Some customers need help, know they need it and ask for it. Others go into denial until they're beyond help. This year you may face the dual challenge of figuring out how to help the first group and how to prevent losses with the second. Here we talk with two experts who have long experience in working successfully with distressed credit customers.
If a major customer approaches you to discuss financial problems, you should not only pay attention--you should be grateful. Defaults and bankruptcies are expected to surge this year. Moody's Investors Service last month published its Bottom Rung list of 283 companies (about 15 percent of those whose debt it rates) that it predicts are most likely to default. Smaller companies are apt to suffer proportionately greater defaults. Some of the companies listed on the Bottom Rung have protested that they're doing fine, as no doubt will many shaky smaller companies. But we'll see.
"So many companies are in denial," notes Bill Lenhart, CPA, CTP, CIRA of BDO Consulting, a division of BDO Seidman, LLP. "The customer who comes to you and admits they have problems and wants to talk with you about them may be around in five years. Those who don't seem to think that they have problems may not."
The Smart Thing to Do
Attorney Larry Gottlieb, a partner with Cooley Godward Kronish, agrees completely. "If someone is willing to talk to you, you ought to talk to them," he says. "You should see if you can organize the other creditors to help work something out. We've done some deals where we've handled things out of court without them going into bankruptcy. It's tough to do. One of the reasons people don't know how to do it is that they don't do it often enough. They're worried about calling other creditors, but it's the smart thing to do."
Gottlieb suggests getting as many of the larger creditors together as possible to form a pre-petition, ad hoc, unofficial, creditors committee. "You meet with the debtor and get financial information from them," he says, "You deal with issues directly with the debtor and try to work out a payment plan, or whatever, in order to help them survive without having to go into bankruptcy."
However, neither Lenhart nor Gottlieb recommend waiting for failing customers to approach you. You should be constantly on the alert for failing customers, whether they're in denial or they eventually approach you for help. You do that by:
Scrutinizing Their Relations With Their Lenders
Getting financial information from a privately held company that is in denial can be a challenge. "If you're an important enough supplier, you may be able to pressure them into providing financial statements--at the very least unaudited statements that have some type of footnotes or schedules," says Lenhart. "If you can't get that, you should at least query the CFO or whoever you deal with to try to get loan maturity schedules, so if any are coming due in the near future you can at least ask questions about such things as refinancing."
He emphasizes looking at the maturities of long-term debt. "When they entered into these loan agreements three or four years ago, there was liquidity all over the place, and there was no real issue about refinancing." he says. But now that's all changed. "What we're seeing in a lot of instances where companies had entered into a three-year loan agreement--and those are starting to mature on 2009, 2010 and 2011--you've got to wonder. Is the company going to be able to refinance?"
You have to check out the current lender. Is it a bank or a hedge fund or a private equity firm? Does the lender have the wherewithal to provide the working capital the customer needs--something you never had to worry about before.
Gottlieb says that what you really want to see is the borrowing base certificate. This demonstrates whether the customer has availability under a secured bank line. Can the debtor actually take on more debt and be within the bank's formula?
"If it's a close call and there's not much availability, that indicates the debtor is at the end of the line of its ability to get new product," he says. "So the only way to get the ability to borrow is to sell product. And then when they sell product, they can buy new product equal to the amount they've sold. That's not a growth story. Availability is the crucial thing,"
Another thing to look for is whether the customer has a lot of secured debt; that is, does it have a tranche A, which is the bank's or tranche B, the mezzanine lender, Gottlieb continues. The mezzanine usually uses up a good deal of their availability, because the bank has a cushion, the first lien, so that if things turn bad the bank is still safe. If they have a mezzanine, they eat up that cushion. Often that's because the debtor either had problems and had to take on additional borrowing or did some sort of transaction in order to finance. But what it does is eat up the cushion.
"The mere fact that a customer has a line of credit doesn't indicate whether they can actually continue to borrow," he sums up. "You need to determine whether they have borrowing ability and how much of it."
Constantly Monitoring Their Payment Patterns
Both Lenhart and Gottlieb emphasize the importance of drawing agency reports, using industry credit group information services and, of course, keeping close tabs on your own payment experiences with customers. You should also be aware of who your major customer's major customers are. If you're dealing with retailers, it's more important than ever to know locations of stores and to find out how different regions are doing.
"Sit down and talk to the customer," urges Lenhart. "Have your questions ready. Get a gut feeling. Everybody has been hammered by the downturn. What are their comp store sales? Everybody is negative. How are their margins? These are probably hurt also. Are they paring back? Are they closing some of their distribution centers? Are they trying to cut overhead?
Gottlieb emphasizes the importance of determining whether larger vendors are still shipping and whether factors (in particular CIT) are still extending credit on behalf of their client.
Both cite the complications that the 2005 amendments to the Bankruptcy Code, particularly the 20-day rule, have brought to dealing with distressed customers. Under this rule goods received by the debtor company 20-days prior to filing are considered an administrative claim. As such. they have to be paid before the company can get out of bankruptcy. And because of just-in-time inventory, most of the goods that a company receives may be in that 20-day period.
So, filing bankruptcy gives them no benefit. "As a trade creditor, you'd say, 'Well, that's good. I feel more comfortable than if I shipped and a company filed,'" says Lenhart. "The problem is that it eliminates a tremendous amount of cash flow that can finance a restructuring. So, it can possibly backfire."
Administratively Insolvent
"What we are seeing now, which we only saw in the most dire circumstances in the past, is administratively insolvent cases," he continues. "It used to be that when a company filed you knew that the pre- petition liabilities were stayed until the end of the case. So the company had an immediate infusion of cash because now they had the inventory, but they didn't have to pay for it. Now, with these administrative claims having to be paid and with another 2005 Amendment requirement that utility companies are entitled to a one- or two-month deposit (which has to be escrowed immediately when the company files), it's a big cash outlay.
"So, all of a sudden companies don't have enough liquidity to fund restructuring. So the secured lender says. 'I have all these issues. You have to make a decision in a very short period of time to either sell the company or somehow restructure.' And in this economy it's hard to find somebody interested in buying anybody."
What all of this requires is that, if companies see they're going to run into trouble, they need to start planning way far ahead of filing for bankruptcy. They need to identify their future size and operations and how they will finance it. They must really have a plan put together and then go to major vendors and the lender to get their support.
"It's not easy," Lenhart notes. "But if they have a credible business plan and can get everyone in agreement, they can get through this."
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