Don't Get Squeezed by Tight Credit

Why is financing so tough to get and what can you do about it?

Contractors and developers are very concerned about their inability to find or keep financial sources, as well as obtain financing for working capital or equipment purchases. Since this is such an important issue, I thought I would bring in some additional talent to help address what is going on with the construction/financing relationship and why; when we can expect it to ease up; and what steps you need to take to improve your ability to get financing.

The first person I called is Ken Hedlund, the principal in charge of the Construction and A/E Team at Somerset CPAs in Indianapolis, and chairman of the Executive Committee of the BDO Alliance Construction Industry Group, which represents 50 firms covering more than 1,000 construction clients nationally. As a CPA, Hedlund consults with clients on operational issues, including programs to improve banking relationships.

The second person I called is Robert Frentzel, EVP Specialized Industries - Construction and Engineering Division at The PrivateBank in Chicago. Frentzel and a team of former LaSalle Bank colleagues recently joined The PrivateBank to establish a commercial lending banking platform focused on Specialized Industries. The team is specifically focused on architects, engineers, contractors (general, prime and sub) and construction materials suppliers.

Tighter standards equal fewer loans

Before I contacted my two “partners in crime,” I did some research into banking practices, and came across an article outlining a survey conducted by the Office of the Comptroller of the Currency related to bank underwriting practices. The banks participating in the survey represent 83% of the loans in the national banking system.

In 2008, banks tightened underwriting standards for both commercial and retail loans after four years of easing the standards. The findings show 52% tightened standards and 42% left them unchanged. In contrast, only 6%/15% tightened standards and 26%/35% eased standards in 2005/07, respectively.

Furthermore, in 2008, 68% of lenders tightened underwriting in the retail sector, which covers mortgages, home equity loans and credit card portfolios.

The article notes that examiners reported increased risk in all loan categories. They expect the consequences of past relaxed standards, combined with economic weakness, to contribute to additional losses over the next 12 months.

It doesn’t sound like we can expect much improvement in the short run, leaving us to deal with how to mitigate the impact of banking system problems to get the financing you need to run your business.

Because the sub-prime mess that generated huge losses for banks is related to real estate, banks want nothing to do with anything even closely related to it. Unfortunately, this covers both you and your business. Banks also feel there is more pain to come, with a decrease in available construction work on the horizon. That translates into increased risk in the construction sector.

Both our guest commentators agree market conditions and a lack of capital, coupled with the proposed levels and delayed funding for government projects, are causing a major reduction in available work. Architect billings, which are used as a leading indicator for the construction sector, support this conclusion.

In addition, contractors in the housing sector are crossing into the commercial sector, making competition even tougher for the remaining jobs. This added competition is placing a squeeze on margins, yet there is a lack of available financing to do additional work due to poor financial performance.

It looks like we are facing the Perfect Storm — decreased profitability/decreased working capital/decreased equity lead to weaker balance sheets, which lead to less ability to bond and finance work.

When will it get better?

So when can we expect this situation to ease up? Bob Frentzel offered the following comments regarding construction activity.

Banks have to raise considerable new capital to shore up their balance sheet to comply with Federal Reserve lending guidelines. These equity raises are significantly diluting the existing shareholders. As a result, the pricing and structure of new loans are facing increased scrutiny. Banks are working to reduce their capital requirement by selling off loans on their books and significantly curtailing their business development efforts.

In particular, banks are reluctant to add to their For Sale Residential loan portfolios given the stress in this asset category. This will prevent many larger projects from moving forward, as fewer banks are willing to participate in the loan syndication.

The government’s decision to rescue mortgage investment giants Fannie Mae and Freddie Mac will definitely elevate concerns among mortgage debt holders, which include banks, insurance companies, foreign governments and sovereign wealth funds. What remains to be known is the impact the rescue will have on mortgage availability. On one hand, the government backstop should make mortgages more affordable to home buyers. On the other hand, it will increase government debt, pushing up yields on Treasury bonds and increasing overall interest rates.

Government budgets are also holding things up. All parties recognize the need to upgrade and expand our transportation infrastructure. Unfortunately, there is insufficient funding at the local, state and national level.

These factors are creating a major gap in available work, and Frentzel expects the next two years to be consecutively worse. With the work gap and lead time it takes to draw up and engineer projects, he does not see an upswing until 2010 or 2011. At best, it may start to appear in the latter half of 2009, depending upon the markets you’re in.

This rather scary scenario covers the national perspective. Now each of you must drill down in your work area and niche market to see how your work will fit into Frentzel’s assumptions. If you find he is on the mark, you have to do some very serious planning. On the other hand, if you don’t anticipate this type of downturn, you can plan accordingly. In either case, whipping up a plan for different workload levels is a must.

