Management Accounting

Attack on the 7-foot-tall Woman

Auditors hired to investigate corporate borrowers' working-capital assets pledged against their credit lines say they've been busier than last year.
Sarah JohnsonMay 19, 2009

Besides wrangling with their lenders to keep fees and interest rates down and ensure their credit lines will be renewed, corporate borrowers making use of asset-based lending have had a new nuisance to deal with in recent months: bankers seem to be upping their due diligence by making more onsite inspections of their borrowers’ collateral.

Under ABL agreements, lenders reserve the right to regularly check whether the collateral posted against their secured loans — typically working-capital assets — is all there. And that right entails the ability to make sure what borrowers claim in their weekly or monthly updates is accurate. In good economic times, however, lenders haven’t always been consistent about how often they send in their examiners.

During the current downturn, as regulators push banks to maintain their capital ratios and as companies’ inventories have ballooned in size, lenders are boosting their scrutiny of borrowers and the claims they make about their assets. “Lenders are focusing on their credit underwriting, knowing their borrower, and making sure that the collateral they say is there, is there,” says Paul Mattson, who conducts these examinations and has seen an uptick in requests for his services in recent months.

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Although the increase in the number of collateral audits hasn’t been significant, questioning by examiners has grown more intense, say some who work in the industry. “Besides being a bit disruptive — some auditors will ask management a lot of questions and they take up space — it’s one more distraction for business,” says Robert Zadek, a member of the American Bar Association and an attorney at Buchalter Nemer who represents lenders. “But it’s a necessary distraction. You can’t tell the bank, ‘Don’t audit me.’ “

As a result, some companies must deal with more frequent audits of their collateral and the unexpected costs that go along with those audits. The inspections typically last between three and five days, costing $125 per hour. In total, they can each cost between $3,000 and as much as $27,000 for midmarket companies, which are those mostly likely to seek ABL financing.

First Capital, a financial services company specializing in ABL, conducts about 1,200 of these examinations every year, as much as three to four times in the case of some borrowers. Those exams are designed to verify that receivables are indeed collectable and that a borrower doesn’t have shelves stocked with, for example, unsellable T-shirts for 7-foot-tall women, says Mark Sunshine, president and chief operating officer of First Capital, noting that his firm has always conducted such examinations. The inspections are designed to verify that borrowers have the “right mix” of inventory, he adds.

But during the good times, some lenders may not have been regularly conducting the audits. Instead, observers say, they were more likely to waive the right to win over a potential borrower.

Bob Schleizer, managing director at Kinetic Advisors, which counsels distressed mid-market companies, says this shift began late last year, as sales across industries fell, inventory turnover slowed, and commodity prices declined. By that point, companies were sitting on products that they had overpaid for when, earlier in the year, the price of copper, oil, and aluminum had been much higher.

When such a discrepancies crop up, borrowers are expected to make up the difference in their borrowing base. The borrowing base is an agreement between lenders and borrowers about how much in the way of receivables, inventory, and other assets the company can use as collateral. Negotiations tend to focus on the value of the collateral and the borrower’s risk profile.

Schleizer says companies that hadn’t hedged against rising commodity prices were surprised to receive extra visits from their lenders simply because the cost of goods had dropped in value, not necessarily because they were having financial difficulty.

Schleizer recommends that companies should keep their inventory levels as low as possible and stock products that will turn over quickly. Companies are trying, it seems. For seven months, businesses have been pruning their inventories, hoping to keep up with slowing sales. Recent Commerce Department figures show they haven’t been overly successful, however, in avoiding having swollen backlogs: In March, inventories fell 1% compared to the previous month and 4.8% compared to the same time last year. The current inventory-to-sales ratio sits at 1.44 when last year it was 1.28.

One business sector that stands to gain from the heightened scrutiny: niche firms that conduct collateral audits, also called “field examinations.” Mattson, who owns a one-person collateral-audit firm in St. Paul, Minn., has received an increasing number of calls from lenders who want his business over the past eight months. He’s hired by both small and large banks, with assets between $200 million and over $1 billion, to examine privately held entities.

In particular, Mattson says, lenders want to know why a company’s inventory is moving slowly or appears excessively high. He’s been asked to look at customers whose credit line is up for renewal and ones who may be on the brink of breaking loan covenants. Mattson says that while annual audits are more common, he’s getting more requests for quarterly or semi-quarterly exams instead.

After an audit, a lender may require the borrower to post more collateral, adjust the agreed-upon borrowing base, or decide not to renew the loan.

To be sure, banks have their own problems. Federal bank examiners have stepped up their scrutiny of financial institutions in recent months, paying close attention to lenders’ risk-assessment policies. After all, “the crisis has exposed the inadequacy of the risk-management systems of many financial institutions,” said Federal Reserve chairman Ben Bernanke in a recent speech. Businesses feeling the brunt of this heightened scrutiny in the form of denied loans or higher lending fees have said the examiners have been too aggressive.

For their part, regulators argue that they’ve encouraged prudential lending for worthy borrowers. Moreover, collateral exams are “a longstanding credit practice,” noted Martin Gruenberg, vice chairman at the Federal Deposit Insurance Corporation, during a recent House Financial Services Committee hearing. “In cases where market values of collateral have significantly deteriorated and the borrower also is seeking a modification of loan terms, we have encouraged banks to work with the borrower during this difficult period,” he said.

In any case, regulators may not be the only ones be triggering changes in how banks deal with their borrowers. Some companies are in dire straits and surely warrant a lender’s close watch. A lender may boost its monitoring if a borrower’s main customer — one of the Big Three automakers, for instance — is having serious trouble, says John Kaye, a partner at Sisterson & Co., a regional financial consultancy in Pennsylvania.

Kaye says his firm began receiving a higher number of calls about collateral audits over the past six to nine months. Asking the firm to look at companies that previously weren’t inspected, Sisterson’s lending clients have a “heightened level of concern as the economy has slid,” he adds. 

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