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  • Evolution of Workout and its implications for borrowers

    Do you own a small business, a middle market company, or a fortune 500 company?  Whatever the size of your company, there are no guarantees of success in business, especially when it comes to profitability.  The rewards for success can be enormous, but so are the consequences of failure.  Consequences of failure include investment losses, inadequate cash flow to service debt, and possible financial covenant violations under the terms of your loan agreement with a bank or lender.  If those problems persist, your lender could declare your loan in default and transfer your loan to the “Workout Department” of a bank.  Workout lenders are not your typical bankers.  They take loan defaults very seriously.  The good part is that they can also be your best friends in terms of delivering the much needed quick response and flexibility that you need in order to turn your business around.

    In the 80s, many large savings and loan institutions experienced high levels of non-performing real estate loans as well as tenor mismatch in their loan portfolios.  Similarly, many oil and gas lenders, especially Texas based banks, ran into problems as declining oil and gas prices led to uneconomic development of oil wells as enhanced oil recovery techniques became uneconomical under depressed crude prices.

    At the same time, large international banks started to show serious stress in their loan portfolio due to the Latin American debt crisis. I had been in banking for only a few years and I recall the words of my bank president during one of our weekly staff meetings.  According to him,  “Our Bank did not have any problems until the arrival of these MBA’s”.  Everyone looked at each other and was puzzled at the comment.  Noticing the concern on our faces and realizing that we were wondering what our MBAs and arrival at the Bank had to do with increased problem loans, he clarified his statement by saying, “Oh, I was speaking of Mexico, Brazil, and Argentina, not Master of Business Administration”.  Those were the early days of formal work out departments at banks as many banks began to establish a formal workout departments in their banks to handle the increasing level of problem loans.

    Experiences gained by lenders in managing these high levels of non-performing loans, the associated reporting requirements to shareholders and regulators, as well as the specialized skill, experience, and manpower needed to resolve those problem loans caused many lenders to establish what is today regarded as the “Workout Department” in banks and other financial institutions. As borrowers became sensitive to the negative implications and taboos associated with being managed by Workout Departments, Workout Departments began to change their names to customer friendly names such as Asset Recovery, Managed Assets, and most recently, Special Assets Department.  All of these changes were intended to address the general misconception that borrowers in workout are automatically tagged for exit. Despite the changes to reverse this wrong perception, many borrowers remain ambivalent about being classified as a workout loan.  Whatever name a bank uses to describe these departments, the bottom line is that employees in this department manage loans that represent increased risk for the bank.

    Pre-workout relationship between borrowers and lenders.

    The New Jersey State Lottery once had a commercial that boasted that “you have to play to win”. That, in essence, is the complete story of a business venture. You have to invest in order to make a profit; but there is no guaranty of profit even if you invest. Therein lies the dilemma.
    Investing and growing a business, and maximizing shareholder value require management to leverage shareholders’ equity in order to obtain working capital or long term loans for capital investment. To secure working capital and medium term financing, most companies would borrow the required funds from a bank or other similar lenders. For longer term financing, borrowers with access to capital markets may issue shares to the public, or issue a variety of longer term debt instruments. Whatever the decision, companies need financing to grow their businesses. Regardless of the source of financing, there are usually credit or loan agreements that govern the terms and conditions of the lending relationship between lenders and borrowers.
    Most loan agreements generally outline certain covenants, which, upon their violation, would constitute events of default and entitle the lender to declare a default and take certain remedies. The usual remedies afforded the lender include the right, but not the obligation, to accelerate its loan and demand immediate payment from the borrower.
    In good times, the economy booms, businesses thrive and make money, and borrowers repay their loans as agreed.  If everything continues to go well, lenders are happy and lending officers seek opportunities to sell additional products and services to their customers. These additional services build stronger relationships with borrowers and lenders try to seek opportunities to generate additional fees for lenders.  To sell these fee income services with lower credit risk, banks wine and dine their customers. Many customers are invited to attend sporting events from corporate boxes at the local sports complex, golf outings, and other similar entertainments. This is all in an effort to strengthen relationships and sell bank products and services. Such is the relationship between lenders and borrowers in normal times. Life is good.
    Implications of being transferred to Workout
    Unfortunately, good times don’t last forever. Boom times are often followed by burst and troubled times. The reality is that there are good and bad economic cycles.

