Are Banks Finally Take More Risk?

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Just under a year ago, we wrote an article about how interest rates affect borrowing capacity. Given the rate at which interest rates were climbing at the time, it highlighted how much the increase in rates over the preceding 12 months had eroded borrowing capacity. Since that time rates quickly climbed ~0.75% higher and have moved sideways since. With inflation remaining stubbornly above the target band, it now seems very unlikely there will be interest rate relief until at least early 2025. And in fact the latest data is suggesting that interest rates are more likely to actually go up again before they trend down. This has resulted in it becoming increasingly difficult for commercial real estate (CRE) clients, who are particularly sensitive to interest rate movements, to maximize the efficiency of their capital through gearing levels.

 

The Double Impact of Rising Rates & Stagnant Bank Policies

As rates climbed and then eventually plateaued post COVID, there was an expectation that there would be a softening of property investment yields which would allow for CRE borrowers to achieve the higher levels of gearing seen before and during COVID. i.e. a softening of yields would result in lower property values and therefore the same level of income could service a higher LVR under the same interest cover ratio policy (ICR = net income divided by interest). However, whilst there has been some softening of yields, particularly in lower grade assets, values for sought after asset classes (such as industrial and medical) in good areas with strong lease covenants have only marginally deteriorated, if at all. This has created headaches for borrowers because banks are very slow to move their policies and by not adjusting their ICR hurdle, it meant that each time interest rates went up, the LVR borrowers could achieve reduced. Fantastic for the banks given they were taking less and less risk. Terrible for borrowers who were forced to provide more and more equity to meet bank policies. At some point though the pendulum had to swing as banks need to lend money to make money and their policies were becoming too restrictive.

 

The Banks Finally Catch Up

As mentioned above, banks need to lend money to make money. So it was inevitable that there had to be an adjustment to their policies as borrowers either weren’t looking to transact or they were exploring other options such as private credit, a fast-growing part of the market and a very real threat to banks. As a result, recently some banks have reduced their minimum ICR for CRE debt to 1.35x from 1.50x for certain asset classes. And given most banks have been pretty slow to move and therefore not transacting as much as they would like, there is currently quite a bit of heat in the finance market meaning some very attractive interest rates being offered (all up customer margins < 1.80% above BBSY). When the reduced ICR hurdle is coupled with an interest rate that reflects the risk profile (without the loyalty tax loading or any other reason for charging well above market), the impact on borrowing capacity can be significant. The below example illustrates the combined impact of interest rates and ICR hurdles and highlights how much a small change in the minimum ICR can affect borrowing capacity and subsequent LVR.

As can be seen in the above example, if a client is borrowing at 6.25% (pretty close to the market for quality assets and debt $5m+), a simple reduction in the minimum ICR from 1.50x to 1.35x increases their borrowing capacity by c. $600k. This translates to an LVR increase from 58% to 65%, a significant jump. Meaning the borrower can achieve the fairly standard maximum LVR for CRE debt with a bank. When reviewing the example taking into account a lower ICR hurdle and an interest rate reduction (which may be achievable if the credit risk margin is above market), the borrowing capacity can increase dramatically, particularly if the interest rate is towards the upper end of the range in the table.

 

So Are Banks Finally More Risk!?

The above commentary regarding changes in banks’ policies might suggest that banks are finally starting to relax their risk settings and taking on more risk. The reality is, on the whole, this is probably not true (although for some asset classes or in some areas, they might be from time to time). Whilst it may appear they are relaxing their risk settings, all they are really doing is re-setting their risk levels to where they were before. If you compare the LVR movement based on the recent real life example of a 0.75% interest rate increase and a reduction of the ICR from 1.50x to 1.35x, as seen in the table below, the achievable LVR is actually lower! This is due to the increased interest costs outweighing the benefit of the ICR reduction.

 

 

So although some banks have recently moved their policies, they are effectively just re-setting them at levels from 6-12 months ago. And when banks are still only lending up to 65% for the best quality CRE assets, it could be argued they are still not really taking significant risk.

 

How Do I Find The Best Rate & The Most Appropriate ICR Hurdle?

