The Basics Of Business Lending
With the markets showing signs of calming this week, I have received several calls asking for more detail about the credit markets and why banks are refusing to lend to each other and why business loans are still not available. The fundamental reasons can be found in a thoughtful consideration of the reasons and basis for lending.
The reasons and incentives for business to lend to each other are rooted in one of two basic categories—a fundamental basis or a prospective basis. Some lenders tend to focus on a fundamental view of the relative risks and rewards of extending a loan and a decision is made to extend a loan because the high quality of the borrower is sufficient to satisfy the lender that the risk is low and the return is satisfactory. In order for this type of lending to be available, information must be available, credit quality and financial standing must be transparent and the economic environment must be stable and resistant to change.
Over time, lenders can become confident that economic situations are stable and resistant to change. Through long-term relationships, credit quality and financial standing can be established. And, through transparency, banks and lenders can fairly assess the credit worthiness of a borrower and the relative risks of any particular loan.
In any environment where these conditions are not met, the basis for extending a fundamental loan ceases and lenders are no longer willing to lend; such is the case in today’s economic environment. Borrower transparency is not available, economic uncertainty abounds and even long-term relationships are no longer stable.
Any repair to a fundamental basis for lending requires time, stability and a confidence that can only be established through transparency of financial condition. An unfortunate result of the recent economic downturn is an erosion of the basis for fundamental lending. The outcome is the apparent unwillingness of banks to extend loans to other banks, financial institutions and businesses.
The second reason that lenders extend loans—a prospective loan—is based on the future prospects of a company or organization. The incentives for the lender are significantly different and, likewise, the expected yield is significantly different. A lender that lends on a prospective basis looks to the future prospects of the company and is interested in helping the company achieve a set of business and financial goals that can be achieved with the use of the borrowed funds.
Generally, a prospective lender reviews business plans, evaluates management capability and history, and looks to the future opportunities of the business. A prospective lender will lend funds to a company with a view towards a participation in the future positive outcome of the business.
For example, six months ago, GoldmanSachs was actively looking for funds that they could borrow to keep the company independent and to capitalize on the market environment and the lack of competition created as many of their competitors left the business. When they were not able to find a lender that would lend on a fundamental basis, they opted for a lender that would lend on a prospective basis—Warren Buffet.
Warren Buffet invested $5 Billion into the company in a specially structured preferred stock yielding 10% annually combined with an additional set of warrants worth an additional $1.4 Billion. When GoldmanSachs couldn’t find a lender to lend on a fundamental basis, they opted for a lender that would lend on a prospective basis. General Electric was able to strike a similar deal less than a week later.
In this market environment, many banks, financial institutions and companies are struggling to find lenders that will lend on a fundamental basis. Companies must target lenders that are looking for opportunities based on prospective lending.
High quality companies, that will be the ultimate winners as the economy recovers, are those like GoldmanSachs and General Electric that understand the difference between fundamental lending and prospective lending and they adapt for the economic environment and the business opportunities available. Prospective lenders will require preferred interest and principle payments with a large upside participation.
In this market environment small-cap public companies do not have access to funds that can be borrowed on a fundamental basis; although, many small-cap companies continue to spend valuable time looking for funds to borrow on this basis. Companies like Goldman Sachs and General Electric have adapted to the economic environment, borrowed funds through the available prospective lenders and are moving forward with their business plans.
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