UAE Banks & Entrepreneurs: It's a lose-lose relationship - Part 2

Disclaimer: the views and opinions in this post are entirely mine and do not reflect those of the institution I work with or clients I advise and consult for.

In Part 1, I talked about the fundamental flaw in the relationship between entrepreneurs and banks in the UAE, and which has led to both parties suffering severe and increasing pains since early 2015.

I highlighted the fact that the “lose-lose” relationship stems from one major characterization of the relationship: both parties are exposed to “unlimited downside” in event markets turn bad, and “limited upside” if things go well.

I used the analogy of: if I win, I get $10; and if I lose, I pay $50 - and obviously flawed paradigm.

In this Part 2, and as promised, I’m offering my thoughts on some solutions to remedy this imbalance.

I will provide suggestions to both entrepreneurs as well as banks.

HOWEVER: you will note that I put a LOT more emphasis on solutions entrepreneurs can adopt as opposed to the banks.

Please do NOT misconstrue this as being unfair to entrepreneurs. On the contrary: the reason I emphasize “entrepreneur-centric” solutions is because I have MORE faith in the entrepreneurs’ ability to adapt, implement changes quickly, and be nimble and focused.

By contrast, effecting change in banks requires significant lobbying at the senior-most level, and even at the regulatory level. Furthermore, implementing changes in bank policies means significant increases in costs and “perceived” increase in risk. Both of which are words no bank CEO or board wants to hear about in 2016 given overall market difficulties.

So, with that in mind, here we go:

Any funding plan for any business, large or small, needs to achieve a number of core objectives.

Let us start by stating the objectives.

Objective #1: Provide a long-term and “predictable” funding.
Objective #2: Provide a “buffer” for downside protection & to take advantage of opportunities.
Objective #3: Funding should be an “added value” to growth, and not something you have to reluctantly deal with every month and become the main focus of our attention during times of market stress.

So my dear entrepreneurs:

Never EVER let your net borrowings exceeds 3x your cash flow generation

Here’s the pill that’s often too bitter to swallow: your downside is MUCH bigger than you upside: if you have a successful business, you can expect growth to be in the range of 10%-20% per year. However, one “bad” year can see your business drop by 30%-50% or even more.

Your bank will look at your cash flows vs. your debt. If your cash flow drops by 30%, the bank is going to get worried about your ability to pay your loan, your suppliers, your employees, etc.

So PLEASE do NOT build your business plan and obtain loans on the assumption that you will deliver “steady growth”. No matter how much you believe that, I have almost never seen it in any industry throughout my entire career.

Limiting your borrowing to 3x your cash flow (3x EBITDA) means you have will have a “buffer” when (not if, but “when”) markets turn against you. Banks will tolerate your borrowings reaching 5x and even 6x in a down-turn, but if you’re already at 4x or 5x during the good days, you’re in trouble as soon as things turn south.

Working capital lines / revolver facilities are for emergencies only!

Get a proper CFO who’s smart about financial planning and “listen to him/her!”.

I’m spending quite a bit of time these days advising companies on getting out of trouble with banks, and I see one mistake repeated over and over again, especially with SME businesses:

They use short-term revolving facilities (working capital facilities) to fund long-term investments!

Imagine this scenario: I go to you and say

-       Can you lend me $1000 for one month at 5%?

-       For what?

-       I want to pay for a container of fruit, which I’ll sell in 1-2 weeks, and I’ll pay you back then

-       Sure no problem

Conclusion: no problem.

Now imagine this:

-       Can you lend me $1000 for one month at 5%?

-       For what?

-       I want to pay for a container of fruit, which I’ll sell in 1-2 weeks, and I’ll pay you back then

-       Sure no problem

But then I go and use the $1000 to buy a new TRUCK, because I promised the fruit supplier to pay him in 2 weeks anyway. So I get the fruit, sell it, pay the supplier in 2 weeks, and pay the bank in 4 weeks. No problem!

EXCEPT: this works when markets are doing really well.

Now imagine the same scenario with a “twist”:

You took the $1000, bought the truck, but then your fruit supplier said: I will only sell you the fruit for cash, no more credit.

So you can’t pay to buy the fruit, but you owe the bank $1000 in one month! All you have is the truck you just bought: you try to sell it, but now you can only get $700 for it! So you still need $300, and all of that is happening in 1 month.

You are technically bankrupt!

That’s exactly what’s happening with many companies: they are taking these very short-term loans, and using the money to make long-term investments! We call that an “asset-liability mistmatch”.

Follow this rule of thumb:

-       Short term loans for short-term investments

-       Long-term loans to fund long-term investments

-       And always assume the return on these investments will get delayed, so build a “buffer” in there.

