When evaluating the repayment of a commercial loan, we examine several factors. Cash flow and collateral tend to dominate discussion, but I often feel management is an overlooked component which is just as important.
Management, as a risk factor, was something I first learned about as a regulator. The FDIC Risk Management Manual explains management risk as “The capability of the board of directors and management, in their respective roles, to identify, measure, monitor, and control the risks of an institution’s activities and to ensure a financial institution’s safe, sound, and efficient operation in compliance with applicable laws and regulations…” I think key amongst that quote is “identify, measure, and control risks” and “ensure safe, sound, and efficient operation.”
A profitable business does not necessarily signify good management. The question arises, does the current management have the ability to remain profitable or find repayment when times get tough?
A good idea or a profitable business on their own are not acceptable lending opportunities. A business may be profitable because it is in the right place at the right time, but change in technology or the economy may quickly lead to financial distress. To quote a popular phrase, “A rising tide floats all boats.” The ability to navigate those risks and deal with change is the management risk component. To quote Warren Buffet “Only when the tide goes out do you discover who’s been swimming naked.”
Strong management may make some marginal lending requests better, and weak management might make strong lending requests appear more risky.
I once worked on a lending request for an industrial operator in Washington DC. His core business was successful and in demand. This business would have been quite lucrative if expenses were tightly controlled and marketing opportunities for the product were expanded. The problem was, this core business bored the owner. Instead, he was trying to open new businesses and unproven product lines, which would struggle and lose money. In pursuit of another get-rich-quick idea, he used his core business to guarantee a risky lending venture in a very corrupt country abroad. This shows how poor management can put a good business in serious peril.
On the other hand, dealing with good managers can be a delight. They are organized, involved, and know their operating numbers like the back of their hand. Good management is never a substitute for credit basics, such as collateral and cash flow, but strong managers are good at mitigating risks. When a strong manager has a loan request that pushes the limits of policy, it may not feel like a stretch to grant credit, because the manager is capable. But still, it is not acceptable to throw out policy completely, simply because of good management.
The best way to evaluate management is to first do your own homework. You need to understand the business’s financials and read about the specific industry. Do this, so you can talk to the managers intelligently about their business, and then you can ask them about the good and the bad you see in their financial performance and address any industry specific risks you see.
Strong managers love to talk about these concerns, because they are constantly thinking about them. On the other hand, weak managers tend to be dismissive, and may not be willing to explain the items you have questions about. Weak managers may be unconcerned because they have a lack of focus, or perhaps a lack of understanding. Either case is reason for the lender to be concerned.