Defining C&I Lending – A Primer (2024)

Executive Summary. Both within the U.S. and overseas, banks are increasingly emphasizing commercial and industrial lending in lieu of their historic focus on commercial real estate. However, they need to determine where along the C&I spectrum they wish to play.

Having suffered from risk related indigestion due to overfeasting on commercial real estate (CRE) lending, more banks are now focusing on borrowers with commercial and industrial (C&I) needs.

While banks are moving in the direction of C&I lending, many begin at ground zero in this business, and few appear to have considered how they wish to pursue this area. Oftentimes, we find that even those that think they are already doing C&I lending in fact base their deals on buildings rather than ongoing company results.

Today, banker expectations concerning CRE versus C&I loans vary significantly. Most commercial bankers will steer CRE loans to be refinanced. For example, a one-two year bank construction loan will often be refinanced and become a permanent long-term loan provided by a life insurer or conduit, thereby repaying the bank. C&I loans are usually granted with no similar takeout expectations. C&I bankers assess how their customers operate and constantly monitor their cashflow performance and, in areas such as inventory turnover and receivables quality, the assets that turn into the cash to pay down the loan.

Multiple types of C&I lending.

C&I lending itself is not hom*ogeneous; rather, this category of loan differs in areas such as tenure (one-year working capital versus multi-year term), structure, monitoring, and pricing, among other elements. As discussed below, at least six varieties of C&I lending exist. Bank management needs to determine which of these loan types best fit their bank’s capabilities and culture. In addition, banks need to decide whether to build the necessary infrastructure to support these loans internally or work with a third party partner.

* Unsecured. These loans are made based upon an assessment of a company’s historic and expected cash flow; loans of this type almost always require the owner’s guaranty. Bankers need to be able to analyze current cash flows and understand a company’s cash conversion cycle. Blanket liens provide some protection, but to be effective these loans require monitoring and an ability to seize and liquidate collateral if necessary. Further, the guaranty needs to be evaluated carefully to ensure a liquid net worth rather than one tied up in personal real estate and/or company assets.

* Asset based finance. Banks provide these secured loans based on an advance rate set to a fixed percentage of qualified receivables and inventory. Oftentimes, banks lend using a borrowing base formula but fail to monitor these assets closely. Problems arise when receivables and/or inventory becomes progressively more aged or when asset levels are significantly volatile. Banks that try to pursue this business “off the side of their desk” are likely to suffer losses. Therefore, they need to establish strong internal monitoring capabilities or work with an outsourcer who does so.

* Leasing and equipment finance. Lease financing provides funds to purchase equipment. Banks offering leases often do so with minimum or zero residual value. While the borrower is often paying a higher interest rate, monthly payments are reduced, given the term nature of the debt. Leasing mirrors secured lending, and many small ticket and mid-sized lenders limit their reliance on liquidating the equipment, instead relying on the lessee’s expected cash flow and his expected end-of-lease re-lease or purchase. The ability to dispose of equipment is every bit as important an element of success with this product as with lending; this capability can be developed in-house or with the help of an outside firm.

* Small Business Administration (SBA) loans. In effect, the SBA offers a government guaranty to encourage banks to fund companies that they would not otherwise lend to. Many banks consider an SBA structure as part of a second look for initially rejected applications. SBA procedures are complex, and they require a centralized expert who can check documentation for consistency and completeness to ensure that the loan meets the requirements for a guaranty. Again, outside partners can offer this expertise.

Two other financing products stray further from a bank’s traditional comfort area:

* Merchant advance. These loans involve an upfront payment based upon typical and expected future credit card receivables. Loan repayments are deducted from card receivables as they are submitted for payment.

* Factoring. Factoring provides the advance payment of unpaid customer invoices. The factor purchases them at a discount without credit recourse to the borrower. Obviously, receivables quality drives factor success.

Banks are usually uncomfortable offering these products. The perceived risk is high, and the existing internal knowledge base is low; however, third parties will pay fees for deal referrals.

Picking your focus.

The natural tendency of banks pursuing C&I will be to offer loans that are unsecured or “lightly” secured. While it is part of a bank’s traditional comfort zone, it is also where the greatest competition exists. Moving into leasing and secured financing significantly increases the pool of targets — as well as the return upside. Of course with that comes the need for a more specialized skill set and a tolerance for what many banks will perceive as greater risk. This greater-risk perception is inaccurate, if appropriate risk management systems are put in place and competently staffed and operated. Management needs to determine whether and how to invest in obtaining the required knowledge set.

Working with vendors.

Within the U.S., third parties are eager to work with banks in each of the above product areas. However, virtually every bank we work with can recount past negative experiences with vendors. Either vendors did not perform as promised, or the expected deal volume did not occur, or the promised fees did not materialize. That said, working with experienced third parties allows banks to gain immediate capabilities at limited cost. Banks wishing to provide distinctive value to their clients need to reconsider how and whether to work with vendors. Is the ability to provide additional products and additional revenues/profits worth the struggles of managing through what can seem to be the minefield of a vendor relationship? Given a bank’s limited growth opportunities, it often will be.

Concluding thought.

In considering C&I lending, banks need to answer at least three questions:

* Which products do we wish to offer?

* What capabilities do we need in order to be successful at offering them?

* How do we best obtain those capabilities in a timely and cost efficient manner?

Players will answer those questions differently depending upon skill base, risk appetite, and revenue goals.