Pay for a good lawyer to negotiate loan docs with the bank, the alternative is disastrous

“I know your business is doing ok, but one of your competitors is in trouble, so I want my money bank this month, and ALL of it”. 

That (in a nutshell) is what banks have been telling small and medium-sized businesses since early 2015. 

Banks are “calling” the loans, asking for immediate repayment, and the borrower has no say in the matter: you either comply or your get in trouble.

While these requests may be unreasonable, unfair, unwarranted, etc., some of the blame has to be on the borrower who agreed to such terms in the first place!

How can you enter into a loan agreement where the bank can “pull” the loan for no reason whatsoever and at any point in time without you having a say in the matter?! 

I won’t dwell on this much, but PLEASE get some proper legal advice when negotiating loan documentation with banks, even if it delays the process by several weeks: it will save you and your business when you need it the most.

It is NOT acceptable for an entrepreneur not to have a very solid grasp of his/her company's numbers and don't skimp on high quality finance professionals

“You don’t know your own numbers!” screamed Mark Cuban at an entrepreneur pitching for an investment on Shark Tank.

“No you cannot call your CFO!” shouted Daymond John at another one. 

I’m amazed every time I see this on Shark Tank, and even more so when I’m sitting across the table from a business owner / CEO advising him/her on getting out of a jam with the banks. 

It is absolutely unforgivable for a business owner and CEO not to have a solid grasp of their own company’s financial numbers. No, you don’t need to know every small detail, but you do need to know what drives your business, where the weaknesses are, how vulnerable you are to fluctuations in certain costs, etc. 

If you were to listen in on conference calls where CEO of large companies field questions from the top financial analysts on Wall Street, they may defer to their CFO on some of the questions, but the CEO him/herself answer most of the questions, including the financial ones! 

And speaking of CFOs: there is a big difference between an “accountant” and a “CFO”. While most CFOs / Financial Managers come from an accounting background, what makes them good CFOs is their ability to “grow” beyond that role and develop a wide range of critical skill-sets, including long-term financial planning, knowledge of a wide range of financing solutions, stress testing & sensitivity analysis, and much more. 

Your CFO is the person who’s going to be negotiating with the banks on a day-to-day basis, and a weak CFO will inevitably result in a “one-sided” loan agreement.

So don’t skimp on finance professionals: hire the best you can for the budget you have, and incentivize them properly.

Polish up your bank documents

Impressions matter. 

I’ve seen many deals rejected by banks simply because they didn’t “feel comfortable” with the person sitting in front of them, or because their presentation was “sloppy” or “amateurish”.

A well-prepared presentation (with coherent content, a good presentation of the numbers, strategy, and capabilities, an easy to read and professional-looking formatting) can significantly impact how you are treated by lenders.

Remember, you’re dealing with human beings, and your numbers are only “part of the equation”: how you come across (dress and act professionally) and how you present (clean, coherent presentations & documents) will go a long way towards getting your bankers comfortable with you, and will reward you accordingly.

Educate yourself about and keep an eye on the condition of financial markets

“The change in market conditions caught me by surprise!”. 

If I had a penny for every time I heard someone blaming their misfortunes on the “sudden turn in the market”. 

Recall the example I used previously: banks “pulling loans” from “good” businesses just because a “similar business” is suffering. 

If you (or your “highly skilled” CFO) were aware of “liquidity conditions” in the overall market, you would have seen that coming. You would have realized that liquidity is getting tight, and that at some point banks will come knocking on your door. You would have been able to prepare for it for several months: preserving cash, negotiating longer-term payables with suppliers, etc.

I’m not saying you need to have a crystal ball, but I am saying that you need to be aware of what’s happening in the markets around you. This is where a “qualified CFO” makes a huge difference.

Which brings me to another important point:

Dedicate time to search for fragility / vulnerability in your business & mitigate them

Take a good look at your business, and spend the time to identity what your business is “vulnerable to”, especially things outside your control.

Never assume the future will be “business as usual”. Bankruptcy courts are full of companies which based their forecasts on “stable markets”. 

I’m not saying take a pessimistic view and imagine worst case scenarios. What I’m saying is this:

Have a PLAN for dealing with worst case scenarios IF they develop. Don’t put yourself in a position where you have to COME UP with the plan WHEN the problem arises.

Spend the time to run the analysis:

-       I’ve identified 2 major points of fragility in my business: X, and Y

-       If X happens, I will deal with it by doing 1, 2, 3, 4

-       If Y happens, I will deal with it by doing 5, 6, 7, 8

-       Etc

Flip that $10/$50 equation on its head 

Remember that $10/$50 analogy I used in Part 1?

