One question I am often asked, given my background as a former commercial lender, is what a lender is looking for in a borrower. The answer really would vary from lender to lender, their go to market strategy and risk appetite.
Instead it would be more appropriate to address the question of what key aspects of a lending relationship a borrower should be aware of for a smooth experience throughout the tenor of the loan.
Upon entering into a credit relationship the lender and borrower execute a loan agreement (aka credit agreement). That is the roadmap that provides the rules of the road for the subject loan. Key areas to pay attention to, among others, include understanding the reporting, financial, and negative covenants.
The reporting covenants would typically pertain to periodic reporting the lender would require including but not limited to annual operating statement and rent roll, key principal (or guarantor) personal financial statement and tax return, annual insurance renewal and copy of the evidence of property insurance, etc. Failure to deliver those would result in performance default.
The financial covenants would typically pertain to certain key performance indicators such as debt service coverage (usually a minimum of 1.25x and usually tested on an annual basis).
The negative covenants pertain to other matters such change of ownership, advances to shareholders, loans from shareholders, other indebtedness, distributions, change in property management company, etc. Those are usually to be disclosed by the borrower, though some (like other indebtedness) would usually be reflected in the financials. In the current environment many are talking about making shareholder loans in lieu of capital call. It is important to note that any such loans, would require lender approval before such a loan takes place. In some cases, the lender may also require that such loan is subordinated, i.e. not paid back until AFTER the lender is fully paid off.
This also brings us to the next key item – surprises. No one likes surprises really (especially negative ones) and neither do lenders. It is usually best to raise the issues upfront and proactively think through a solution together vs. asking for forgiveness (especially if such “forgiveness” results in a performance default).
After all, lenders are not in the business of foreclosing. They too are motivated to find a mutually acceptable solution as they want to get paid back (ideally in full and with a profit).
Reading an understanding the credit agreement upfront would also give an operator the opportunity to raise questions or bring up matters that may potentially impact their business or operations upfront. For example, if one wants to add the flexibility of making shareholder loans up to a certain amount (as way to inject additional capital into the business) – that can be discussed with the lender and possibly baked into the structure upfront. In some cases, the lender may be less inclined or able to do so (e.g. agency loans or private investor loans). Nevertheless, it is still worth asking and definitely worth reading the loan documents upfront so one can at a minimum walk into the relationship with eyes wide open.
I had a situation once where the lender required us to pledge not only the property but also the shares of our respective LLCs. This was not acceptable to me (or any of the partners when I raised this to their attention) and so we raised the issue with the lender.
Open and transparent communication, adhering to the loan documents, and strong operational track record all add up to create a satisfactory borrower-lender relationship.
Other than a matter of principal, why would that matter? Well, unexpected events do happen from time to time and borrowers may hit rough waters from time to time. Having a satisfactory pre-existing long term relationship in good standing would certainly make those difficult conversation go smoother and keep all parties motivated to move forward. Bad prior behavior (surprises, frequent performance defaults, poor operational record, etc.) would not help the case and in fact may result in exit of the relationship.
I hope today’s snippet shed some light on key points an operator should keep in mind as they enter into a loan relationship and key aspects on how to make such relationship and experience a smooth one.