Commercial bankers, especially those in the core and lower middle market, face so many obstacles to growth and profitability – from a looming regulatory environment to nimble, creative non-bank competitors – that it’s a wonder some don’t throw their hands up in despair and go fishing. But there is hope for those willing to address the fundamentals – especially in the approach to evolving opportunities in middle market lending. The Gaffin Group principals have extensive experience working both in and with small- to large-sized regional bank lending platforms, where we find many of the banks’ trials come from lack of rigor related to an ostensibly laudable philosophy. In practice, we also observe this: unfettered, one of the most expensive words in commercial banking is “relationship”. This manifests itself in areas including, but not limited to, poor pricing discipline, ineffective account management, and weak loan performance.
Many say that “relationship banking” is ubiquitous to the point of non-differentiation. Perhaps. (One veteran bank insider joked: “I cannot recall the last bank pointing to lapel pin exclaiming ‘Transactions R Us’”.) On one hand, the term’s prevalence points to key success factors in middle market banking: building, nurturing, and protecting customer relationships which makes long-term success in the sector especially hard – and rewarding. But the other hand, real hurdles arise in keeping the actions of bank personnel consistent with prudent lending principles while those relationships are built and managed. Here’s where this too often comes off the rails: “relationship” is so often an internal, reflexive drum beat for any request in the march for customer retention; but pursued overzealously, relationships can quickly become asymmetrical, inappropriately profiting the customer at the expense of the bank (ironically, this behavior is often tacitly rewarded by the performance appraisal and compensation systems of the bank itself).
As a non-banking example of asymmetrical relationships: Many middle market commercial companies also build relationships with their key customers. But over time, cumulative concessions to these customers (whether they be customized products or services, credit terms, specific investments, discounts, price concessions, etc) risk making the overall relationship unprofitable. In our consulting work with these clients, we illustrate the importance of systematic evaluation of both top-line and contribution-level impact of major customers to drive sustainable, profitable growth. In the banking world, a similar pattern holds. A customer may become so ingrained in a bank’s regional business plan that the bank ties its own hands in dealing with the company in an objective way.
Prosperity makes friends, adversity tries them. – Publilius Syrus, Maxim 872
Consider the following banking examples which are intentional caricatures – colorful illustrations, with certainly exaggerated features to paint a picture (as I have asked my peers, if you’ve been in banking a bit, let me know if you have never seen one of these rear its ugly head):
The Whale in a Small Pond. This is one of our favorite lines from bankers, “We have an opportunity to bring this client on due to our longstanding relationship with the new CFO. We knew him at Little Fish Inc. and now he’s starting at Whale Industries. We need to be really competitive on price and structure to help him get the attention of the Whale Industries CEO, but we’ll make it up on ‘full-boat’ cross sales and price increases once we’re in.” Uh, right. I wonder if the Bank, itself, would be pleased with vendors that tried that approach with them. More likely, Whale Industries will take best valued deals (balancing price, feature, availability) now and down the line. They probably got big, in part, by being intelligent on vendor management (which includes banks). Also, flash forward: if there ever are problems with this major account, be sure the regional executive will strenuously warn of ‘visibility’ and ‘political fall-out’ in the local business community if the bank appears even conceivably heavy handed; unfortunately this typically means attempting to exercise rights and remedies (see loss given default discussion below).
We’ve Known Jonesey, like, Forever. This is often the multigenerational account (both on the customer side and having been passed down relationship manager to relationship manager within the bank). Now, no one can remember the last meeting in the actual offices of the customer – it’s all dinner, drinks, and golf ping-pong (“oh, hey, I’ll invite you to our tournament with heaps of bank execs then I’ll bring a mess of folks to play at your charity event, and then…”). There is much to be said in support of a multidimensional relationship with key customers, but the obvious caveat is to not get too close, too involved. The risks run from lender liability issues to potential complicity with a customer’s inappropriate actions when under stress (“ah, gosh, they need another 6 weeks for the audit numbers ‘cause the old, stupid auditor quit – I’ll talk to him at dinner next week”). Anecdotally, it is not uncommon to see increasing frequency of dubious client get togethers just before events of default (whisky and waivers don’t mix). We have seen many lenders cross that critical line with house accounts and put banks in very uncomfortable positions when it comes to light – such discoveries never failing to surface at the worst moment. These are most definitely not just a new-lender problem but also quite often includes those with long tenures (note I did not use ‘long experience’ as time-in-job is not necessarily correlated with true, valuable experience). An observable symptom of these relationships are the queries put to management at customer functions – these so often go beyond softball questions (as at least a softball is tossed in some manner) – these are more like “T-ball” questions. But there is nothing that puffs up a banker’s chest more than to have customer start their response with “That’s a great question, Biff…” – especially when other bankers are at the meeting. Unfortunately, this praise is usually inversely proportional to the insightfulness of the question.