    In bad economic times, weak companies generally start to experience distress – lower profitability, poor cash flow, and reduced ability to service debt. Left unresolved, these problems cause the affected companies to experience more serious problems. As the losses mount, equity declines, and lenders become concerned about the increased credit risk of their borrowers.
    If these problems persist, the affected borrowers may begin to violate the terms of their loan agreements resulting in events of default.  Examples of Events of Default may include financial covenant violations, poor reporting, and failure to provide financial statements on a timely basis. As the situation deteriorates, and cash flow becomes tighter, companies fail to make principal or interest payment (or both) on a timely basis. The occurrence of these events of default are not only violations of the terms of the lending relationship between the borrower and the lender, they also point to increased risk to lenders.  The result is increased concern about the borrower’s ability to repay its loans. If the affected borrower’s financial difficulties continue unabated, the lender may consider the probability of loan repayment lower. It is at this time that lenders start to take actions to reduce its loan balance and other credit exposure to the borrower.
    Continued deterioration in the loan quality or perceived higher risk of non-payment of a loan would generally cause the lender to internally classify the loan as a “Workout Loan”. When so classified, the lender would want the borrower to resolve its business and financial problems within a reasonable period of time or face being asked to repay the loan in full.  A loan can be classified as workout loan without being classified as Non Performing. “Non-performing” is a technical term used to describe loans that have been placed on non-accrual meaning that in most cases, the lender is no longer taking interest to income.   Interest continues to accrue internally but any interest paid by the borrower is used to reduce the principal balance.  Non -accrual is just a technical term used in loan accounting.  It does not mean that the loan has stopped accruing interest.  In general, “Workout” means the process of actively managing a loan to avoid further deterioration in order to reduce credit risk or loss to the lender.

    General Misconceptions about Workout

    All loans classified as workout loans by a bank or similar lenders are not necessarily bad loans and are not necessarily tagged for repayment. The first question asked by many borrowers who find themselves in Workout is “what is workout?” or “what is Special Assets?”.   The simple answer is that Workout is a Department set up by banks or lenders to manage troubled loans to borrowers while affording the borrowers with opportunity to resolve their financial problems.  The workout Department can be likened to an Emergency Room of a hospital. Once you are in it, you have to get better and be transferred back to the good area of the bank, or get worse and face the consequence of being asked to repay your loan.
    There is a general misconception that once a loan goes to the Workout Department of a bank, the lender wants the loan repaid. Nothing could be further from the truth.  As an analogy, Workout loans are like cars that are having problems.  All such cars are not destined for junk yard. Some of those cars may have to be traded in for new cars, some will have to be junked, but most of them can be repaired and returned to the owners.  Similarly, whenever a loan is classified as a workout loan, lenders, particularly banks, generally classify the loan into three categories:
    • Retain – meaning that the lender wishes to retain the borrower in the bank if the underlying problem can be resolved;
    • Work-With – meaning that the lender will work with the borrower for some time before deciding the next cause of action;
    • Exit – meaning that the lender would want the loan repaid because the lender no longer wants to continue the relationship with the borrower.

    It is therefore important to every borrower whose loan has been classified as a workout loan to determine the specific classification (Retain, Work-With, or Exit).  The strategy a lender employs and the flexibility that is available to the borrower are dependent upon the classification of the loan once it goes to the Workout Department.
    Workout can be your friend

    Many borrowers react negatively to being transferred to the Workout Department. In fact, many borrowers engage in what psychologists refer to as “Transfer Aggression”. This is a situation where the borrower is already unhappy with how he or she has been treated by his prior lending officer and as a result, once in the Workout Department, they begin to react in an adversarial manner to any restructure proposals made by the new Workout Officer. Borrowers that are in Workout Departments should take full advantage of where they are. While being in the Workout Department may have some negative implications, being in the Workout Department can also provide some advantages – quick response and decision making due to shorter chain of command, no bankers’ hours for Workout Officers, the ability of Workout Officers to dedicate sufficient time towards helping customers to resolve their business problems, providing customers with alternative loan structures, and suggesting professionals that can assist the borrower.
    To locate a turnaround consultant who can help you with navigating through the often challenging task of dealing with workout officers and lenders, please contact BSD Advisors at or 866-982-2822