Cash Flow Lending by Commercial Banks: What Went Wrong This Time? (Cash Flow Lending)
Rusnak, Raymond L., The RMA Journal
Cash flow lending has its allure and its foibles for senior lenders. The author looks at what mistakes were made and suggests a way that senior lenders can make cash flow loans to venture fund investments while avoiding some of the pitfalls that are currently causing them trouble.
Cash flow lending to finance acquisitions has been around in one form or another for a long time. Banks often lent more money than was justified strictly from the value of the assets on the balance sheet when their best customers believed the purchase of another company or division would create synergies with the existing business. The enhanced results would quickly bring debt back to traditional levels, bankers reasoned; if that didn't work as planned, a division could be sold or liquidated to reduce debt.
The Era of the HLTs
In the 1980s, Michael Milken of the investment bank Drexel Burnham Lambert and his followers argued that traditional bank balance sheet analysis was irrelevant to the lending decisions. Balance sheets looked backward and revealed only what was available on a given day. The only real test of a company's ability to repay debt, they reasoned, was cash flow, expressed as EBITDA (earnings before interest, taxes, depreciation, and amortization). Not surprisingly, this approach to credit analysis showed that a company could service much higher debt levels than had previously been thought.
As this approach to lending caught on with commercial banks, what became known as HLTs (highly leveraged transactions) were put together to finance leveraged buyouts (LBOs). This worked fine as long as companies met their projections and the equity market continued to climb. In the late 1980s and early 1990s, however, it all came unraveled. A recession appeared and EBITDA declined. There was no secondary source of liquidity as the stock market also declined. Banks consequently wrote off much of their HLT debt and withdrew from the market.
The "New Economy"
Then along came the roaring '90s. Believing in the New Economy, many financial professionals decided recessions were a thing of the past. Institutions were looking for alternative forms of investments that would bring higher returns than the stock market, and venture capital firms mushroomed. Because they were not necessarily buying companies that fit well strategically with an existing business, these firms became known as financial buyers. The goal was to combine similar companies, quickly bring overall operations to a scale that could go public or be sold to a still larger company, and exit the investment within five to seven years.
Venture capital funds have been around since the 1950s. The original funds were organized as a company that would manage a fund and, as the fund became more successful, would grow in size but continue in operation forever. With the growth of funds in the 1990s, fund managers discovered that they could attract more capital from investors by creating separate funds that would have an expected life of only a few years. These funds would invest a fixed amount of money; when the money was fully invested, the fund would concentrate on harvesting the investments and the proceeds would be distributed among the investors.
While this process gave very measurable results that could be shown to potential investors in new funds, it meant that follow-on investments to existing investments were limited by the liquidity of the fund at any given time. An investment in one fund typically could not have a follow-on investment from the next fund, since the shareholders of the two funds were not the same. Furthermore, the partnership agreements for these funds required that funds be immediately distributed to investors once investments were sold (a liquidity event). Therefore, once the funds were fully invested, there never could be a source of additional funds for the remaining investments. This has become one of the prime impediments to working through the problems that are being experienced today, as the funds are limited in their ability to support transactions that are not working as planned. …