Lessons Learned and Relearned from One Economic Cycle to the Next: Analyzing a Borrower’s Repayment Ability--Part 2: Guarantees

Guarantees
The guaranty is, strictly speaking, a legal document obligating a third party, the guarantor, to repay the debt if the  borrower defaults. Therefore, like inventory, the guaranty must be evaluated on its value at default and usually after the collateral has been liquidated, certainly not at inception. The difference is that a guarantor is not a physical asset but usually a person or an entity, and the guarantor is far more difficult to value. There is a psychological component to add to the mix; the guarantor may have the ability to repay but not necessarily the willingness to repay. After all, a limited guarantee suggests only a partial willingness to repay. Consequently, the lender must judge both the creditworthiness and the character of the guarantor.

Bankers usually require guarantees for loans made to partnerships, privately held corporations, or other entities in which the owner’s and business financial interests are artificially separated by the legal concept of limited liability. However, a guarantee “pierces the corporate veil” of limited liability and brings back together the owner and the business; the owner- guarantor promises to repay the loan to his business if the firm fails to repay. Guarantors exert additional pressure on the principals to repay the debt. The owner or partner is likely to work hard to make sure the firm succeeds so that he or she does not have to repay the debt from personal resources.

Types of Guarantees
The degree of guaranty ranges from unlimited to non-recourse, but non-recourse is a euphemistic way of saying there is no guaranty. In stark contrast to non-recourse, an unlimited guarantee is continuing, joint and several:

?     The guarantee does not expire, that is, it is continuing, and it covers all current and future credit extended to the borrower
?     The guarantee is joint and several for those situations where there is more than one guarantor; each guarantor is liable for the full amount, and the lender can proceed against one or all of the guarantors

A limited guarantee may have an expiration date, or limit the amount of liability for any one guarantor. Many banks will accept guarantees that limit the amount of partner exposure if the aggregate guarantees are sufficient to cover the exposure. To protect the bank against the differences in wealth among guarantors, the bank may require that the guarantees add up 125 percent
of the exposure. For example, five doctor-partners agree to sign guarantees equal to 25 percent of a $1,000,000 loan, which means the bank has 125 percent coverage of its line and may seek payment up to $250,000 from each of the five doctors until it is able to recoup its $1,000,000 loan.

The bank is obligated to keep the guarantor apprised of any significant change in the borrower’s financial status, the terms of the debt, or in the status of any collateral. Of course, if the guarantors are also the principals, the communication is much easier.

Now it is time to figure out what a guarantee is worth. We know that the guarantor ought to be able to repay the loan if the borrower defaults, so that means the guarantor ought to have enough resources - wealth and income - to repay the debt. Therefore, the guarantor’s financial statements are key to calculating the value of the guarantee.
Adjusted Net Worth
When banks lend to a closely held company, they usually require the guarantees of the principals. If the company is very small or very new, the banker may prefer to lend directly to the principal, with the company as
guarantor. When banks lend to individuals or principals/guarantors, they ask for personal financial information to estimate income available to repay debt and to estimate the assets likely to be available for conversion to cash. The principals/guarantors’ income is typically added back to the company’s cash
flow to calculate a global cash flow for debt service, but what about their personal wealth?  Over time, the personal net worths of owner-principals should increase as their enterprises reward them with a reasonable return on their investments. On the other hand, the principals may have also covered cash deficiencies from operating losses or unexpected events. The banker’s dilemma is that the principal’s company and the principal/guarantor are so intertwined that the failure of one usually leads to the ruin of the other. Thus, the banker wants to measure the financial strength of the individual borrower/guarantor outside the company’s interests. The technique of adjusting net worth  gauges that strength.

The adjusted net worth (ANW) is the net value of the assets the individual possesses exclusive of any direct or indirect interests related to or dependent on any closely held business and any hard-to-value assets, plus any omitted liabilities. Calculating ANW is simple; just deduct from the book net worth the overstated portion of an asset’s value and the understated part of a liability’s
value. Conversely, in the rarer situation, in which an asset is undervalued or a liability overstated, add back the amount of the assets under valuation of the liability’s overstated portion.  Just as we expect there to be sufficient collateral value to liquidate the loan if income fails to repay the loan, we should and
collateral liquidation. Ideally, the guarantor has enough net assets to repay the loan in full. 