Finding the best rate and the most attractive ICR hurdle can be difficult. The key is being able to access numerous finance options, understanding what each option looks like and introducing competitive tension. And you can only do this by working in the finance market each and every day. Whilst many property investors and business owners have a good understanding of the finance market, few have the time needed to continually explore all options to ensure they are getting the best deal. At Nexus Capital Partners, we focus solely on commercial finance. So we can confidently say we have a deep knowledge of what is available in the market and where best to place debt.

 

If this is something you would like to discuss or explore more, feel free to reach out to Nexus Capital Partners. We are experts in ensuring your finance arrangements are optimized ensuring not only you get the best deal, but you also don’t miss out on future opportunities.

 

 

Supply Chain Cycle & Working Capital Finance

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Effective management of the supply chain cycle is crucial to a successful business. The supply chain cycle is essentially a sequence of processes and activities involved in the production, distribution, and delivery of goods and services from suppliers to customers. It encompasses the entire journey of a product or service from its raw material sources to the end consumer. To help understand the cycle, here is a very simple example of a typical supply chain cycle for a wholesaling business:

 

 

The above example is further explained below:

  1. $500k cash invested to buy inventory.
  2. The inventory arrives 8 weeks after purchase assuming no delivery or delays (wishful thinking?).
  3. All stock is sold within 30 days on 30 day payment terms.
  4. Cash for the sale of the stock is received 4 months after paying for it.
  5. Assuming all clients pay within 30 days (also wishful thinking!?), the business has been drained of cash for a period of 4 months.

 

In the simple example outlined above, if the business started with only $500k, it has essentially $0 to pay staff, rent and invest in additional inventory until it receives the cash after 4 months. And in the likely event that everything does not go to plan and it either takes longer to receive the cash or all the stock isn’t sold, it is effectively cash sitting on the shelf.

 

Many high-growth clients experiencing rapid sales growth, or clients with businesses that are seasonally affected, have heard from their accountants, advisers and bankers to simply ‘stretch out your suppliers or collect your debtors more quickly.’ This is obviously a lot easier said than done, and can significantly impact customer & supplier relationships.

 

Often clients experiencing a never-ending cash drain from their supply chain cycle, or who struggle to operate efficiently with an existing bank overdraft, haven’t had the benefit of having an advisor independently sit down and understand their cash conversion cycle and determine where a working capital debt facility can ‘fill the gap.’ They are also likely to be unaware of numerous working capital facilities options available to businesses that have strong earnings and a healthy balance sheet – many of which do not need property as security. Facilities that are generally far better at assisting with managing their cash flow than a poorly structured overdraft which is secured by their property.

 

The Relationship between the Supply Chain Cycle and Working Capital

 

Efficient supply chain management can significantly impact a company’s working capital. The supply chain cycle and working capital are interconnected because how a company manages its supply chain can significantly impact its working capital position. Efficient supply chain management can help optimize inventory levels, cash flow, and the timing of payments, all of which play a crucial role in maintaining healthy working capital.

 

If this example sounds familiar to you or if you are an accountant and you see this scenario with one of your clients; reach out to us for a chat and let’s see if we can put together a solution or advise a better funding package around working capital options.

How do interest rates affect Borrowing (Debt) Capacity?

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With interest rates continually climbing, most of the commentary focuses on how much more it will cost borrowers each month. Whilst it is important to understand this impact, it also very worthwhile to assess how much an interest rate increase restricts further borrowing through debt capacity &/or LVR restrictions.

Our analysis below demonstrates the significant impact even a 1% interest rate movement can have on a customer’s ability to borrow. And given BBSY is ~3.50% higher than this time last year, it is easy to see how much the interest rate movement has restricted customer’s borrowing capacity.

 

As seen in the example above, a 3% increase in Business Lending rates reduces the customer’s borrowing capacity by nearly $1m (based on repayments over 10 years). So if a customer is looking at an acquisition or purchasing a property to operate from, they may have to raise an extra $1m due to interest rate movements.

And for property investors, who traditionally have a smaller ‘spread’ of interest rates due to providing tangible security, a 0.50% increase can mean losing well over $1m in borrowing capacity, despite the LVR being within normal guidelines. i.e. even if a Bank was willing to lend up to 60% LVR, if the interest rate is 6% the borrower won’t be able to borrow more than 55% LVR if the Bank’s ICR Hurdle is 1.50x.

