of course, there must be enough cash flow from operations to amortize the debt in an appropriate period, and the loan-tovalue ratio of the collateral should not be excessive. * The lender permits the borrower to use advances on the seasonal loan for purposes other than current assets and liabilities, such as capital expenditures, dividends, and payments on other debt. This situation can occur through ignorance: the lender had not discussed with the borrower how the funds are to be used. * The lender does not provide enough margin for error, particularly on speculative or faddish types of inventory that should be financed with the owner's capital. * The lender and the borrower do not agree on a marketing plan for a commodity inventory subject to price fluctuations. For example, when financing a corn or soybean producer, the bank and the borrower should agree on hedging strategies, a marketing program, and so on. Before the current season is over and the loan repaid, the bank issues letters of credit for the purchase of goods for the next season. The bank is therefore committing itself to the next season before it knows the outcome of the current season. Loan policy issues. Part of the credit decision is ensuring that the proposed loan meets loan policy guidelines. When the policy is unclear, the analyst can perform a service for the organization by proposing a policy that can be thoroughly debated, amended, and ultimately approved by management, credit, and the line. Analysts and loan officers often feel they have no power to propose policy. Most managements would be delighted to have such policy proposals. When management does not react, it is often because someone has pointed out a problem without suggesting a solution. Seasonal loans are generally fairly straightforward, particularly if there is a history of short-term borrowings. Policy often focuses on the need for a margin of error for more speculative inventories and on marketing plans for inventories subject to commodity pricing. The seasonal loan must be structured so that a cleanup occurs and the trade is brought current. If the cleanup does not occur, the loan officer must report it immediately to management along with a recommendation of

proposed action and a risk-rating change if necessary. The loan can be termed out only if there is solid evidence of the ability to generate cash flow from operations. Term Loans Term loans are repaid from the cash flow from operations over a period longer than one year, or longer than the normal operating cycle of the business. The purpose of a term loan is often to purchase noncurrent assets, although there can be several other reasons for a term loan. A term loan can convert a permanent capital loan with no repayment understanding into a loan repaid over time on an agreed-upon basis. A term loan might be used to finance a change of ownership, such as in a treasury stock transaction, or to finance an acquisition. A term loan might also be used to repay the carryover debt on a seasonal loan that was not completely repaid. Analysis. Term loan analysis emphasizes the cash flow statement. Because the loan is repaid from cash flow from operations, it's necessary to understand the borrower's long-term profit potential. The analyst must have a fundamental understanding of the borrower's management, industry, and market position. Some key management issues are character, flexibility, and philosophy of risk and reward. The analyst must develop an understanding of the borrower's position within the industry and thc factors that separate the winners from the losers. In terms of market position, the analyst must understand the borrower's niche and be able to identify its sustainable competitive advantage. The analysis of a term loan focuses on the long-term generation of cash from operations and how this cash is disbursed to capital investments, dividends, treasury stock, other creditors--and the term loan. The analysis begins with a base-case projection and then alters the assumptions behind the cash flow drivers to determine how wrong the bank can be and still be repaid. A term loan rarely goes exactly as planned at inception, and an analyst should not be unduly concerned if a five-year term loan pays out in six to seven years. That is certainly an acceptable tolerance of error. On the other hand, the analyst should object to a loan where a 200-basis-point increase in interest rates would mean the difference between success and failure. Projections and sensitivity analysis should help the bank determine the maximum payment that the borrower can apply to debt while still maintaining enough liquidity for growth, fixed-asset maintenance, and other agreed-upon expenditures, such as asset purchases that will generate new revenues, service on other debt, dividends, and treasury stock purchases. Loans for fixed assets, such as equipment, should be repaid before the useful life of the asset financed has ended. Nothing is more constricting than needing to finance new assets while debt is still outstanding on useless assets. A banker should always be satisfied that management has analyzed the return on investment of any asset it finances. A term loan should be profitable to both lender and borrower. It makes little sense to make payments on an asset that is not paying its own way. Facilities. A term loan implies that the funds advanced by the bank will be outstanding for a defined period of time and amortized on a periodic basis. Monthly payments are preferable from the bank's point of view for two reasons. First, the more frequently interest is collected, the more profitable the loan. Second, if monitoring fails to point out a problem, a delinquent payment raises a red flag and a 30-day warning is better than one coming 90, 180, or 365 days later. If the bank also has a seasonal loan, it might be desirable to collect interest monthly and principal during the cleanup period so the bank is not paying down the term loan from advances under the seasonal loan.

