Successful Business Lending: Pay Attention to the M&Ms

Now I know that someone will say, “Ah!  Finally someone has found the secret of lending in chocolate candy!”  Now this is not about that kind of M&Ms.  But understanding commercial lending can be boiled down into getting a good understanding of the math and management of a company.

A few weeks ago, as I was helping my daughter with her algebra, she asked me, “Dad, how much do you use math in your work each day?”  Her question caused me to realize just how much my job is based upon math.  We look at all kinds of ratios:  Loan-to-Values, Debt Service Coverage Ratios, Current Ratios, Debt/Assets, just to name a few.  Some of these same principles and ratios are used to judge a company to determine if it is a good investment.  In the case of either lending or investing, once you gain a commanding review of the math and all the factors that drive the numbers, decisions can be made to the credit or investment worthiness of the company.

I once had a loan on a used car dealer who had created one of these buy-here, pay-here car lots.  They catered to people who needed a vehicle and who could not handle the payment of a new vehicle.  The company utilized quite a few different banks to fund all their inventory and loan paper.  Looking back, the company was too leveraged, and we had problems historically with the debt to assets and the DSCR, was acceptable, though it was thin.  We did the loan with a SBA guarantee on it to help facilitate a new car lot.

Well, in this case, my violation of the key math ratios proved deadly to the credit.  The company failed to make it in a downturn in the used car market and we were forced to liquidate what we could get our hands on and file a claim for the remainder.  In this case and in nearly every other case in commercial and agricultural lending, if the math does not work, the credit will not work.

The second “m” is management.  Even if the ratios work well and the deal passes muster with all the empirical credit analysis, it still takes good management to execute acceptable performance in the company.  I once had a high-performing hotel in a resort community in my portfolio.  The owner wanted to sell and I financed the new buyer.  The borrower had an adequate down payment, good reserves, and had even owned and run a successful restaurant in the same community.  So surely, this was an easy credit, especially since the math works, right?

Wrong!  The success of the restaurant was largely due to good people that he had hired.  When he purchased the small hotel, in order to save money, he moved into the manager’s quarters on site instead of using an experienced general manager.  Then, he decided to cut housekeeping staff and do most of the work by himself and his wife. 

The challenge here is that he did not have or develop the skill set to keep the hotel desirable and also to relate to the customers.  An example was his solution to deal with a noisy customer was to post laminated sheets of paper throughout this beautiful, rustic hotel, telling the clients to be quiet.  These stuck out like a sore thumb.  His interaction with the customers was as abrasive as well.

Then, to save more expenses, he attempted to cut down on ongoing maintenance items on the property.  The hotel, once a desirable place to stay, had become a place where people would avoid.  The credit that worked so well with the math, had failed with the management execution.  It had become a problem credit. 

So a violation of the empirical math or the ability of the owners to execute on the mission, can each quickly become the death knell of the company, and unfortunately, your credit.  The best management skills can rarely overcome bad financial ratios.  And the best performing companies can fall into disarray if the leadership is not able to perform.