Equity Injection Math for a Workout

At Clifton & Co. Merchant Banking we talk to a lot of bankers and lenders. While workouts are not yet abundant, many like us, believe they are coming. Banks are ending their practice of "amend and extend." Post-pandemic, businesses were recovering, and banks generously allowed them to flunk the covenant with a plan to get it back in line once the comparable trailing twelve-month period was more favorable. So they drafted an amendment and extended the payback. But these loans and credits are reviewed quarterly, rates are adjusted, and business results are compared against the loan requirements.

For many borrowers, rates have moved up, cash flow is down, the stimulus has long run out, and the credit is not looking "solid." A few years into the original loan, rates have gone up, from e.g. 7% to 10%, and cash flow went down by e.g. 25%. This example loan will fail to get extended and the lender and borrower have to engage in a difficult conversation. Here is some basic illustrative math for this scenario:

When the company engages with new potential lenders, the lender will still be looking for a 1.5x minimum debt service coverage ratio. Pricing of a five-year loan will be closer to 15%, with a maximum borrowing value of about half what is outstanding at the end of year 3. How will this small business plug this hole? How will the balance sheet get corrected? I foresee needing an equity injection of some sort to avoid default and more dire consequences for the business, which is struggling but still certainly viable. As shown in the illustration above, it is a large sum, over $1 MILLION. That is the "price" to be insulted and start paying 50% more on half of the borrowing!

Many small and medium-sized businesses have been coddled by their friendly banker these past few years and will feel betrayed and blind-sided when banks begin changing their posture and demanding corrective changes to the balance sheet or asking them to find a new lending partner or seek an investor to bolster the business. This will suck up some of the dry powder private equity has been sitting on (favorable bolt-ons) and begin a small withdrawal from business owners' market holdings and investments. We welcome thoughts on how big this challenge will be for US SMBs, how soon it may come, and other options to weather the storm. Thanks for reading.