In many cases, and certainly with loans of a significant size, a term loan agreement or simple letter of agreement is useful. The agreement spells out the terms, conditions, expectations, and responsibilities of both the borrower and the bank. The agreement also sets forth the remedies available to the bank if the agreement is breached. The term loan agreement defines the relationship of borrower and lender, and violations should not be taken lightly. Covenants of the agreement should not be written so restrictively that the borrower is constantly in default over trivial issues. On the other hand, violations should be dealt with immediately so as not to demean the agreement or establish a practice of the bank not taking action. The term loan agreement keeps the loan, other than current maturities, in the long-term section of the balance sheet, which conforms the current ratio to the reality of the facility. Most importantly, the agreement outlines the expectations of the borrower/lender relationship. It provides a framework for the husbanding of cash by restricting payments for such things as noncurrent assets, dividends, and salaries to agreed-upon levels. The agreement can easily be amended to conform to new situations. When well crafted, the term loan agreement can enhance communications and be an excellent tool for establishing a banking relationship. Collateral considerations. The lender is often secured by a mortgage on land and buildings and a security interest in equipment. Receivables and inventory can obviously be taken as well, but they are often collateral for seasonal loans or permanent capital facilities. All lending facilities should be cross-collateralized and cross-defaulted. The lender must estimate the useful life of the noncurrent assets used as collateral and ensure that the loan is retired well before the assets become worthless. Replacement value should be considered, as the borrower may very well need to finance the new assets. The collateral value of an asset is its liquidation value, which has nothing to do with book value under generally accepted accounting principles. Liquidation value is the cash value of the asset when sold at the .worst possible time under the worst possible conditions and at the highest possible expenses of liquidation. (2) Collateral is the second way out of a loan, and reliance must be placed on the primary source of repayment. The secondary source of repayment is often the weakest point in the analysis of a credit. What can go wrong? * Projected sales may not materialize, resulting in insufficient revenues to clear the break-even point for debt amortization. * Expected synergies may not develop or margins may be less than expected. When margins are abnormally high and the entry cost is reasonable, competition usually increases, forcing margins down. If the borrower is excessively leveraged, well-capitalized competition might reduce pricing and force the borrower out of the market. * Faced with sales that are less than anticipated, management may be unable or unwilling to reduce the break-even point by cutting overhead. Some fixed expenses, such as lease agreements, may be impossible to cut. * Higher-than-projected sales or changes in working capital component turns may absorb more cash into current assets, causing the term loan, or part of it, to become a permanent capital loan.

* Fixed assets may become obsolete before the corresponding debt is retired. * Overhead and debt servicing may be contracted before sales volumes are reliable. For example, a new restaurant normally attracts the curious for the first six months, but volumes are not reliable until sometime thereafter. * Cash may be spent on noncurrent assets or excessive salaries. Common lender errors. * Analysts frequently straight-line sales indefinitely into the future at some compounding rate, which rarely occurs in real life. * Sensitivity analysis is incomplete or nonexistent, so analysts do not understand their margin of error. * Analysts fail to identify the borrower's sustainable competitive advantage in the market. * Management's ability to adapt to change is overestimated in a volatile or rapidly changing industry. * Analysts project rapid sales growth, but do not anticipate additional financing needs. * The value of collateral is overestimated. * Given historical earnings volatility, the term of the loan is excessive and the collateral is insufficient. * As many of the assets, such as goodwill, are intangible and little hard collateral is available, the analyst justifies the transaction by stating that the loan is covered by "enterprise value," or the value of the company derived from its cash flows. Of course, if the cash flows are not there to amortize the loan, they are not there to support enterprise value. Consequently, there is no second way out of the loan. This is the problem that has caused such high losses in investor-owned real estate and in "air ball" loans such as leveraged buyouts. Loan policy issues. Most commercial loan policies set maximum maturities on term loans, often defined by the collateral--for example, five to seven years for loans secured by equipment and 10 to 15 years for loans secured by land and buildings. This approach virtually ensures that every term loan will be structured with the maximum maturity. Policy should state maximum terms, but also suggest that terms should depend as well on the ability to generate cash flow If a borrower can pay for a building in seven years, why set it for 15? Isn't it to the borrower's advantage to repay the loan rapidly so that it is in a position to borrow again to take advantage of other opportunities? Naturally, for maximum flexibility, the borrower would like a 15-year loan at a fixed rate with no prepayment penalties. This becomes a competitive and negotiating issue rather than a question of repayment logic. Policy should also state that the term of the loan should correlate with the historical and projected volatility of cash flows and the value of collateral correctly adjusted for its useful life. The final maturities in a term loan portfolio should not all cluster around the maximum stated in the loan policy. They should be based on projected cash flow generation, the perceived stability of cash flows, and the strength of the second way out.