How to become more credit worthy

The question now becomes how to finance the work that is out there. Banks are still in business, and there are banks that still cater to the construction industry. They may not be dealing on the same terms they offered 24 months ago, but they are still closing deals.

So I asked Frentzel to tell us what contractors need to do to get financing under current market conditions. He indicates you will need to:

  • show a healthy balance sheet with strong internal reporting capabilities to properly track costs relative to the profit in your backlog;
  • demonstrate (a) management’s experience in working through business cycles, (b) multiple revenue sources to spread the risk and (c) that the business is sufficiently capitalized;
  • establish an understanding about where your business will be coming from and where new markets exist;
  • demonstrate how you would adjust operations if revenues fell short;
  • produce a business plan that projects revenues and expenses and discusses how you will track results, then adjust as necessary; it should include cash flow schedules and projected balance sheets.

Your best bet now is to bank with people you know. Make an effort to establish relationships. Leverage your network to find out who is offering the best terms, borrowing base formulas and minimum personal guarantees. Banks are looking for fully collateralized loans using a borrowing base that is probably less liberal than the one you are used to.

Also fall out of love with your equipment. Keep highly utilized equipment and sell off the rest. Or sell off old high-maintenance units, replace only what you really need and rent the rest.

I asked Ken Hedlund for his input on this topic, as well. As a CPA specializing in the construction industry, he works directly with clients to develop many of the documents bankers like Frentzel look for as part of a credit request. Here is what he had to offer.

If you have a bank still working with you, it may be better to stay put. Do the planning. Work the relationship, and find out what other banks are doing in your area.

Expect changes in borrowing base formulas and monitoring. Underwriting standards are tougher. The borrowing base most likely will decrease. A/R related to bonded jobs and retention A/R may no longer be included in the base.

Banks want fully collateralized loans and are asking for personal guarantees, additional paid-in-capital or cross collateralization with hard assets. If you have a clean deal with collateral and a backlog of work, you can shop your deal to mitigate guarantee requests, advance rates and interest rates.

Don’t approach a bank without a business plan that demonstrates management experience and depth, a history of performance through cycles and debt management. Explain backlog and the markets you intend to work in. Note that this plan should include history, as well as projections.

Document how company management plans to manage overhead and its workforce under different revenue assumptions. Have logical support for revenue assumptions.

Document plans to reduce fixed costs and the break-even point. Take steps to reduce costs to get back to “lean” status. Prepare an ROI analysis for each job you complete, because you can’t afford to tie up resources on break-even work. Implement performance-based pay plans to keep management personnel in line with company goals.

Bonding requirements also call for a strong balance sheet and the proper equity level. Take a good, hard look at your balance sheet. There may be opportunities to restructure credit arrangements and other liabilities to improve working capital.

Often, in a level or down market, prior year tax deferrals tend to reverse (cash basis, completed contract, depreciation, etc.). Be aware of your tax situation. Thorough tax planning is critical. Plan ahead and know your tax cash flow requirements. A proactive CPA will work with you to eliminate any surprises and minimize your tax obligation.

Alternative forms of financing are out there, but they’re expensive. More joint ventures may be required to be able to get work.

Develop a solid defense

Unless you’re one of those companies in a strong niche position, have a healthy backlog (that won’t soften up on you) or work in a section of the country that promises to remain strong on the construction front, the next 24 months will be challenging.

After discussing the financing crisis with Hedlund and Frentzel, there is no question in my mind that all members of the construction industry have to contemplate and prepare a defensive game plan. The goal is to generate a strong balance sheet and equity position supported by projected income statements and cash flow schedules. These documents need to be prepared properly, containing supportable data, and should be presented in a professional manner to bankers and other lending sources. Contractors aren’t going to get many swings to get financing, so you need to take your best shot every time.

By the way, that business plan you’re preparing isn’t for the bank. It is to help you manage your business and cash flow. Banks like to know that you understand how to prepare one, and like to review your assumptions to see if they make sense. But what banks really want to see is your capability to manage the changes that occur and still meet your profit or cash flow goals.

You know the old sayings: It’s not planning that makes perfect, but perfect planning that makes perfect. Do not expect what you don’t inspect. Plan the work and work the plan.

You get the idea. You may be back to basic “blocking and tackling”; but the more effort you put into managing the day to day activities, the more in control you will be.

Garry Bartecki is the managing member of GB Financial Services LLP and VP Finance for the Associated Equipment Distributors. He can be reached at (708) 347-9109 or [email protected]. Kenneth Hedlund, Somerset CPAs, can be reached at (317) 472-2103 or [email protected]. Robert Frentzel, The PrivateBank, can be contacted at (312) 564-1238 or [email protected].

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