Financing In Uncertain Times: How Factors Can Succeed in an Economic Downturn

While factors can often find great success during times of economic turbulence, it takes a practiced hand to do so. Steven N. Kurtz discusses the opportunities and challenges factors and asset-based lenders will face during the looming economic downturn.

BY STEVEN N. KURTZ, ESQ., LEVINSON ARSHONSKY & KURTZ, LLP

The past two and half years have been a roller coaster. We’ve experienced a global pandemic that won’t go away, supply chain problems, skyrocketing energy prices, record-setting inflation, stock market declines, a rise in crime, mass shootings and a war. Combine the foregoing with the lack of civil discourse on both sides of the aisle and the world certainly seems like a powder keg.

While I’m not an economist, we have also experienced an economic downturn which may turn into a more serious recession. Economic downturns typically result in good opportunities for the factoring and asset-based lending community; however, challenging and uncertain times also tend to shake out and eliminate certain players in the industry as well. Your goal is to be in the camp that prospers. 

Grow and Assess Your Portfolio

Many folks in the factoring and asset-based lending industry welcome a recession. Deals that were lost to traditional banks are now business opportunities. In economic downturns, banks also tend to kick out the deals that were once welcome. As bankruptcies go up, so will the opportunities for debtor-in-possession financing, which is not just for the larger deals anymore, as Congress has extended what is known as subchapter V and set the debt limit for small business bankruptcy filings at $7.5 million. Because of the streamlined procedures in small business bankruptcies, debtor financing is much easier for a small business. As interest rates go up, yields will increase as well. The inflation rate, while presenting challenges, has resulted in higher factoring fees due to the pricing of accounts financed by factors. These are just some of the opportunities in an economic downturn.

While economic downturns will result in business opportunities and higher yields, they also present various challenges, starting in a factor or lender’s portfolio. More business problems and failures mean that some deals in your portfolio can (and will likely) have issues. The key is to identify the challenges. 

You can start by assessing your portfolio. Make sure that your deal documents are all in order. Monitor for tax compliance. When clients and borrowers get into trouble or experience cash flow crunches, many turn to merchant cash advance lenders, which of course will eventually accelerate the demise of the factor client/borrower. Many MCA lenders don’t file financing statements and most folks don’t learn about this problem until something goes wrong. One way to check for additional borrowings is to get online access to your client/borrower’s deposit accounts. Look for regular debits on a daily or weekly basis; when you see a strange number being debited on a regular basis, you can be pretty certain that there is a MCA lender nearby. For further information on what to do if a deal goes wrong, feel free to check out my article from the February 2019 issue of Commercial Factor.

Know Your Lender

During economic downturns, you will also need to deal with your lender(s). First, you need to make sure that your lender is financially strong and has financed factors and asset-based lenders through a prior recession. There are always new players in the lender-to-lender market and many have not experienced an economic downturn. Some lenders-to-lenders are financial institutions that will experience their own portfolio losses in different segments, including consumer lending, real estate and business loans. In prior downturns, there have been financial policy decisions made by folks who have no idea about any of the lender-to-lender financing deals on the books. For example, before its Chapter 11 bankruptcy in the Great Recession, CIT was a major player in the lender-to-lender market. Several really good factors and asset-based lenders had large financing facilities with CIT. Many saw the writing on the wall and left, but the reality is that this is a relationship business and there were several companies whose leaders were loyal to their relationship with CIT. Shortly before CIT filed its Chapter 11 bankruptcy, there was a brief period when it was only financing its clients and borrowers on designated odd and even days. That did not bode well for the factors and asset-based lenders financing with CIT at the time. 

In addition to knowing your lender, you should evaluate your deal with the lender. Keep in mind that most lender-to-lender financing deals are based upon an eligibility standard. If you have a borrowing base, make sure you really understand how it works and, most importantly, how your portfolio now stacks up against said borrowing base, as well as how it may look in six months if there is a problem. Communication with your lender is important and if tinkering needs to be done, it’s best to start before you really need it. 

Get Creative

Difficult and uncertain financial times also give you an opportunity to be creative and do out-of-the-box deals. One example is participations. For instance, some bankers don’t want to see a borrower exit because of challenges but also are not in a position to provide further financial support for any number of reasons. This gives a creative factor and/or asset-based lender the opportunity to step in and finance a piece of the deal, allowing the borrower to stay with the bank on a large portion of its facility and pay bank rates. In essence, the borrower needs further financing, but the bank can’t go past its constraints. Therefore, the factor and/or asset-based lender steps in, finances its part and everyone wins. This type of “slice” or partial deal financing requires a basic intercreditor agreement that putts the factor first on its factored accounts and other points to be negotiated, which can be structured by your counsel. Generic participations are also an opportunity for factors and asset-based lenders, as they allow the players to spread the risk, stay in the transaction and still earn fees on a challenging deal.

Unfortunately, every downturn in the economy results in finance company failures. Most factors and asset-based lenders who do not make it, generally do so because their lender had lender fatigue. There will be portfolios for sale. There will also be deals that can be taken over. Typically, when a lender forecloses on a factor or asset-based lending portfolio, it does not foreclose in the traditional sense. Usually, the lender will take over and service the good deals until the portfolio can be sold. Of course, due diligence is required, but taking over deals from a lender to a lender can be a good opportunity.

Economic downturns present opportunities and challenges. For those who have not financed through a recession, doing so will be the equivalent of combat duty or earning a merit badge. Factors and asset-based lenders can thrive in challenging economic times, and hopefully if we go down that path, you will be one of those success stories.