Loans that have no real secondary sources of repayment but are based on enterprise value should have a loan policy designed specifically for them. These would include loans to investor-owned commercial real estate, most media, and other "air ball" loans such as leveraged buyouts. The policy must ensure that risk and reward are in balance. If policies are not clear, analysts should discuss the problem with their managers and offer to create a discussion draft. The policy might also specify some guidelines for sensitivity analysis to ensure that a reasonable margin for error is developed. Knowing how wrong we can be is one of the keys to success in term lending. Bridge Loans Bridge loans bridge a gap until a specific event occurs that repays the loan. Three types of events can repay a bridge loan: 1. The sale of noncurrent assets. The sale of land, buildings, equipment, a subsidiary, or patent rights could produce cash with which a bridge loan could be repaid. 2. Refinancing debt with other debt. An interim construction loan is an example: A bank advances funds to complete a project and then is repaid from the placement of a permanent mortgage with another lender. 3. The infusion of equity. An initial public offering (IPO) of stock or an investment by a loving uncle can repay a bridge loan. Bridge loans and the circumstances that create them are generally exceptions to the borrower's normal operations and require special decisions by management. Consequently, these loans stick out like sore thumbs. Of the four types of loans in terms of repayment, bridge loans are the easiest to spot. If all else fails, just ask management if it intends to sell any noncurrent assets, borrow from someone else, or sell any equity. Analysis. Bridge loan analysis focuses on two areas: 1) the likelihood of the event occurring that will repay the loan; and 2) the ability to service the debt in case the event does not occur. If the event failed to occur--say, the canceling of an IPO because of market conditions--the bank could be stuck with a very longterm loan or a permanent capital loan. In this particular case, the EBIT-tointerest ratio would be pertinent. Facilities. Bridge loans are normally structured with maturities to coincide with the anticipated event, such as the sale of a fixed asset, an IPO, or the completion of a construction project. Bankers should avoid demand notes or renewable 90-day notes, as these instruments are not self-policing. When a maturity date falls on a bridge loan, the loan should be repaid in full. If the loan is not repaid, the event has either been delayed or a failure has occurred. Interest on a bridge loan should be kept current, preferably monthly, so that principal does not erode. Collateral considerations. In a sale of a noncurrent asset, the bank will normally be secured with the asset being sold. In this way, the bank can control the flow of the proceeds as the buyer will want clear title. This means being present, or represented by proxy, at the closing table. The same principle will apply when the bank is being refinanced--say, in an interim construction loan.

