No More Fixed Rate Loans for You, My Friend

As managing partner of GGG and the Turnaround Authority, I get the pleasure of providing guest posts by our other partners. The following post is by our newest Partner, Vic Taglia.

Have you tried to get a fixed rate business loan lately from a “too big to fail” bank?  Has the bank said it only offers variable, floating rate loans?  Has it then offered to introduce you to its affiliated company that can help?

No More, My Friends

If you answered yes to these three questions, you are not alone. Many smaller borrowers find that the traditional 15-year fixed rate mortgage on their factories, warehouses, offices, etc. can’t be had from their long-time lender.

With interest rates at all-time lows, you can understand why a banker doesn’t want to fix his return for 15 years, just as much as you do want the fixed rate option. Bankers really need to limit their interest rate risk in these days of aggressive regulation, and avoiding long-term fixed-rate assets is one sure way to do so.

Their Friend Isn’t Your Friend, My Friend

But I don’t write to pity the TBTF banks.  I write to alert you to one of the pitfalls of this “affiliated company that can help” offer.

Most banks are part of bank holding companies, and big bank holding companies have investment banking subsidiaries. These investment bank subsidiaries can sell the borrower an interest rate swap contract that effectively swaps the borrower’s obligation to make payments based on variable rates for an obligation to make fixed payments for the life of the contract.

For example, a borrower may get a 15-year floating rate loan at prime plus 2% for his factory. At today’s rate that is 5.25% and will change the day the bank announces a change in its prime rate. For a million dollar, 15-year amortizing loan, the monthly payment at 5.25% is $8,039. If the prime increases to 8.25%, the loan rate rises to 10.25% and the payment increases to $10,900, an increase of 36%.

(For those of you with short memories, the prime rate was 8.25% from June 29, 2006 to September 18, 2007. Yes, four years ago, the prime rate was 8.25%.)

The Pitfalls for My Friends

We can see why no one wants to take the risk of interest rates increasing if he can avoid it. And the banks have a special incentive not to do so — avoidance of regulatory criticism. So their investment banks developed interest rate swaps. Great idea, but beware of a few potential pitfalls.

First the accounting for these derivative contracts is complicated and changes every month.  As interest rates increase and decrease and the present values of the cash streams change (as they will as time passes), the differences must go through your income statement and be recorded in your company’s equity. Some borrowers ignore this during the year and have their CPAs figure it out later.

I realize this is just paperwork and has little impact on your business (remember Cash is King), but it will impact your financial ratios, possibly hurt your covenant compliance and give you one more thing to explain in your financial statements.

More potentially troubling is that your obligation to make these fixed payments is for the life of the swap contract, not the life of the loan. So what happens if someone offers you a bunch of money for your business and you want to retire? Great, right?

Not so fast. You must pay off the mortgage note, but you still have the obligation to pay the fixed mortgage payment, every month, for the remainder of the swap contract or buy your way out of the obligation.

So read the fine print, negotiate an early maturity for the interest rate swap or even buyout prices in the swap contract. And ask yourself just how much you are willing to pay to trade one type of risk for another.

Have you gotten involved in one of these situations? What has your experience been?

Life’s Lessons and Surprises: 18 Months at Life University

Life is full of surprises, and as a business leader, you can’t let those surprises turn your business upside down. If you learn to manage them as part of your business, expecting that they will be there and creating contingencies for them like emergency cash, a fully stocked resume and interview line should you need some fast hires, good networking, a solid relationship with your banker and so on, then you will likely survive when they surprise.

In 2003/4, I did a turnaround for Life University, the award-winning chiropractic institution in Atlanta, GA. Life had a lot of lessons about the power of surprises.

Life’s Problem

After achieving an all-time high enrollment rate and setting the standard of excellence in contemporary health for its chiropractic undergraduate and masters degree programs, Life University was challenged with a loss of accreditation and defaulted on $35 million in secured bond debt.

Our Solution

Upon becoming the Director of Refinancing and CFO, we redid the budget based on declining attendance and negotiated a forbearance agreement with the Trustee and Bondholders. We also sold assets and refinanced others while the board searched for a new president.

The Outcome?

