This week, I turn to a lending issue that we seem to have seen a rash of recently. Many deals we have seen recently, seem to have a heavy dependency upon chattel and accounts as collateral. Chattel in this case is any type of property that is not real estate and can be moved that is not a titled vehicle. It can be equipment, fixtures, furniture, inventory, or such items. I use accounts to speak of any accounts receivable. I also am not discussing using a single asset that is purchased, such as a crane, forklift, or friction stir welder. I am speaking of a lien on what may be called “general business assets”.
These items usually have their collateral perfected by a UCC filing. This presents some challenge as some institutions do not even execute a proper search to see what other lenders may have already used these as collateral. Occasionally when we review existing files, we find loans where the lender believes they have a first lien on said assets, and sadly, they don’t. The next challenge is if the UCC filing was perfected correctly. The final issue is if proper extensions have not been filed for UCCs every 5 years, your filing has expired and you have no collateral.
One factor the lender must consider is how much reliance is placed upon business assets, what kind of assets make up the chattel, how the chattel is valued, and possible loan advance rates. As the lender first looks at the amount of reliance that the loan relies upon chattel, any other collateral that is available to the loan is also reviewed. If collateral that tends to have more stable marketable value is available for collateral and that constitutes the overwhelming portion of the collateral, then a lot of scrutiny on the chattels may not be warranted. If a large portion of the loan is tied to the chattel and other available collateral is skim, a closer inspection of the chattel is needed.
The asset composition of the chattel is important. Is there any way to determine an actual market value of the equipment, machinery, or crop outside of what is provided you from the borrower? How marketable are the assets? Do you have specialty assets that may not be easily sold to someone else in a liquidation or is the equipment in high demand with an easily determined market? A specialty asset may provide problems with liquidating the property upon foreclosure.
Valuation of the chattel is the next issue. A key factor is how this is determined for a large loan having a heavy reliance upon the equipment. In many cases, we have seen lenders just use the value as presented by the borrower without any third party appraisal. In some cases, the gross asset value without any consideration of depreciation, is used. We have also seen cases where not only is the gross asset value used, but no inspection was made by the lender to see what chattel is actually owned.
Again the appraisal issue is determined if the loan is larger and has a very heavy reliance upon the chattel or the accounts. Some options may be to check auction houses or get market values from different sources. In some cases, an equipment appraisal, whether on site or desktop, is necessary. The value the lender is most interested in is an “orderly-liquidation value”, or the value that would be most likely seen in the case of a structured sale by the lender. In some cases if the loan is large enough and the structure requires it, inspections may be needed throughout the life of the loan and the ability for the lender to rebalance the loan if there is a collateral shortfall should be in the loan agreement.
Loan advance rates are determined by answers to the first three questions and also loan policy. It is not always wise to run an advance rate up to the highest acceptable by policy. For a loan on equipment, generally the highest one will want to advance is 75%. This number may be lower if the equipment has limited marketability, is special in nature, or would require substantial cost to the lender in a foreclosure. The age and type of the equipment should also be assessed. Furnishings, signage, etc. should be at a much lower advance rate, perhaps around 25%. Inventory advance rates may range from 25-50% depending upon the marketability, valuation method, and inventory turn days. If there is a heavy reliance upon the inventory, a borrowing base may be used.
Accounts receivable based loans should be tied to a borrowing base factoring out issues such as concentrations, ageings, retentions, and receivables from sister companies. Generally, A/R under 90 days old would have an advance rate max at 75% after eliminating the other factors.
A lender must take a holistic approach to lending on chattel and receivables. The strength of the company, size of the debt, reliance upon these assets, availability of other collateral, are all some of the factors that go into properly structuring a loan to help best manage the credit risk. To deceive yourself into thinking you are adequately collateralized on a chattel based loan where the value comes directly from the borrower without any third party valuation or even a lender inspection, is dangerous lending. If the loan fails to pay, you may see how exposed you are in the end.