When the bank is being repaid from the infusion of equity, the new shareholders, be they the investing public or a loving uncle, will want to know what's being done with the proceeds they are investing. In a public offering, the use of the proceeds will appear in the prospectus. In a private offering, the new investor(s) should know as well so there is no misunderstanding or recriminations at a later date. Consequently, the bank should be discussing the use of proceeds with management well before the infusion of the new equity. What can go wrong? The most obvious potential problem is the nonoccurrence of the event anticipated to pay out the loan. Some examples include: * Failure of the asset to sell or its sale at less than the anticipated price. * Prior liens on the asset or divergent claims, such as taxes. * Uninsured damage to the asset intended for sale. * Lack of firm commitment to refinance. * Inability to meet all contingencies of a commitment. * Inability or unwillingness of the other lender to meet its commitment. * Increases in interest rates that make it difficult to service the debt. * Inability to attract additional equity because of company specific conditions or general market malaise. * Underwriting equity sales on a "best efforts" basis as opposed to a commitment. Common lender errors. * Failure to consider all contingencies that could prevent repayment. * Overvaluing the asset being sold so that the loan is only partially repaid. * Not having enough refinancing available to repay the debt be cause of such problems as cost overruns and excessive accumulation of interest. * Insufficient cash flow generation to carry the loan if the primary event of repayment fails. * Improper risk/reward balance. Loan policy issues. Because there are so many bridge loan possibilities, effective policy guidance is difficult. For something as specific as interim construction lending, there should be complete policies for, say, owner-occupied and investor-owned real estate. The latter might be broken down by property type. Other bridge loan opportunities arise sporadically and are borrower specific. Accordingly, they must be considered on their own merits rather than under the umbrella of policy. Perhaps the biggest loan policy issue is maintaining an appropriate risk/reward balance because the secondary source of repayment is often weak or unpredictable. In such cases, the bank should demand enough equity up front from the owner to ensure adequate collateral value. The risk/reward balance of most commercial lending operations means that the bank must have a high degree of

confidence that the repayment event will occur. There should also be a secondary source of repayment and enough cash flow to keep the loan alive if all else fails. Permanent Capital Loans Permanent capital lending is revolving credit financing used to purchase current assets or pay current liabilities. In such cases, the amount of the loan should always be secured by the liquidation value of the collateral. The collateral will be predominantly accounts receivable and inventory, although equipment and real estate are often included. The term "permanent capital" is used because repayment understandings are indefinite, and the debt is really a substitute for owner's equity. Permanent capital lending is exercised under many different names, even in the same financial institution. For example, it is also called asset-based lending, accounts receivable and inventory financing, secured lending, working capital loans, and evergreen credit. Dealer floor plans and cattle and hog feeding loans are examples of permanent capital loans frequently handled in departments other than commercial lending. Permanent capital lending has several implications for lenders: * Advances should increase current assets or decrease other current liabilities. Purchases of noncurrent assets, the repayment of other than bank debt, dividends, and treasury stock purchases should be considered as separate lending issues calling for an understanding between the bank and the borrower. * Permanent capital lending truly revolves. Advances are continually being repaid from the collection of receivables, and new advances are made against the creation of new inventory and receivables. Outstanding advances fluctuate up and down as current assets expand and contract. * Constant monitoring is required to ensure that appropriate margins are maintained. Permanent capital lending requires a positive working capital configuration consisting of 1) slower-turning receivables and inventory and 2) faster-turning payables and accruals. An increase in sales will require an increase in financing as working capital absorbs cash. The receivables must represent true sales where a contractual obligation has been created. For example, contractors should normally not be financed by permanent capital loans because receivables and work in progress are not collectible until the job has been completed to the owner's satisfaction. The liquidation value of collateral should be estimated as if the borrower had ceased to exist, which is generally the condition when we need collateral. A number of situations commonly give rise to permanent capital lending: * Rapidly expanding sales that outstrip the owner's equity position. * New businesses that cannot demonstrate repayment capacity. * Depletion of working capital through purchases of noncurrent assets, such as acquisitions, treasury stock purchases, and losses. Leveraged or management buyouts often produce the need for permanent capital financing. A common situation for permanent capital financing is when a bank inadvertently finds itself in a position where a seasonal, term, or bridge loan cannot be repaid because of some setback, such as unexpected losses or the inability to sell assets.

