Summary: Middle-market companies that are out of compliance with their lenders are typically assigned to the Special Assets group. Usually, these companies must find a new lender as part of their workout process.
Few lenders finance distressed companies in this market segment. Consequently, finding a replacement lender can be a significant challenge for lower middle-market companies. Lower middle-market companies have revenues between $12 million and $150 million.
This article provides a list of financing options that are available to smaller middle-market companies in distress. We cover the following:
- What is Special Assets?
- Evaluate your situation objectively
- Get the right advice early
- Distressed company financing options
1. What is Special Assets?
A company can fall out of compliance with its lender for several reasons. The most common reason is that key company metrics, such as Debt Service Coverage Ratio (DSCR) or revenues, no longer meet required thresholds.
Companies that fall out of compliance are usually transitioned to the Special Assets department. A transition to the Special Assets department marks an important change in your relationship with the lender. It indicates the lender considers your company a risky client.
The Special Assets department is in charge of handling loans that are out of compliance. Special Assets has three objectives:
- Minimize losses
- Recover principal
- Recover profits (if possible)
You can expect the lender to step up their oversight and monitoring. Be prepared for your reporting requirements to increase. Additionally, your costs may increase since loans typically allow for a higher default rate.
The transition to Special Assets is never easy, especially if you were not expecting it and were not prepared for it. Handling the transition correctly from the beginning is important. It helps avoid missteps and increases your chances of success.
2. Evaluate your situation objectively
Every company that gets transferred to special assets is different. Some companies are in good structural shape but are out of compliance. Their issues can usually be worked out if all parties cooperate.
Other companies are in bad financial shape. These companies require a lot of work, drastic measures, and compromise. Even then, success is far from certain.
The path toward turning around your business starts with an objective assessment of your company’s tactical and strategic situation. This first step can be a stumbling block for many lower middle-market companies.
In our experience, many small company managers have an unrealistic view of their company. They emphasize the positive aspects while downplaying problems. This view is understandable, but it undermines your chances of success.
3. Get the right advice early
One of your first courses of action should be to get advice from professionals with experience negotiating with Special Assets groups. Not getting the right advice early on can be a serious mistake and make the situation worse.
The type of professional you engage with depends on your company’s situation and your management team. At a minimum, consider working with an attorney who is familiar with Special Assets situations.
The attorney will help you understand your contractual rights and obligations. They can also help you negotiate the forbearance agreement.
Consider retaining an experienced CPA or turnaround professional to help determine your company’s financial condition. They can also counsel you on the financial and managerial aspects of turning a company around.
4. Distressed company financing options
Companies that end up in Special Assets typically need to find a new lender. It’s unusual for a company to return to the commercial banking group, even if the company is turned around.
This scenario can be a major challenge for smaller middle-market companies. These companies are typically referred to as lower middle-market and have revenues from $12 million to $150 million.
While bigger than a small business, they are still considered too small for conventional middle-market lenders. Consequently, they don’t have the variety of financing options that their larger counterparts have.
Lower middle-market companies have fewer options, often at a higher cost. In our experience, they typically use one of the following options:
a) Asset-based loans
The first alternative for small middle-market companies is to transition to an asset-based loan. These loans are flexible, structured based on your assets, and have have simpler qualification requirements.
Machinery and equipment are typically financed using a conventional term loan. The loan provides funds immediately and is paid off according to a schedule.
Accounts receivable and inventory lines can be structured as a revolving financing line. They vary based on your accounts receivable and inventory volume. The revolving lines typically help improve your company’s cash position. Read “What is an Asset-Based Loan?” to learn more.
b) Ledgered lines of credit
A ledgered line of credit, also called sales ledger financing, is a special type of asset-based loan. It operates as a standalone facility that finances only your accounts receivable.
These lines operate like a revolving line of financing. They enable you to finance up to 85% of your accounts receivable. They are flexible and are designed to improve your cash flow. The line can increase as your eligible receivables increase.
Ledgered lines typically operate with a borrowing base certificate, A/R schedule, or similar document. The lines have several advantages, are simple to implement, and have fewer covenants than bank lines of credit.
c) SBA loan and a working capital line
One alternative for some middle-market companies is combining an SBA loan with an accounts receivable revolving line. The SBA loan is secured against physical assets of up to $5 million. The accounts receivable factoring line is used to finance the A/R. This line provides a revolving facility to improve cash flow.
Note that this structure requires that the SBA lender subordinates its position on accounts receivable to the factoring company. Only a few SBA lenders are open to this arrangement, and they typically work with only specific factoring companies.
d) Accounts receivable factoring
An accounts receivable factoring line provides the benefits of a sales ledger financing line. However, it has simpler qualification criteria and can be deployed comparatively quickly. You can use this alternative if the company cannot obtain any of the previously discussed options.
Factoring lines have few covenants but come with tighter controls. Companies with cash flow problems can use them as a stepping stone for other options. Read “What is Accounts Receivable Factoring?” to learn more.
Looking for middle-market financing?
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