Given the substantial impact a relatively small interest rate movement can have on borrowing capacity, it is critical to ensure your interest rates are as competitive as possible to maximise your borrowing capacity. And with inflation stubbornly high, it doesn’t look like rates will be trending down anytime soon.

To make sure your finance arrangements are optimised, having an expert debt advisor like Nexus Capital Partners is key to making sure your business doesn’t miss out on future opportunities.

Is Non-Bank Lending for Me?

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Dealing with the Big 4 Banks over the last five years and in particular post royal commission has been slow and a time-consuming process. The rates are low, so most clients are just used to “playing the game” to finally get some sort of approval (Sometimes). Is Non-Bank Lending the way forward?

Recent data has suggested that non-Bank lenders are forecasted to share some 35% of the commercial real estate (CRE) debt market by 2024. The Big 4 Banks once controlled nearly 85% of the market.

The market share of Australia’s big four banks (ANZ, NAB, CBA, and Westpac) fell during the June quarter of 2022, to 70.3 percent. The 10-year average is 78.2 percent. The big banks’ share of lending was 84.7 percent in 2013. So, who is taking the market share from the big banks? The Non-Bank sector is proving to be an option for many borrowers, as are smaller banks and second tiers.

Why Has Non-Bank Lending Become a Thing?

  • Willingness to take more risk
  • Faster loan approval process (2-3 days compared to 2-3 weeks with a bank)
  • A less onerous application process and a tendency for a non-bank lender to view asset risk as the priority i.e Won’t get too tied up in wider group assets or other cash flow activities.

CRE Construction – Why Does Nil Presales / Nil Pre-leases Make the Transaction More Appealing

 On a standalone project basis, big banks take next to nil risk and will rarely speculate. i.e you build a nice new office, they will want it pre-leased, you build a 10 townhouses development, they will be seeking a level of pre-sales which varies depending on the economic climate and quality of the project.

No presales and preleases can mean:

  • More cash in the developer’s pocket at the front end of a project as marketing and presales commissions are not as important i.e less cash equity
  • As the market moves and times change, holding stock provides flexibility to sell or lease at different rates or hold stock to take advantage of market movements
  • And most importantly; the project can commence sooner without having to have qualifying presales or a prelease commitment, which means you avoid a rise in costs and take advantage of commencing other projects.
  • Also, a lot of buyers like to ‘see, touch, and feel what they are buying (especially with large purchases such as property). Low or no pre-sales provide the developer with the opportunity to build the product and then sell it when buyers can inspect the property, often leading to a premium price.

Is Non-Bank lending only for property transactions or can my business borrow from a Non-Bank lender?

A common misconception is that non-bank lending is only for construction funding where developers are looking for more flexible conditions. Non-bank lending is also a large source of funding for traditional trading businesses. Much like non-bank funding for property transactions, the benefit often lies in the risk the non-bank lenders are willing to take. This is represented by aspects such as:

  • Ability to leverage against the balance sheet & or cash flow without property security
  • Lower cash equity contributions for acquisitions
  • Greater willingness to have other funding arrangements as part of a transaction (eg. vendor finance, working capital funder, etc)
  • More relaxed repayment profiles enable the business to build up cash reserves (rather than using all surplus funds for debt reduction)
  • Non-recourse lending (no Director’s Guarantees)

Buyouts (MBOs)

 An MBO is often viewed as a preferred option for a business owner as the continuity and a sense of “looking after the staff” are at times important to a business owner when looking at an exit.

The issue with an MBO, in particular one of a larger size and the $millions, is management teams won’t have the capital or security to execute the MBO, and traditionally this has meant vendor finance was the only option. Major banks in the SME space ($1m-$25M debt) are traditionally looking for tangible security and won’t leverage off historical and forecast cash flows if they do its traditionally very conservative leverage with a rapid payback period of 3-5 years.

A non-bank option for a buyout is a great option and deals can at times be structured at 3.5-4.5x normalised EBITDA, on a pure cash flow lend basis i.e. a non-bank won’t ask, “Can I have your house as security”?