A lender might start out with a seasonal loan that ends up with carryover debt at the end of the season. The lender then converts the balance to a term loan, but finds that the borrower does not generate enough cash flow to repay the loan. At that point, a permanent capital loan has been created, and the bank must handle the loan as if it had willingly made a permanent capital loan in the first place. The same situation can obviously occur when a bridge loan fails to pay out. With a permanent capital loan, repayment is indefinite, so the bank's ability to withdraw from the loan is tenuous at best. The banker will hope that the borrower has long-term cash-flow-generating power, and that the permanent capital loan can eventually be converted to a term loan. Or if the permanent capital requirement has been caused by rapidly increasing sales, a leveling off in sales will eventually produce favorable conditions for a term loan. Another source of repayment is refinancing with another bank or a professional asset-based lender. Of course, the borrower must still be attractive to another lender, which means that the borrower must have adequate collateral and cash-flowing capability. If the company does not have cash flow and no infusion of equity is available, liquidation may be inevitable. Banks that understand the considerable risks of permanent capital lending can handle such loans as a natural part of their commercial lending operations. On the other hand, all banks should develop some capability in this area because it is normal that a certain number of commercial loans will inadvertently become permanent capital loans. Analysis. The analysis of a permanent capital loan focuses on the following areas: * Management--Because of the heavy debt burden, margins for error and reaction times are considerably reduced. Therefore, management must be exceptionally capable and flexible enough to adapt quickly to changing circumstances. * Long-term cash generation--The ability to generate cash over the long term is usually the best means of repaying the loan. Without the ability to generate cash, the lender is often faced with a liquidation. Consequently, the lender must understand the borrower's sustainable competitive advantage in its industry and market. * Internal controls--The bank relies on frequent borrower-generated reporting. Management must have accurate and timely control and reporting mechanisms in place. * Credit policies--Because of the reliance on accounts receivable, management must have effective credit policies and procedures in place. * Collateral valuation and control--The lender must have the means of periodically examining the collateral to ensure that its liquidation value covers the loan outstanding with adequate margin. The foregoing analysis applies to a lender who knowingly considers a permanent capital request. However, any bank involved in commercial lending occasionally incurs a permanent capital loan because of a payment failure on another type of lending. When that happens, there will normally be shortcomings in some or all of the areas just mentioned. Nevertheless, the lender should immediately put permanent capital lending procedures in place because early detection and fast reaction are crucial. Facilities. Professional asset-based lenders tend to use lengthy, lawyer-produced loan agreements. Although there are many safeguards for conditions under which funds will not be advanced, the loan is usually accounted for as a long-term liability in financial statements, which does reflect the

facility's intent. The guiding principle of this type of revolving credit is that advances are made only on proof of adequate collateral, usually by certification, and all receipts are deposited intact and applied on the loan. New advances are made with proof of adequate collateral. Advances and repayments are often reflected on a revolving demand note. Collateral considerations. Before extending the facility, the bank must analyze the collateral to determine appropriate eligibility for advances and adequate margins. Accounts receivable are analyzed in the following areas: * Credit policies and procedures. * Credit quality. * Concentrations. * Selling terms in comparison with the industry. * Aging. * Returns and allowances. * Potential problems such as contra accounts or repurchase agreements. If the loan goes bad, the bank must be in a position to collect the receivables, which means having access to the books, records, customer lists, and so forth. Such records may be on handwritten ledger cards or electronic impulses. Long before that unfortunate stage, the bank would be well advised to control the cash receipts through a lock-box. Inventories are generally poor collateral unless the bank has significant expertise. Inexperienced lenders tend to value inventories as some percentage of book value. Book value has nothing to do with liquidation value. If the borrower ceases to exist, only certain portions of raw materials and finished goods are likely to have any value. Since the lender must dispose of the inventory at the worst possible time and conditions, a number of factors must be considered: * Costs of storage, transportation, and security. * Obsolescence. * Warranties. * Perishable items. * Costs of disposal. * Commercially reasonable means of sale. Inventories normally cannot give much comfort to commercial lenders unless they are fungible goods or commodities with established markets, or such items as packaged goods with brand names. Most commercial lenders without significant expertise in asset-based lending would be wise to restrict permanent capital lending to receivables, with inventory available as a margin for error. Equipment presents a long list of valuation issues, including useful life, obsolescence, and cost of disposition. Complex equipment, such as printing presses, needs constant and expert maintenance

