Debt Restructuring: Strategies and Options
A normal part of operating a business is taking on debt, but if that debt is not effectively managed, it can cause cash flow crunches, financial distress, and many other problems. Fortunately, borrowers can use debt restructuring to renegotiate their delinquent financial obligations, so they can restore liquidity and continue their operations.
Companies utilize debt for various reasons, depending on their unique needs. Small businesses often take on debt for the purpose of cash flow leveling, according to Michael Branham, a partner and senior financial planner with The Planning Center in Anchorage. “For example, for companies with the uneven realization of revenue (like a financial planning firm that might bill quarterly), but that still have to meet regular monthly expense needs, a line of credit can be a useful tool to fund expenses in an interim period until revenue or accounts receivable are realized,” he explains.
Branham also sees small businesses assume debt for acquisitions, capital investments or equipment purchases, or funding a business succession or ownership change. Small business owners also typically restructure debt to improve interest rates, and some small businesses opt to consolidate multiple types of debt—capital loans, lines of credit, and possibly real estate loans—to ensure they can pay their existing financial obligations.
Companies that are restructuring debt can seek lenient repayment terms and even ask to be allowed to write off some portions of their debt. “Debt restructuring can eliminate the risk of defaulting,” says Lori McCaffrey, Alaska market president and commercial banking sales leader at KeyBank, “as well as providing an alternative to bankruptcy when a borrower is experiencing financial distress. It can benefit both the borrower and lender.”
Sheila Lomboy, vice president and lending unit manager at First National Bank Alaska (FNBA), expressed similar thoughts on the rationale for debt restructuring. “The end goal for the borrower is to allow some breathing space, a chance to reset or refocus, by changing the direction of how they got there in the first place,” Lomboy says. “For the lender, restructuring debt is a way to reduce the credit risk.”
When to Consider Restructuring Debt
Determining exactly when to restructure debt will depend on the borrower’s situation. However, early detection is critical. “It’s easier to approach a bank when you have historically paid the loan as agreed,” Lomboy says.
Paying the bank first is key. “If you have to make the difficult decision on who to pay first—lender versus vendors—that is the sign to contact the bank and have an honest conversation,” Lomboy says.
The borrower can start the process by reviewing the current debt, including the interest rate and the loan terms. This information can facilitate devising an approach to resolving the issue. “Short loan terms equate to larger monthly obligations,” Lomboy says. “Consult with your banker on how they can properly restructure the debt to lower the payments or lengthen the term.”
It also can be helpful to recognize fundamental balance sheet shifts that might require the business to have more capital on hand. For instance, if a company is seeing its accounts receivables begin to stretch, the company must address this use of cash. “It might mean that a larger line of credit is needed for additional working capital into the business,” Lomboy explains.
McCaffrey also advocates that borrowers take a preemptive stance if they begin having complications with their cash flow. If a business is experiencing financial distress, its managers or owners should immediately assess why and communicate this information to their financial institution. The institution, acting as a trusted advisor, will consider the circumstances around the company’s liquidity issue, including an impending change in ownership.
Ideally, business borrowers should have plenty of liquidity to help them through a dip in their finances, Lomboy says. However, the prolonged COVID-19 pandemic has made maintaining liquidity more difficult for many businesses and has amplified the importance positive cash flow. “The recent pandemic has allowed business owners to realize that cash is king,” she says. “Without proper reserves, it is hard for businesses to continue paying rent, paying payroll, and buying supplies when there is a sudden halt in their revenue.”
For borrowers that are having trouble repaying their debts, their lenders might explore these questions: “Do they have enough cash saved up in the event that their revenues drop? Can businesses maintain to pay their fixed operating expenses and the debts they promised to make? If so, for how long?”
These scenarios are some common signs that businesses may need to restructure their debt. A reduction in revenue is another indication that debt restructuring may be warranted—although not always. “Revenue drops can be due to competition in the market. Having to outbid competition can equate to low margins on jobs,” Lomboy explains.
“Debt restructuring can eliminate the risk of defaulting, as well as providing an alternative to bankruptcy when a borrower is experiencing financial distress. It can benefit both the borrower and lender,” says Lori McCaffrey, Alaska market president and commercial banking sales leader at KeyBank.
Approaches to Restructuring
Debt restructuring is distinctly different from bankruptcy or refinancing. Bankruptcy is a process in which a debtor facing financial difficulty defers payments to creditors through a legally enforced pause. If debtors cannot honor the terms of the repayment plan, they must liquidate in order to repay creditors. Refinancing is simply replacing an old debt with a newer debt, usually with minor changes to terms, such as a lower interest rate.
