We often focus on cash flow and collateral when analyzing loans. Surely if the deal will produce adequate cash to satisfy all operational expenses, take care of all payments, and leave leftover money for the owners or for the future, that would be sufficient, right? If a business has a strong equity position and may even have more of its own money invested into an asset than you do on the loan side, that would be sufficient as well, correct? Both of these factors are important in assessing the credit, but perhaps the people factor can be the deciding issue of if a business will live or die.
I once financed a horizontal construction business who did amazingly well when the economy was going great in the early 2000s. They went from one subdivision to another putting in streets, sewer, and water lines. But then the crash in 2008 hits. Three subdivisions are developed by them and the owners did not make the full payment. In some they took property back as payment, but unfortunately, property does not pay the bills. The company saw most of its equity erode away with the large losses.
Throughout this entire time, the borrowers never missed a payment. They held one of the first characteristics you want in a borrower, they did whatever necessary to fulfill their obligations, even when it meant the sacrifice of their comfort.
The second characteristic is they had the ability to look at their business critically and make hard decisions which required a business mind to make with an absence of sentimentalism. They assessed and sold off a line of business they were in, even when that line was profitable. They realized the timing was good to sell and they also were able to get rid of a divided focus and concentrate on their core line of business. A different result came from a custom countertop manufacturer I had financed. When the economy turned and business dried up, he continued to promote granite countertops, even when the demand ended. He refused to go to other countertops that were selling which were of lesser quality and also less expensive, even when those surfaces were selling. Eventually, he closed down.
Another factor is the ability to be taught. I met my horizontal contractor for lunch one day and shared with him how his business looked to a lender. We identified three symptoms in the business financials and traced them back to their three root causes. In addition to selling off a line of business, they brought in additional capital from the owner’s family, and established strong pricing discipline. They stopped chasing any business that did not have at least a gross margin at a level they believed was necessary to operate the company. This led to less business, but what they did do, they made money with.
If these folks were not willing to learn, they would not have made the necessary changes and been able to survive. When I visited with the countertop builder identifying some of the same issues, I was met with an explanation of how I did not understand the business and thus could not offer advice. He would not look at the symptoms of his sick business and work to trace back to the root cause. Eventually, he closed.
Businesses that survive are also filled with leadership that can cast a vision and provide hope to others on the team. Challenging financials, tight liquidity, shrinking margins—all of these can be horrible downers to their staff. But somehow, these leaders were able to point toward the eventual goal and cast a vision in the mind of the workers. It was essential during the three-year period that took them to claw out of their poor financial state.
Character is developed during times of struggle. We sit at a time with renewed excitement for business prospects since the election. Also when Trump and Congress are able to achieve real tax cuts, healthcare reform, and regulatory relief, we will see our economy take off in ways we have not seen in years. A lot of money has been sitting on the sidelines in the past decade, and those funds can really be put to work in the economy.
But the challenge for a lender is to try to assess the character of your borrower. A strong economy can hide a multitude of sins. We have seen that in the Bakken area. A few years ago, horribly performing businesses could still make a tremendous amount of cash. When wheat was at $7/bushel, all wheat farmers were making money. There was no push to become more efficient, putting money aside for a rainy day, or growing at a measured pace. So when prices tumbled, the impact was greater.
If your borrowers have a strong character, they will often be able to rise above the troubled waters. The difference was worlds apart between the countertop manufacturer, which we foreclosed on, and the horizontal construction company. The last problem I had to work with on the horizontal contractor was what to do with the excess cash that the company was generating. They went back and made up their missed contributions to profit sharing plans for the employees and paid bonuses.