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In the News "Appraisals and the Asset-based Lender" By David K. Levy, DoveBid Valuation Services The history of lender’s reliance on appraisals is founded on the negative experiences that banks and financial institutions encountered during the 70’s and 80’s. These experiences in selling the collateral they had relied upon for their security, in whatever failed lending transactions they may have been involved in, was the basis and motivation for the growth of reliance on appraisals. Historically, lenders, and specifically the banks, had a traditional and extremely safe borrowing base of Fortune 500 entities. At some point those Fortune 500 entities moved away from borrowing from the banks for their capital needs and began raising their own capital through the issuing of subordinated debt. As the Fortune 500 firms increased their own debt financing and funding; the banks began to search for appropriate marketplaces to replace the lost borrower base. The logical and available market to the banking institutions of this country was in fact to be found in the middle market and in large part was based upon collateral or asset based lending. Transacting business with middle market firms was very different from the easy Fortune 500 deals of the past. Initially asset based lenders relied on cost information in large part to determine the collateral value for assets supporting a loan. When asset based lenders began experiencing failures in their portfolios they sought to recoup their funds through the sale of assets. The misleading nature of cost information placed lenders in an untenable position. It became apparent that cost was only one factor in assessing value. An analysis of what “cost” is comprised of reveals a number of potential pitfalls for the commercial lender. The appraiser needs to understand how versatile an asset is to assess its true recoverable value. If an asset is specialized in nature or application then the pool of end users will be limited. A smaller pool of end users generally correlates to a low recoverable percentage of cost for an asset sale in a failure scenario. Soft costs such as design and engineering, transportation, as well as installation and set up are a misleading and non-recoverable expense in calculating an assets true cost. Once the lending community was educated to the problems of “cost lending”; appraisals became a part and parcel to the collateral loan process. It was the disappointing sales of assets that caused the asset based lending community to realize there needed to be a more scientific approach in assessing collateral value at the outset of a transaction. The unsatisfactory experiences that the lenders endured in the early days served as a lesson for the behavior of today. The fact that cost was not a true indicator of value in a liquidation scenario was driven home time and time again when the sales of these assets occurred at startlingly lower prices than the portfolios had relied on for making the loans. Collateral finance has grown dramatically as different commercial sectors have experienced radical change in their constitution and funding requirements. Just in time production, mergers, acquisitions, spin-offs, ESOP’s, growth in governmental regulations and FIREA compliance are but a few factors involved in the growth of and demand for asset based loans. The result of this tremendous growth in asset based lending is an equally large growth in the demand and need for appraisals and evaluation services to support these transactions. The undeniable trend of a greater reliance on formal appraisals by lenders is important in establishing real value for collateral purposes and documenting that value in the lender’s portfolio. An interesting development, in commercial finance circles, has been the onset of reliance on commercial inventories as collateral for revolving loans. Evaluation of inventory for commercial finance applications requires due diligence on a number of important levels. The first step in the evaluation process is to recover a basic understanding of the pertinent details regarding the inventory. The information gathered should include but not be limited to: inventory description including a detailed description of the inventory, count information, cost information, product categories and sub categories, as well as financial information such as gross profit margins, aging reports, and operational overhead factors. It is important to not only receive present technical data but also historical data to ensure the most accurate value assessment possible. It is important to gain a knowledge of the potential inventories market share, to understand competing inventories and to find out the acceptance factor the specific inventory enjoys within the market place. The objective of rendering an opinion of value regarding liquidation scenarios of an inventory is to, if not eliminate risk, create an awareness of risk and to quantify the extent of that risk. In understanding an inventory, important weight should be given to waste factors and quality considerations. Make sure the inventory is good, that it does not have a particularly high return rate and that work in process (W.I.P.) is carefully tracked. It is recommended to remove W.I.P. from lending formulas when computing advance ratios. A good rule of thumb is to test check inventory against the information being provided. It is important to physically spot check all cost, count and aging information provided regarding the inventory. If there is one thing to learn regarding inventory evaluations, it is to really check and not accept at face value the specifics regarding an inventory. There are a couple of important axioms regarding inventory evaluations that should be mentioned: First, inventories do not make good term lending prospects due to the fluctuating status of inventories. Inventories should be lent against as part of a complete package where the lender controls both term and revolving debt. Second, the higher the inventory volume, or inventory turns, the lower the margin the more liquid the inventory will be if liquidation is required and, conversely, the lower the inventory volume, the higher the margin, the more difficult the inventory will be to liquidate. Inventory evaluations are complex projects that require true time commitments and extensive analysis. However, if the proper information is gathered, accurate assessments as to inventory liquidation values can be reached. The ability of appraisers to accurately reflect asset value in a myriad of property categories on a number of different levels is primarily what lenders are seeking when they have evaluations performed. An appropriately constructed and properly guided appraisal is viewed by the lenders in large part as an insurance policy to their transactions. The fact that appraisals have limited lifetimes and therefore lenders and other interested parties have a need to reassess the value of assets on a regular basis has only increased the demand placed upon appraisers. The need to reassess values of assets on a regular interim basis is driven by many economic factors. Those factors include a fluctuation of economic conditions such as interest rates, and technological developments and extend to the individual needs of the borrower. The ability to recognize those factors in periodic reviews and valuations enables the lender to adequately address the borrowers needs while maintaining an adequate level of security. The sophistication that appraisers are employing when assigning value to varying asset universes has developed in concert with the demand for better and more accurate forecasting. Appraisers are now relying on hard sales data, videotape, industry trends, production capability, as well as computerized databases to assist in correctly evaluating assets. Appraisers are now reporting complete documents over the internet, providing evaluations on CDROM and creating review programs all in response to lender’s increased support needs. The ability of asset based lenders to more completely serve their borrowing base has been greatly augmented by the increased capabilities of appraisers to handle the diverse asset universes and large variegated asset pools. Appraisers and lenders alike understand the cyclical nature of various marketplaces and the corresponding value for assets within those markets. It is appropriate to comment that history has shown that asset based lending can be a safe and rewarding business model for banks and commercial finance operations. The various asset universes which extend from real property to machinery and equipment to intellectual property are all appropriate security for loan transactions as long as appropriate value conclusions are the basis for those transactions. Lenders have recognized the need for direct market involvement as a guiding light for most asset based lending transactions. The ability of appraisers to be familiar with and reflect appropriately current market conditions is paramount to the asset based lending communities’ needs. The ability to quickly and accurately assess value and report those findings completely and professionally is equally important in this highly competitive pressure filled environment. The need to find appropriate valuation services and to quickly and safely respond to any borrowers needs is clearly a major part in any loan officers success and is important in his or her service oriented business strategy. If appraisals have been appropriately founded, are based in reality and the amortization schedule for the loan is correctly based on historical market depreciation the asset based lender will find by and large a safe transactional path. As borrowers needs continue to increase so will to the reliance by lenders on appraisals. It started with real property and heavy industry and has worked its way through every commercial sector and now includes receivable, inventory and intellectual property in many collateral based transactions. The need to tie all asset categories together in a “blanket” or “universal” relationship offers greater fund availability to most borrowers; at the same time most lenders are receiving greater control and a more complete level of protection in these types of global transactions. The future of the appraisal industry, as well as the past, is in large part integrally tied to the activity of asset based lenders. It would appear that the past was bright and the future is brighter for both lenders and appraisers alike. |