In today’s cloudy economic climate business owners still need the opportunity to borrow money to either start their company, expand their current business or make those necessary improvements. However, as the job market continues to shrink and companies across the country continue to tighten their belts, are banks still willing to lend money to business owners in need?
“Houston is a bit of an anomaly compared to the rest of the country in terms of having a stable economy,” says Cecil Arnim, senior vice president and business banking market manager for Wells Fargo in Houston. “Commercial banks are certainly doing more in-depth analysis than before and more stress testing of repayment scenarios.”
Smart Business talked to Arnim to better understand commercial lending from the bank’s perspective.
What does a bank look at when considering whether to provide a commercial loan?
When we look at a commercial client one of the overriding business factors is the equity investment the client is making. That customer looks at a rate of return anywhere from 15 to 20 percent at a minimum in order to invest. In order to achieve that return, the customer will have to be patient as it may take from one to two years for the investment to bear that kind of fruit.
In commercial lending, on my best day, I may have a spread of 3 percent, and that, by definition, makes me risk averse. If the relationship requires extra work or analysis, if you start looking at allocating salary and man hours, a 3 percent spread may drop to 1 percent very quickly. So I may not be making as much on that deal over the long term.
What we are trying to get across to our customers is that because our commercial lending spreads are so razor thin, typically that’s why we require a lot of financial information so that we can fully analyze that company and its ability to repay the loan. By the same token, because we are fully informed, debt always tends to be cheaper than equity. If I want equity investors I’ve got to pay them over time between 15 and 20 percent or more. On the amount I borrowed from my bank I may be paying prime plus one, which could be 6 or 7 percent. The debt costs less but I have a very definitive repayment schedule and I have to continue to deliver updated financial information to the lending institution.
A second point every client needs to understand is that banks can only provide service as well as the client allows it to provide. If a client provides me with updated financial information when it is expected to do so by virtue of the loan documents then we have a good idea of where that company stands. So when it has that emergency expense and comes to us for help we can move that much quicker because we have the updated information.
With such a thin spread, what is the incentive for a bank to provide a commercial loan?
A banking relationship is more than just lending money. It’s the deposit side, the treasury and cash management; it’s all of the other products and services we provide. Typically the client will have the greatest need on the lending side, whether it’s short-term working capital needs or maybe a client that’s been renting warehouse space and is considering taking the plunge and buying a building. Individuals with a strong capital structure and the ability to repay benefit by being able to borrow from a commercial bank at much cheaper rates than those who have to go out and find investors or pay the full price themselves. Is a company better off financing 70 to 80 percent of a building at 6 percent when for that same investment it could have invested in an alternative business that paid greater than 6 percent?
What red flags do banks look for?
A client with a fair amount of debt on the books that is greater than the amount of equity is one red flag. Small-to medium-sized businesses are usually leveraged from one to two times but once you start getting more than three times the equity we start having greater concerns.
Another red flag is when a company takes a long time to provide financial information or keeps making excuses for the delays. Finally, companies that are always changing CPAs is a great concern. Is it a matter of them firing the CPAs or do the CPAs fire them? Either way is not good.
CECIL ARNIM is senior vice president and business banking market manager for Wells Fargo in Houston. Reach him at (832) 251-5505 or Cecil.H.Arnim@wellsfargo.com.