What Bad Loans and Management Shortfalls Mean for Investors

What Bad Loans and Management Shortfalls Mean for Investors

U.S. Banks are growing concerned — if not alarmed — and are reevaluating just how lax they are when it comes to handing out commercial loans. With sour loans on the rise, that’s not a pretty picture for companies that rely too much on credit lines or commercial loans. This is, in essence, a self-imposed business risk, as they are more dependent and susceptible to any fluctuations that occur.

A recent Financial Times article reported that non-performing loans increased by 20% at ten large commercial lenders. How much of an impact is that on the bank industry exactly? According to the Financial Times analyst, that’s a hefty $1.6B in the first quarter alone, a significant shift from credit quality since 2016, an era where the dust had settled from crashes and subsequent defaults on loans. The future started looking bright. Lending portfolios and credit quality began to improve. 

With merely three years of positive momentum, fast forward to present day and all that has changed and not for the better.  “Since most businesses utilize a credit line or other commercial loans, any slowdown will impact all types of commercial lenders – banks, asset-based lenders and factors,” said Yoav Cohen, an interim executive who has spearheaded eight turnarounds and liquidations, each one successful in paying off secured lenders in full. Cohen has seen it all, serving in roles as varied as interim CFO, COO, and a Chief Restructuring Officer.

Management Shortfalls Cause Bad Loans

Banks are identifying management shortfalls in companies as a cause of sour loans or defaults on non-accrual loans. From poor management of expenses, to lax financial controls, to taking on more than they can chew when it comes to capacity and resources, these businesses set themselves up for failure. It can be a slippery slope for lenders, banks, and investors, who end up imposing higher standards and restrictions on future loans.

“Non-performing loans are almost 99% due to management failures as well as bankers not understanding the operational side of business. Turnarounds are rare these days because banks are not providing bridge loans to fix company problems. Even California utilities are declaring bankruptcy. Private equity liquidates non-performing companies quickly and/or sells them cheaply,” explains Richard Lindenmuth, a Chief Executive Officer and CRO expert in turnarounds who has assessed and redirected strategies across industries and mentored business teams during significant change.

A recent New York Times article reported over 52% of employees are not engaged in the workplace, which Lindenmuth says is most likely a symptom of a management shortfall. “My experience is that number rises quickly when the company has visible issues,” he says. 

How Non-Performing Loans Impact Investors 

What does the rise in bad loans mean for investors? With the increase of non-performing commercial loans, banks will need to respond by increasing reserves. Inevitably, this will lower their profitability, and investors should be cognizant of how this will affect their earnings.

“Investors should be cautious about commercial bank stocks not only because of the possibility of increased reserves, but also because, according to Kiplinger.com, analysts project an overall earnings growth of just 2.9%,” warns Cohen.

With bank performance at risk, banks will ultimately take a more conservative approach to managing their loan portfolios. As a result, this may mean that businesses will have less lending options available.

David Johnson, an experienced interim CFO who has led many organizations through instability back to good financial health, explains that companies that are ready and willing to expand could potentially have their hands tied as they wrestle with less access to resources. “The risks are that companies optimized for growth will be slow to adapt to a more resource-constrained business climate and be forced to restructure, imposing significant losses on investors,” he said. 

David added that “Increasing levels of bad loans suggest eventual declines in public and private equity values, as lenders facing a loss look to force restructurings and increasingly risk-averse lenders restrict credit for new projects.”

Yoav Cohen has already seen a shift in attitude amongst lenders, saying that a major New York City based asset-based lender has reported that some clients are currently experiencing a slow down in their businesses. “The lender is bracing itself for possible problems in their loan portfolio in the second half of the year,” he says, pointing to the apparel industry as an area where issues have arisen, especially with sourcing of many products from China. 

How Can Investors Spot a Company Might Be in Trouble? 

What are the risks and red flags that a company might be in trouble, especially in the midst of “management shortfalls” that some banks are experiencing? If management cannot put their finger on the exact causes of chronic underperformance that’s a huge red flag. Tight cash flow that doesn’t seem to subside results in paying vendors late and capital expenditures being delayed. Dwindling gross margins are also telltale signs that things are heading south, and the business might be in trouble.

To avoid an impending default on loans, companies need to be on the lookout for signs. Cohen explains that businesses should routinely evaluate key areas, including the marketplace where they sell products and where and how they source raw materials or products. “In my experience, many business owners do not pay enough attention to the warning signs, and that’s how they get in trouble,” he says.

For companies and management teams in need of fresh eyes, a business assessment or company health check up from an interim executive can be a solution. Lindenmuth explains: “My experience is that an Interim that does not have any legacy can move quickly and engage workers into teams and make significant improvements in a short period of time.”