As a reminder: businesses in a $10/$50 environment will gain $10 when things are going “well” but lose $50 when things are going “badly”.

So how can you flip this in “real life”?

By being Strong in the land of the Weak: By applying the principles I listed above, you will not only survive a crash in the market/economy, but you will be much stronger than your competitors, allowing you to steal away market share and maybe even buy some of their assets on the cheap, putting you in a much stronger position.

Bank Finance Isn't the Only Option

While a number of my investments in SMEs are in the form of straight equity, I have also extended "convertible debt" to others.

In addition, I've helped some companies secure mezzanine finance from reputable mezzanine funds / investors.

What I'm trying to say here is that bank finance isn't your only option. In fact, given the rigidity of bank finance, the possibility of the bankers not understanding your business properly, and the potential "knee-jerk" reaction banks may have to downturns in the market, you may want to look for alternative forms of finance.

Providers of alternative financing solutions typically have experience with small businesses and therefore may tolerate volatility and "temporary" set-backs better.

Furthermore, you can negotiate with providers of such financing on a "case by case" basis (instead of entering into "standard contracts"). In most cases, such "case-by-case" agreements would have "built-in" solutions for dealing with market difficulties (e.g. step-ups, convertible triggers, warrants, etc.). 

As for my message to the banks

First of all, I'm not going to get into the much needed regulatory changes. Your CEOs and risk officers are very much aware of them, and so is the Central Bank of the UAE. Going to jail for bounced cheques is just not acceptable in my opinion. Not having a bankruptcy regime is also not acceptable.

There is nothing much I can do about these matters and which can sway them into acting more quickly.

HOWEVER: there are a number of things you (the bankers) CAN do to help: 

Improve (significantly) the quality of your staff working in the commercial / SME departments

I’ve recently sat in on meetings between SMEs and their bankers (full disclosure: not the institution I work for). I was a “silent” listener / observer to the conversation in all of these meetings.

What came across loud and clear to me throughout these meetings was the sub-par quality of bankers managing relationships on the SME-side. While some had a rudimentary understanding of accounting and finance, most of them had very superficial knowledge. They were rejecting proposal after proposal from the client, and it was clear to me that they were not understanding what was being proposed

Business is much more complex than “selling products”, “collecting on invoices” and “paying loans”.

Bankers need to be knowledgeable enough to understand the industry dynamics of their clients, monitor trends and identify triggers shifting those trends. They need to maintain open lines of communications with the clients and propose creative solutions “before” the problems arise.

Other critical steps (but which require a firm commitment to change)

Improve Risk Management

While most banks apply decent risk management principles on large loans, they rarely do so on the SME side. They don't spend the resources to monitor for high correlation within the portfolio, and between their portfolio and other banks.

They don't react to a problem until it's staring them in the face.

Typically, risk managers get involved in the "loan approval" stage, and then when there is a problem. Educate your relationship managers in the arts of risk management, and they will be able to monitor the loan on a regular basis, taking action before a problem arises.

Banks spend large sums of money on commissioning market research on industries they operate in, looking for trends, risks, and opportunities. But that is almost always limited to "large corporates" (e.g. oil & gas, real-estate, industrial). Doing the same for SME lending would be far cheaper than writing down millions in "bad loans".

Involve your syndicate teams

It's not enough to monitor the risk in the business of a company you lent money to: other banks have lent money to that company as well, and if THEY have concerns which force them to "pull lines" from that company, you'll be left holding the bag, with an outstanding loan to a company that's now struggling for no fault of its own or yours.

Your syndication team already talks to the syndication teams at other banks. They may not be involved in small loans, but involving them means there is an open line of communication among all banks - they can better coordinate responses to "market downturns" instead of panicking and "creating the market downturn" in the first place.

Securitize parts of your portfolio

That's a tricky one, and perhaps the UAE banking market is not ready for it yet. But securitization is one of the best tools to "spread the risk" so no single loan and no single bank would take a major hit from badly performing loans.

Yes there are risks, and if were to repeat the securitization schemes of the 2000s, we would be creating a bubble akin to the one which led to the collapse of my previous employer Lehman Brothers (among others)...

But once again, it comes down to risk management, and if we apply the lessons learned from 2008/9, we should be able to build (and properly price) portfolios of loans and help banks avoid concentrated risk and cross-market contagion.

As a parting note: I was surprised to see so much engagement on Part 1 of this post, so:

Given the strong interest in the subject, I am open to organizing a small seminar in Dubai where we can spend half a day discussing these issues, and where I can share some guidance on how to implement each of the strategies I mention above.

If you are interested, please mention so in the comments, and if we have a sufficient number, I'll get it organized very soon.

Tony