How to Underwrite Loans Using TEV as Collateral

As the economy continues to improve and commercial loan volume rebounds, many community banks are making more loans to service businesses. These include medical and dental practices, nursing and retirement homes, and hotels and motels.

Lending to these kinds of businesses, however, entails a different kind of underwriting, as well as unique risks. Such businesses usually don’t have the kinds of hard assets like equipment and inventory that manufacturers and retailers do that can be pledged as a secondary source of repayment.

While these businesses operate out of real estate, the value of the operating entity itself — or the total enterprise value — is directly related to the success of the business.

Jeopardizing the Secondary Repayment Source

Increasingly, community banks are being asked to consider total enterprise value, or TEV, when underwriting loans to service businesses. But there’s one potential problem when it comes to underwriting loans to service businesses using TEV as part of the collateral: The value of the enterprise is going to be negatively impacted if the business isn’t generating enough cash flow to service its debt. And this will place your secondary source of repayment in serious jeopardy.

In other words, if the service business can’t repay its loan, this is because its cash flow is suffering. In a worst-case scenario, your bank would need to liquidate the business in order to recoup the loan. But a service business with poor cash flow has little liquidation value — and therefore, little value as a secondary source of repayment to your bank.

The bank regulators have issued guidance to help lenders with regard to the underwriting of this kind of leveraged lending, including their final guidance on leveraged lending activities that was issued in 2013. In particular, regulators have been concerned about the absence of meaningful covenants in loan agreements addressing debt service coverage and maintenance of loan to values in collateral.

They are also concerned about the aggressive nature of capital structures and repayment assumptions for some transactions, as well as reliance on enterprise value without adequate independent validation of the TEV.

Leveraged Lending Best Practices

Here are six suggestions to keep in mind if you decide to underwrite loans to service businesses using TEV as collateral:

1. Make sure the business has strong cash flow.

Service businesses should be able to demonstrate a reliable, consistent source of recurring cash flow to service the debt. This, after all, will be the primary source of repayment for the loan.

2. Underwrite the loan using a higher debt service coverage ratio.

This will give you more leverage to act quickly, if necessary. If you would normally underwrite a loan at a debt service coverage ratio of 1.2 or 1.25, for example, increase this to 1.4 or 1.5.

3. Scrutinize the management team.

The company’s management team should have a proven track record and high level of competence in the industry in which it operates.

4. Carefully examine the owner’s personal finances.

The owner needs to have some of his or her own money in the business — or some “skin in the game” — as well as a highly liquid and marketable net worth.

5. Structure a tight loan agreement.

The agreement should be written in such a way that you can step in quickly and take action if things go wrong with the loan — before the enterprise value has evaporated and, along with it, your secondary source of repayment.

6. Use conservative LTV ratios.

In particular, be conservative in the loan-to-value ratio used for collateral pledged to secure the loan.

One of the first rules of lending is that the primary and secondary sources of loan repayment should be independent of each other. Leveraged lending using TEV as collateral essentially goes against this rule. Therefore, it’s important to use extra caution when venturing into the TEV and leveraged lending waters.  

Contact our office to discuss TEV and leveraged lending safeguards in more detail.