Equity always comes into play and equity being contributed, cash being left in the business and the vendor finance arrangement is all analysed and factored into the overall deal metrics.

The advantage of a non-bank is we can structure facilities to work alongside other debt instruments and working capital facilities via inter-creditor agreements. Non-banks will always provide higher leverage over a major bank, and it’s important to factor in the total cost eliminating or reducing the equity requirements when considering a non-bank option, as the rates are often >10%.

Should I Consider Non-Bank Funding?

Non-banks are not subject to the same capital and regulatory requirements as banks, so this often means

  1. Often can speculate on earnings, and sales on development, or in general a more aggressive funding package is put together
  2. Non-bank funding costs are typically nearly double those of major banks, but the flexibility, ability for higher leverage, nil presales, and overall, often a quicker loan process is enough for a client to be attracted to a non-bank and private fund for capital.
  3. Developers can often be frustrated with their bank reweighting their CRE portfolios and this can mean a developer who specialises in industrial for example, their bank might “pull the pin” on industrial for 6mths as they are overweight in that asset class.

Non-Banks are now popping up everywhere, and as it is an unregulated world compared to a major bank, the options can be overwhelming for clients who perhaps are not active borrowers, and a lot of the smaller and more agile non-banks and private funders do not advertise their product offering, so the average person won’t know where to find the solutions to suit their needs.

Nexus Capital Partners are very active in the non-bank world, and we hold relationships with numerous players, and we can provide clients the full suite of options and illustrate the pros and cons.

 

Working Capital & Funding Options

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As most people in business would know, cash is king. No matter how profitable a business is, unless that profit is converted into cash, the business will eventually run out of money. And given the raft of external factors currently impacting trading conditions (supply chain constraints, ballooning electricity prices, tightening of the labor market, and rising interest rates to name a few), the ability of a business to actively manage its working capital is a key ingredient to success.

 What is Working Capital?

Working capital is essentially the money (capital) available to meet a business’s current, short-term obligations. i.e. the capital required for the day-to-day operations of a business. For most businesses, there is a delay between when they outlay cash for raw materials, to when they can convert the sale of their products into cash. This is called the working capital ‘gap.’ Unless a business either has a very small working capital gap (or best case none at all) or has sufficient cash reserves to meet the gap, it will require a source of funding to assist with the delay between the outlay of cash and cash collection.

The Working Capital Cycle

The working capital cycle often referred to as the cash conversion cycle, is simply the time it takes for a business to outlay cash for what it produces to the time it collects cash for selling its product. This period is influenced by trading terms (of both suppliers and customers) and the time to convert raw materials into a saleable product (inventory).

How to calculate the Working Capital Cycle

The working capital cycle is calculated by the following formula:

Inventory Days + Accounts Receivable Days – Accounts Payable Days

An illustration of a traditional working capital cycle for a manufacturer, along with a calculation of their working capital cycle, is illustrated below:

 

 

The working capital cycle is calculated as per the above formula:

Inventory Days (20 + 15 = 35) + Accounts Receivable Days (45) – Accounts Payable Days (30)

Therefore the manufacturer has to wait 50 days from when they pay for raw materials to when they receive cash from their customers.

How much Working Capital do I need?

The amount of working capital a business requires is calculated by the following formula:

$Inventory + $Accounts Receivable – $Accounts Payable

How do I fund Working Capital?

Working capital can be funded by several different options. Each has different pros and cons. A table is provided below comparing the key features of the four main working capital products available to SME & mid-market businesses (pricing and security are based on reasonable risk spreads and may be larger).

 Overdraft / Line of Credit

Overdrafts (attached to a transactional account) or Lines of Credit (managed separately to a transactional account) are the least cumbersome working capital facilities to run. They have no real controls and can be drawn down immediately at the client’s request.

Trade Finance

Trade finance is a facility that can be used to fund stock & inventory and is aligned with your working capital cycle. To draw down on the facility evidence of what the funds are being used for is required to be provided to the financier. This is generally in the form of an invoice or purchase order. The finance is provided for the amount of the invoice over a term aligned to the expected time it takes to convert the raw materials to cash (as determined by the working capital cycle).

