I met with a manager from one of the major banks recently in relation to arranging finance for a very profitable, currently debt-free, private business. The business owners, understandably, were not keen to mortgage their homes to secure the business loan and wanted the security to be limited to a registered mortgage debenture over the assets of the company, of which there were more than sufficient (even based on the bank’s own loan to value ratios) to cover the required level of debt.
We seemed to get over the hurdle of the home mortgages only to be told that the bank would require an annual audit, not just of debtors and inventory - which were the only assets taken into account as security - but a full audit. The bank manager seemed surprised that I was surprised by the need for a full audit – he said that was the bank’s normal requirement.
The reason I was surprised was that I have a number of clients with this bank and only one of them has been required by the bank to be audited.
It started me thinking about financing arrangements in the 1990s, and earlier, before funds became so plentiful that banks were fighting each other to lend to any solid business, offering minimal margins, minimal covenants and no audit requirement.
My recollection is that pre 2001, banks sometimes did insist on an audit where they relied solely on non-real estate assets as their security, although this stipulation could often be negotiated away if the business was attractive enough. Perhaps, indeed, this was a normal requirement.
It was also normal for businesses to be charged a margin considerably higher than the 1% (or less) we were seeing three years ago, and for lending covenants to be more onerous than just a simple interest cover ratio.
The lending environment of the 1990s was on the back of the recession-we-had-to-have, when banks exercised their right to call in facilities and wind up businesses that failed to meet the terms of their borrowings. That environment served to reinforce lending fundamentals in the 1990s. However, just as low-doc loans resulted in more residential property lending over the last decade than would previously have seemed prudent, so the lending fundaments for businesses were largely cast aside in the rush to deal with the abundant money supply.
So what we are experiencing now, in the wake of the global financial crisis (GFC), is probably normal. We are remembering that it is normal for banks to price for risk, to require audits and to impose a raft of lending covenants.
It is also normal for businesses to be concerned that their facilities could be pulled for breaching a lending covenant. This was not taken too seriously in pre GFC conditions.
Indeed, there will be business owners now who have been in business for a decade and yet have never before experienced ‘normality’.
Traditionally it has been normal for a growing business to eventually get to a point where its balance sheet cannot support any more debt and requires equity capital or mezzanine finance to reach the next stage of development. In the era of plentiful cash this point was extended so that far fewer SMEs had to seek equity funding than in the 1990s. With the drying up of cash, and the return of lower gearing ratio covenants from the banks, the need for equity funding for growth will increase. However, many private business owners are wary of taking on equity partners, often preferring not to grow to their full potential.
Pricing for sales of businesses has recently reflected the increased difficulty in obtaining funding for acquisitions. While business confidence and the demand for good businesses may have bounced back from the GFC slump, the inability to obtain funding appears to be restricting the number of transactions taking place. We are seeing that those acquirers with funds are able to drive a better bargain in the absence of a myriad of cashed-up competitors, resulting in lower price to earnings multiples, for example; SMEs that may have been sold for a six times multiple three years ago, may now sell for four times. But, overall, this could be a good thing. Paying over-the-odds for a business just increases the risk of failure, as the business struggles to service the level of funding required for the inflated price. With pricing going back to something like historical norms, businesses have more breathing space and can apply their cash flow to more productive matters than servicing the owner’s debt.
The reduction in sale prices also has an effect on succession planning. Before the GFC hit, many family businesses were seduced into selling by the high prices they could command. We are now witnessing a return of family businesses to a more normal mix of exit strategies, placing an emphasis back on succession planning.
Businesses in many countries continue to suffer in the depressed conditions induced by the GFC. In Australia, it seems we have been lucky and what we are now experiencing is simply a return to normality. We just have to get use to it.