Corporate debt begins life in a whirlwind of optimism. A bank or bondholder would never willingly lend money to a project that they expect to fail, after all. Not if they want to keep their job, anyway.
However, on rare occasions, the recoverability of some corporate debts will begin to slide through grades of certainty. Large, publicly listed companies may have their debt rated by one of the major credit rating agencies such as Fitch, Standard & Poors Global Ratings or Moody’s.
For a private company, no such ratings may be available and therefore credit risk managers must scour other sources, such as Dun & Bradstreet for more corporate information that may give them an indication of whether a company is beginning to struggle to make payments or raise further finance as necessary.
In rare cases, the initial optimism turns out to be totally unfounded and the creditworthiness of debt becomes non-existent. From the debtholders perspective, this is a disaster, but it’s no easier for the corporate borrower.
The impact of a non-performing loan on a business
When a company is unable to meet the covenants or payments associated with a loan, things start to become very difficult.
- Any breach of a covenant, however minor, may give the lender the legal right to demand full repayment of the loan, including accrued interest. This places the business under tremendous external financial pressure.
If a company has breached a covenant attached to their debt, they are inherently likely to be performing poorly and therefore will not have sufficient cash flow from operations to be able to raise the funds needed in the course of ordinary business.
- The breach may also impact the businesses ability to raise further finance from banks and investors and may therefore halt existing growth strategies or even necessary capital expenditure to continue operations.
- The crisis will inevitably lead to higher borrowing costs on any new arrangement, as the risk to any lender will be higher than when the original loan was taken out under more optimistic circumstances.
The ultimate mistake to avoid when restructuring debt
When restructuring debt to deal with a recall or covenant breach, business often assume that they need to stick with their current financial provider.
A bank or lender with a non-performing loan will not necessarily want to extricate themselves as quickly as possible. In order to receive the highest possible payment, they will likely be willing to renegotiate new terms (such as a lower monthly repayment or a later maturity date on the debt). This is in their best interest, but it may not be in the interest of a business to stay chained to the same lender. It can seem like a lifeline, but not all lifelines are optimal.
Lending is a marketplace, and like with any marketplace, the cheapest provider for a service at a point in time may no longer be competitive five years later.
Also, different lenders have a different ‘comfortable range’ of credit risk, and therefore in your businesses’ current position, there may be lenders in the market who are far happier to lend to your business in its current state than your original lender.