to maintain its value. As a company deteriorates, cash may not be available for maintenance so the collateral may be deteriorating much faster than the bank thinks. Sometimes, professional appraisals will be required. What can go wrong? * Loan proceeds may be used for other than current-asset purchases or payment of current liabilities. The purchase of noncurrent assets or other unexpected uses without the knowledge or permission of the bank can cause considerable problems. * Losses may occur in the receivables portfolio because of concentrations, inadequate investigations, or other violations of sound credit policies. * Inventory may not be sellable, perhaps because of speculation. * Cash flow may be insufficient to carry heavy debt. * The borrower may come under pressure and create collateral eligibility fraudulently. The potential methods of fraud are too numerous to discuss. Common lender errors. * The lender ignores the red flags indicating a permanent capital loan and calls in a professional asset-based lender too late. After valuing the collateral, the professional is unwilling to lend enough to take out the bank. The bank must then decide if it is willing to subordinate some of its loan to the professional. * The lender places excessive value on the inventory. Frequently, banks place values such as, say, 50% of the book value of inventory instead of an adequate margin against the portions of inventory they can actually liquidate. As a result, banks often end up liquidating inventory at 10-30% of book value. Book value is a function of historical costs and irrelevant in establishing liquidation value. * The lender fails to establish a means of collecting receivables, so when the loan is called, there is no way of notifying account debtors. * When an asset-based loan is deteriorating, a professional tightens eligibility requirements and margins. This practice may hasten liquidation but ensures that the loan is repaid, which is in the best interests of the borrower. Inexperienced lenders give more eligibility because the customer "needs the money." This only prolongs the agony and increases the ultimate loss to both the bank and the borrower. * The lender realizes that a permanent capital loan has been created, but fails to establish assetbased lending procedures, such as cash controls. If the credit deteriorates, the bank cannot protect itself. * The lender does not have the expertise or stomach to handle one of the most difficult situations in commercial lending and does not ask for help. Loan policy issues. The main loan policy issue raised by permanent capital loans is how far the institution should go in accepting them. Should it actively solicit them and, if so, under what conditions? Should it avoid them but be prepared to deal with them if they occur inadvertently? Or is the best solution somewhere in between?

Typical commercial loan departments in banks do not have the resources and skills to compete with professionals, nor should they assume the same risks. Yet permanent capital situations arise constantly, so bankers need policy guidance on how far they can go and what administration should apply. Without such guidance, commercial lenders tend to take on more risk during economic expansions and attempt to lay it off with professionals during the downturns. Professional assetbased lenders will confirm that their toughest competition in good times comes from commercial lenders. By contrast, they find less competition and do better during economic downturns and credit crunches. The Art of Loan Structuring Loan structuring is an art, not a science, where reasonable people disagree, although the approaches of most experienced lenders will tend to cluster fairly closely. Loan structuring is also a means of defining where commercial lending ends and equity and subordinated debt financing begins, thus ensuring an appropriate risk and reward balance. Effective loan structuring can substantially improve the credit quality, efficiency, and profitability of the entire portfolio. Notes (1.) My favorite story concerning the liquidation of a seasonal inventory came from a bank that was lending to a garment manufacturer that had just produced a warehouse full of Nehru suits, a highly popular but justifiably short-lived fad from decades ago. The suits could not be sold at any price, and the manufacturer went broke. After months of disappointing efforts to sell the inventory, the bank sold the lot to a scrap dealer, realizing less than two cents on the dollar. The dealer scrapped the jackets and sold the pants as slacks for $40 each, making a killing. (2.) If you do not believe that statement, have lunch with some workout personnel. Morsman can be contacted by e-mail at edmorsman@prodigy.net [C]2002 by RMA. Morsman is retired from his position as E VP and chief/ending officer of Norwest Bank Minnesota, N.A. He is author of a number of Journal articles and other RMA publications. This article is adapted from a chapter of his book, Beyond Traditional Credit Analysis, available through RMA's website, www.rmahq.org COPYRIGHT 2002 The Risk Management Association COPYRIGHT 2005 Gale Group

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Edgar M. Morsman, Jr. "Commercial loan structure". RMA Journal, The. FindArticles.com. 19 Jul, 2012. COPYRIGHT 2002 The Risk Management Association

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