Reconciling the book net worth to an adjusted net worth is a common approach that shows how the original value was modified to yield the ANW. The following example format in Figure 4 illustrates typical modifications made to the book net worth to arrive at the adjusted net worth:

Figure 4. Format for Adjusting Net Worth
Total Assets
 -Total Liabilities
= Unadjusted Net Worth Less:

- declines in value of stocks and bonds
- investment in borrower’s firm
- amounts due from related parties, such as affiliates, subsidiaries, parent company, employees,
stockholders, and officers.
- fractional ownership interests, that is, less than 50 percent
- net equity in personal residence if lender does not hold mortgage
- personal assets such as furniture, fixtures, jewelry, art autos, planes, and oats.
- any other assets of unsubstantiated value
- estimated personal and corporate income taxes (for owners of S corporation)
- any other liabilities not already disclosed
Plus
+ appreciated value of stocks, bonds, and real estate
+ overstated portion of any liabilities, such as reduced income tax debts and favorable settlement of lawsuits
= Adjusted Net Worth

The decision to subtract from or add to net worth should be based on the bank’s own credit philosophy and the lender’s common sense. There is no absolute rule on valuing assets or estimating liabilities because of philosophical differences from bank to bank. For example, some banks may permit counting transportation equipment instead of deducting them as personal assets. Regardless, consistent application of the institution’s philosophy is critical to valid conclusions and sound decision-making. When ANW is positive, you can enjoy some cautious comfort, but when it is negative, you must underwrite your loan to rely more heavily on income and collateral for repayment.

The ideal guaranty repays the outstanding principal and interest in full, so the guarantor should have net assets, that is, total assets less total debts, to repay the borrower’s loan in full. Of course, evaluation of the guarantor’s repayment ability would eliminate assets with no liquidation value and add undisclosed liabilities to arrive at an estimate of the guarantor’s net assets or outside net worth. Therefore, the ends of the guarantor continuum are straightforward enough; a loan can be either unconditionally guaranteed or not guaranteed at all. A full guarantee is a promise to pay the entire loan, and an unconditional guaranty typically refers to the absence of expirations or events that would cause the guaranty to end before the loan matures. The latter condition is commonly described as non-recourse instead of unguaranteed. The halfway point between these two polar ends would be where the guaranty’s adjusted value, defined as ANW, is sufficient to repay fully and unconditionally the outstanding principal and interest (P + i) as long as the obligation exists:
ANW/(P + i) = 1.0
Between this halfway point and non-recourse lie various points of limited guarantees, promises to pay some portion of the debt but not all of it, and/or promises to pay part of the debt before some date that expires prior to the loan’s maturity date. At the other extreme beyond the halfway point lie points of increasingly extra coverage from multiple guarantors, any one of whom is capable of repaying the obligation. Figure 5 illustrates the guaranty continuum:

Figure 5. Guarantees
[(-) Non-recourse]------(a)----[ANW/(P+i)=1.0x]------(b)----------[ANW/(P+i)>1.0x]
Some of the intermediary points on the continuum include comfort letters and keep well agreements (a) and variations on limited guarantees. Parent companies of borrowing subsidiaries offer comfort letters or keep well
agreements to the lenders in order to avoid having to disclose guarantees in the parents’ financial statements. The parents usually promise to induce their subsidiaries to act responsibly, to honor all their obligations, and to maintain a majority ownership interest so long as the obligations exist. By definition, these promises are not guarantees and not legally enforceable. A little farther up the scale at point (b) lie limited guarantees, usually set at dollar or percentage
limits on individual guaranty obligations. There are also so-called “burn-off” or “earn-out” guarantees that diminish or expire based on some performance criteria and/or time limit. For example, a guarantor might agree to guarantee in full until the company achieves a DSC ratio of 1.25 for two consecutive fiscal years, then reduce the guaranty to 50 percent of the outstanding balance for the third year, 25 percent for the fourth year, and finally zero percent for the fifth
and subsequent years. The gold standard is the full guarantee — unconditional, unlimited, and continuing, so its infinite coverage is well represented at the far right of the guarantee continuum where the plus (+) sign sits.
In the next installment, Part 3, we will look at collateral.