Invoice Finance

Invoice finance accelerates the cash collection process by a lender extending a limit against your unpaid invoices. This can be up to as much as 95% of the invoice. You are still in control of the invoice collection and your customers are not advised that a lender is provided finance against the invoice.

Invoice factoring is when your unpaid invoices are on-sold to a third party who then takes responsibility for collecting the outstanding funds. You might choose to use invoice factoring if you want to outsource your debt collection while obtaining immediate funding for the unpaid invoices.

Borrowing Base

Borrowing base facilities are facilities that provide leverage against the assets of the business. The customer borrows against a pool of assets (typically stock & debtors) referred to as the ‘borrowing base.’ The pool of assets can vary from time to time, meaning that the credit will vary by the assets’ value.

Reasons why a business might require additional Working Capital

Each business may require a working capital facility for a slightly different reason but generally, there are a few common underlying reasons for working capital funding. These are:

  • A steep growth trajectory with a large working capital gap
  • Seasonality in businesses where there are periods of lumpy cash flow
  • Change in either creditor (shorter) or debtor (longer) terms which means the business has to outlay cash quicker (creditors) and wait for cash longer (debtors)
  • Taking advantage of discounts on bulk purchases

 How Nexus Capital Partners can assist with Working Capital

In complex businesses, it can be challenging to see where opportunities exist to release cash from working capital. Understanding where the opportunities sit and unlocking that value can bring huge benefits, from better cash flow to more funds for debt reduction and investment activities.

We look at people, processes, and systems to find and unlock cash and working capital value. We put our “banker hats on” when reviewing a client’s supply chain and working capital cycle and we particularly can add value to high-growth SMEs who may not yet have a strong finance function and finance management team with internal capabilities on how to assess the true funding gap. Put simply, we provide solutions.

Often clients think they need some sort of working capital facility, our competitive advantage of understanding how banks assess true working capital and modeling this for clients is our point of difference.

The Target of a Tender Process

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We see a lot of advertisements around mentioning don’t pay the banks too much “loyalty tax” i.e. another way of saying – Let’s find the cheapest interest rate. Commercial and corporate lending facilities are not home loans; sometimes cheaper isn’t always better.

When we are engaged by clients to tender their banking arrangements and/or market scope terms for acquisition; it is easy to be drawn to “what is the cheapest rate you can get me”.

Whilst no one loves paying an absurd amount of loyalty tax to their financier, sometimes there is a lot more to pull apart in a debt structure than just an interest rate. The most critical question we ask a client is:

What are they trying to target as part of this tender process? Is the target objective simply the cheapest possible all-up interest rate under any circumstances, or are you trying to find that sweet spot between rate and overall terms?

We feel targeting the interest rate as a standalone objective for a tender of debt facilities, especially in the +$10M debt space, is fraught with danger. Anyone can go to the market and conduct a race to the bottom on an interest rate. When appointing Nexus Capital Partners as debt and capital advisors, we review full terms beyond just the rate and advise clients on non-monetary factors such as:

  • Covenants and conditions – Have these been stress tested? Does the business have the finance function and resources to potentially report quarterly/half-yearly to a bank? Does the client understand the implications of a covenant breach?
  • Loan Structure- Does this amazing cheap rate mean a full review is required in 2 years or is the rate for a loan term of say 5 years? Does the client value loan tenure? Does the client understand the review process and what is required from the financer? A cheap rate may mean a certain risk profile needs to be maintained, has this been stress tested?
  • Growth– If the client is on rapid growth, are they aware of the cheapest rates bank’s appetite to grow with them? Are there precedent transactions in the market illustrating that the financier is comfortable to grow in the client’s sector beyond the current offer? Does the financier offer facilities to support growth down the track i.e bespoke working capital lines?

Of course, the interest rate is important, and a difference of 100bps on a $10M facility is $100k in “loyalty tax” each year. A lot of clients ask themselves, how many more widgets do I need to sell to a net profit of $100k? The answer is often A LOT. However, it is important to engage the right people, who acutely understand the entire picture, to run a tender process and advise clients accordingly. Not simply pat each other on the back because they saved a client 0.25% on their borrowings when 12 months down the track uncover aspects of the facility they weren’t fully aware of because they focused solely on the rate when accepting the loan offer.