Familiarity Breeds, well, Laziness. This tends to show itself in the lack of on-going due diligence in client relationships. It is an obvious notion that companies change as they grow – it is not as obvious that all lenders do the work to keep up with the increasing complexity facing their clients. It is all-too-easy to get caught up in “new biz dev” versus blocking and tackling on existing accounts (“hey, that’s what portfolio managers do”). If that latter split is carried too far, not only does optimizing opportunities with existing clients suffer – it most certainly allows signals of emerging risks to fall through the cracks. We’ve too often seen the perfunctory annual review (largely cut and pasted from last years with dates changed) fail to do appropriate due diligence on emerging issues. Credit analysts tell us they’re admonished: “This is a house account, don’t rock the boat” and thus suffer the wrath of a regional executive protecting a loan book. So, the backward-looking compliance certificates are copied, the ratios are calculated by Excel, and the elevator analysis is dutifully ground out – but there is no fact-based scrutiny of the borrower’s strategy and tactics, of governance or succession planning, of new customer or new product development hits or misses, of drivers to variances from budget and pragmatic responses thereof, etc. Not surprisingly, these are the lending teams that don’t see a problem until it hits the figurative windscreen. This is all the more inexcusable if the lending is also levered lending.
Note, we don’t use the ill-advised short cut of leverage lending = equity sponsored, but we use levered lending in the more generalized form. Interestingly, research is pretty consistent that equity-sponsored levered loans pose less risk, on average, than similar non-sponsored levered loans. In fact, we would argue that the main driver for the poor performance of non-sponsored leveraged loans is that they are probably ‘relationship’ or ‘house’ accounts somewhere in danger of rapidly being members of the caricatures above. To be clear there is some art in the designation of internal risk profiles – and for house accounts often the probability of default is soft-peddled a wee bit due to (inaccurate) belief that ‘we know the customer’. Ex post, that knowledge turned out to be superficial familiarity, at best. The loss-given-default turns out to be worse than sponsored deals often as a result of the cumulative, incremental political accommodations at the alter of ‘relationship’ (but less supported by objective business sense). Having advised on a number of turnaround situations, we’ve seen the gnashing of teeth and beating of breasts when one of these loans goes bad. In the clamor for answers – usually elsewhere directed rather that reflective – I have yet to see an true analysis of the trail of ‘modifications by memo’ that have slowly, but surely, increased the risk of the deal – each time tweaking the facility to the point where it is barely recognizable to the originally approved deal. Also, we advise banks not to play the ‘blame it on the customer’ game. The customers try to get the best deal they can for themselves – the responsibility to others (depositors, stockholders, regulators – even a potentially naive customer) lies squarely with the trained experts in the bank. Moreover, excuses do not help grow institutional or individual knowledge.
We present these caricatures, not to make fun of anyone, but to show a stark contrast to how the majority of smart, conservative middle market banks intend to do business. But like the old tale of the frog in a pan of water who won’t jump out as the heat is gradually turned up to a boil – sometimes, our lending teams are those frogs – and the increasing risk profile of an asymmetrical ‘relationship’ is the boiling water.
Successful middle market banking requires a particular skill set. Proximity to decision makers/owners/operators is fascinating, but can also overwhelm ill-equipped lenders. Notably, our Group has seen several banks recognize the need to shore up these areas in advance of the next cycle. We applaud their efforts and continue to work with banks to ensure they are making investments to be more effective and competitive as the market evolves. Middle market banks have been, and should continue to be, valuable debt capital providers in the middle market. But the wise banks make sure the philosophy of ‘relationship’ is properly used as a lens and do not become blinders.