When restructuring debt, Lomboy says, “Borrowers may begin by refinancing existing debt with their lender to lower their interest rates. In addition, some lenders can structure loans by lengthening the maturity date to reduce the monthly obligations. Another alternative is to change the payment status to interest-only for a brief period of time… Additional approaches to restructuring involve consolidating debts or equity extractions for borrowers who can demonstrate loan repayment.”
At FNBA, the timeline for restructuring debt depends on the original loan collateral and the agreed changes between the borrower and lender. “Credit approval for any modifications to original terms must be underwritten to evaluate the impact on the business’ future performance and collateral condition to determine the overall credit risk,” Lomboy says. “Borrowers should keep in mind that refinancing and restructuring debt that deals with real estate might require a commercial appraisal. In this case, the borrower should count on four to six weeks for a commercial appraisal to be completed.”
At KeyBank, it can take weeks to months for a borrower to complete the entire process to reconfigure their debt. The process generally encompasses an assessment of need, negotiating a proposed modification of terms and conditions, completing a financial analysis, underwriting, and closing.
Since circumstances will vary for each ownership entity, market, property, and credit facility, KeyBank often customizes debt restructures with negotiations tailored to specific situations. “Depending upon the circumstances,” McCaffrey says, “reduced or deferred amortization [or] forbearance of payment for a period of time may also be considerations, as well as consolidation of debt, different covenant structures, addition of personal guarantees, increased monitoring, collateral exams, et cetera.”
Apart from dealing with lenders directly, numerous third-party companies are also available to help borrowers navigate the process. In Alaska, The Planning Center offers financial planning and advising to businesses and individuals. Its broad services include asset, debt, cash flow, and income management, as well as investment management, estate planning, and tax management. Borrowers can also consult with online debt restructuring options like Second Wind Consultants, which touts its ability to work with major banks and creditors to help clients avert bankruptcy, liquidation, and financial trouble.
Working Directly with the Lender
Usually, though, borrowers work with their lender instead of a third-party mediator when restructuring business debt.
“I think the first priority is to work with a current lender, with whom you’ve developed a banking and lending relationship,” Branham says. “But in a situation where there’s little relationship equity, looking at other lenders could be a viable solution.”
FNBA, the state’s largest locally owned community bank, prides itself on working alongside its customers to help them navigate through the best solutions to help them succeed financially, Lomboy says. “Business owners and lenders should have a working relationship built on trust,” she says.
The bank treats restructuring based on the situation presented to meet the needs of the borrower best. FNBA can recommend how it can help borrowers modify their loan to resolve their situation. That is, “As long as the bank understands how the loan will continue to be repaid, the bank is likely to modify the terms reasonably to the benefit of the customer’s ability to repay,” Lomboy says. “Once an agreement is set, the banker and the borrower will provide updates until the loan has been satisfied.”
“Just like with all relationships, no one likes a surprise… Always keep the lender involved, and sometimes even a small mishap is okay to let the lender know about. This builds credibility,” says Sheila Lomboy, vice president for First National Bank Alaska.
With the typical debt restructuring to alleviate financial stress, the lender will review the overall risk profile of the client. This can include historical and projected performance and cash flow forecasts to determine the client’s forecasted cash burn; liquidity position and access to liquidity; ability to service debt, including upcoming debt payments from other lenders; legal liabilities (lawsuits), if any; capital expense, in particular deferred maintenance; owners’ distributions and tax liabilities; and the type of industry, its volatility, and industry-inherent risks.
“If the client has a proven history of navigating through difficult financial conditions in the past, that would prove beneficial to them in a restructuring of debt situation,” McCaffrey says. “Dependent upon the client’s overall risk profile, the lender may also take into consideration the availability of personal guarantees, additional collateral, or other protective measures.”
By working closely with their lender to restructure their business debt, borrowers can facilitate the process—and keep their financial institution from being caught off guard. “Just like with all relationships, no one likes a surprise,” Lomboy says. “Always keep the lender involved, and sometimes even a small mishap is okay to let the lender know about. This builds credibility.”
Debt Restructuring Tips
Like debt itself, restructuring is a tool. Financial experts agree that honest communication with lenders is the first step to straightening out a business’ debt payments.
Branham encourages business owners to establish a proactive relationship with their bank or potential lender, especially when a small-town bank or credit union is involved. “It can make the discussions more tenable when it comes time to increase borrowing or restructure existing debt,” he says.
McCaffrey agrees, adding that early communication and responsiveness can be effective in managing lender expectations. “A borrower should have the requested information readily available,” she says. “And a financial institution can often be more accommodating to a restructuring request when the loan is current.”
“Trust is built both ways,” Lomboy says, “and lenders should be able to identify and provide feedback on the vulnerabilities that a business owner may encounter.”
Debt restructuring is a strategic tactic that can be implemented by businesses large and small. And regardless of the company’s size or approach to reorganizing debt, the primary objective is to minimize financial harm, overcome financial hardship, and improve the business.