Within 18 months Life University’s cash flow was stabilized, accreditation was granted and the bond debt was refinanced. As part of the long-term plan, the school retained a President and Chief Financial Officer from a competing school. Victory was ours, and we won the Non-profit Turnaround of the Year Award in 2004 from the Atlanta Chapter of the Turnaround Management Association (TMA).

What I Learned from Life?

Professionals need to hire consultants and advisors who have different skill sets than their own. When professionals go outside their sweet spots they often make mistakes or don’t consider all the issues. Business is not the forte of all professionals – and it doesn’t have to be. Bring in business people to do business.

Life Always Has Surprises!

There are always surprises and things you didn’t account for. At Life, the CFO had a heart attack and bypass surgery, and without him we couldn’t find all of the documentation or understand the cash flow budget.

This created issues with the bondholders because a key member of the management team had been changed. Then, six months in, the president was gone, too.

A new president and a new CFO do not breed confidence to lenders.

What You Can Learn from Life

Be prepared for unfortunate events: heart attacks, death, personal tragedy, community strife. These things are part of life, and as a business leader, you have to have contingency plans in place to know how you would operate should the unthinkable occur.

Ultimately, in this case – and many others – communication solved these problems. Through extensive meetings, we got support in a forbearance agreement, which gave us time to hire a new president and to show results from fund-raising efforts.

Always have open communication.

The spirit of the chiropractic staff was great. They were committed to their university and seeing it survive. Anything I needed from them I got. Being part of a team that believes in the cause is a great thing, and in a crisis it’s very important to return to core values and purpose and to be able to lean on them.

Parting Words of Wisdom

This was a wonderful, award-winning turnaround. In turnaround management – as in business – there are always surprises. It’s your job not to let those surprises undermine your goals, but to deal with them as part of a business day.

What surprises have you encountered in business? How did you deal with them?

“If the Alligators are Biting, It’s Too Late to Drain the Swamp”

You may have heard this saying before:

“If the alligators are biting it’s too late to drain the swamp.”

Keep this in mind while running your business. Doing so can affect not only profitability but also your very survival.

Here are a few examples of when the alligators start biting:

1. Consider the sales manager who is not producing what you’ve come to expect from him; you notice a decline in sales and even a disruption to the team. He should either be refocused or fired. Now your revenue and profits are down. If he handled your largest accounts and the competition has now stolen them from your company, you’ve been bit by alligators.

2. Your CFO is constantly late with financial statements, and the bank is growing concerned. You then discover after months of frustration that he has personal problems that have affected his performance.  Now the bank is concerned about your ability to run your business. You’ve been bit by alligators.

3. The classic survival story involves fraud. Almost half – thats 50% – of our clients have encountered some kind of fraudulent situation. When the CFO/controller has been systematically stealing, the bank’s knee-jerk reaction can leave you scrambling to find another bank. That’s not so easy in this economic climate. You’ve been bit by alligators, and your company may be devoured.

The key here is to put safe guards in place with the assistance of your auditors. Don’t let the CFO set the testing limits above the limit he’s stealing. Let your auditors run the process. Also, as the CEO or key manager, you should periodically sign every check for a month that would normally be a “one signature” check handled by the CFO/Controller. This control is one great way to start draining the swamp.

How to Avoid Being Bitten by Alligators?

Be proactive instead of reactive. Drain the swamp before the alligators take up residence and start chomping.

As your company grows and you start delegating work, make sure that you keep yourself embedded in enough of the processes to have proper control. Don’t delegate and forget.

If you have auditing processes, don’t stick to limitations (e.g. we’ll look at all transactions over $5000). Mix things up and be unpredictable, so that no one can take advantage of your complacency or your routines.

Ask a lot of questions of your key people. Learn about your cash flow, your payables, and your company’s projections. Don’t believe what you’re told. Follow up on the details and have an auditor check out those projections. That’s prudent business practice.

I’m not suggesting that you don’t trust your CFO or that you don’t believe anyone. I’m just saying you need to question what’s happening and check up on things for yourself.

This may not be draining the swamp, but it is keeping the water level down. This is being proactive – not reactive – and it will always cost you less time and money.

Until next time, don’t get bit by the alligators.