Author Archives: theintangibleblog

The real security question – banks evaluating a loan application

For any bank evaluating a loan application, the first consideration is whether the business in question can afford to repay the amount being sought. This is sometimes called serviceability. Without evidence that sufficient cash should be available to meet the resultant debt and interest, the verdict will always be ‘no’. Most business owners would probably agree that this approach is perfectly fair and reasonable.

Hot on the heels of serviceability comes another factor: security. This is about the collateral which a company can provide as a safeguard. And to be honest, if you ask a business to describe their discussions with banks about security, their first words are pretty unlikely to include ‘fair’ or ‘reasonable’. So what’s the problem?

Security is partly a question of identifying secondary exit routes – lender-speak for assets that can be sold off if needed to repay debt. Banks have become accustomed to using tangible assets that have resale potential, like commercial property, for this purpose.

At first glance, this policy seems perfectly sensible. The ability to realise value in extremis seems particularly important in a period of economic uncertainty and low growth.

However, to rely on tangible asset security solely for this purpose would be to have an extremely short memory. Over-exposure to tangible assets that people thought were valuable is not only one of the practices that got half the world into its current mess, but also continues to be one of the reasons we can’t get out of it.

No, the real reason for taking security is because lenders know the importance of their customer having ‘skin in the game’ – showing their intention to repay by putting something of value at stake.

Banks want, and need, the businesses in question to make a real commitment of their own; but as is widely reported, security is the place where many conversations between banker and business currently fall down. In the absence of available, tangible, company-owned assets, directors generally get asked to put up their personal assets to fill the gap.

This seems to be borne out by ONS data (see blogs passim). Not only is the lack of collateral the biggest single reason for declinations being given; but also, where loans are provided and guarantees are obtained, they come from owners and directors in 94% of cases.

The data also points to one (although only one) of the reasons why the Enterprise Finance Guarantee scheme falls short of the mark. EFG is great in theory as it recognises that many companies don’t have enough of the kind of security a bank traditionally likes to see. However, the scheme can’t be used unless all other avenues – including personal assets – have been exhausted, which is why it hardly features in ONS data.

What’s needed to create good quality security is an asset class that is truly core to the business and as closely associated as possible with the way it generates value, rather than a commodity that the company can do without or easily replace.

Anything come to mind…?

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Categories: All, Lending | Tags: , , , , , | Leave a comment

Merlin’s spells need more work – sector specfic bank lending

Project Merlin has hit the headlines again in the past few days. Despite news that all the large players (bar one) reached or exceeded their SME lending commitments under this Government deal, there still seems to be ample anecdotal evidence of unmet company need.

What’s really going on…?

One set of data that was released by the Office of National Statistics in October 2011, and referenced in the Chancellor’s Autumn Statement, is quite enlightening. It contains evidence from a Europe-wide survey comparing the financing experiences of a large sample of businesses, across a range of sectors, in 2007 and in 2010.

The headline is that demand is up and approvals are down. This is no particular surprise (though the increased demand shown in the ONS data seems a little at odds with bank surveys, which consistently suggest that companies overall are choosing to repay existing debt rather than request more). However, the scale of the change in loan approval rates for certain sectors is quite striking.

Reflecting the shape of the UK economy, the majority of the companies in the sample were service businesses. 32% of these sought finance in 2007, which grew to 37% in 2010. Of those seeking finance, the main source was bank lending. Again, so far, so unsurprising. But approval rates for bank loans to these businesses were running at 84% in 2007: in 2010 the approval rate fell to 61%.

The position for ICT businesses is worse, where demand for finance has grown more strongly (28% to 36%), and bank loan approval rates have fallen more sharply, from 85% to just 45%. And this is puzzling, when 70% of construction industry applications were still approved in 2010.

The same picture emerges on less formal lending via overdraft. 2010 approval rate for construction companies, 73%: for ICT firms, 63%. And if you are unlucky enough to be a service business looking for an overdraft, the ONS data shows that your chances of getting one in 2010 fell to a barely credible 26%.

So your prospects of bank funding seem to vary markedly by sector. Which suggests that the underlying issue may be a process problem as much as any overall lack of appetite.

After all, at the same time as banks are being told to take more risk by increasing their lending, they are also being required to strengthen their capital adequacy ratios, a message strongly backed by the Bank of England. The Basel III regulations undoubtedly encourage, and arguably compel, banks to do more of their lending to lower risk, better secured customers.

The largest single reason obtained by ONS for loan declinations in 2007, and in 2010, is lack of collateral. And what is the key difference that separates the manufacturing and construction sectors from the service and ICT sectors…?

Virtually all businesses, including manufacturing ones, have valuable intangibles which generally do not feature on the balance sheet. There are solid accounting reasons why they don’t, but the omission has the effect of making these assets not only intangible, but invisible. Trouble is, wherever these intangibles do appear in a company’s accounts, credit teams tend to attribute a nil value to them. This is a bit of a problem, considering that intangibles are the main source of corporate value and the main focus for company investment.

The ONS data seems to point to a pretty fundamental disconnect between the access to funding needed to build a successful, competitive, knowledge-based economy and the steps that have to be taken to reduce the risk of further financial shocks. It’s a dilemma that must be resolved, because as nearly all commentators agree, growth is essential if structural debt is to be reduced.

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Seeing the value of intangibles

Just how important have intangible assets become in business?

Ultimately, everyone knows there is only one true arbiter of how much a given set of assets is really worth: how much someone else is prepared to pay for them. This maxim is even more applicable to intangible assets, which don’t (yet) have the same ready market as the tangible commodities companies own.

However, that doesn’t mean it isn’t possible, and necessary, to understand the quantum of value now resting  in businesses’ Intellectual Property (IP) and other intangibles – even if these assets (or companies) in question aren’t currently for sale.

To get a sense of the contribution they make, we can look at how much companies spend on intangibles; how these assets appear to influence share values; and what happens when firms sell stakes based on an intangibles-backed offering.

Helpfully, the 2011 UK IP review by Professor Ian Hargreaves provides some (fairly) recent data on investment in intangibles. The report quotes Government statistics from 2008, showing that UK businesses now spend about one-third more on intangible assets than they do on tangible ones – £137bn vs. £104bn. A key contributor within this asset class is IP, estimated to account for around £65bn of this investment.

What about share prices? One of the organisations looking regularly at intangible values is Ocean Tomo in the USA. Its analysis suggests that the “80/20” rule now provides a good shorthand when thinking about the level of value in intangibles (read more here).

Back in 1975, the implied intangible asset value of the S&P500 (derived by looking at book value as a proportion of market value) was 17%: in 2010 it came in at 80% when measured on the same basis. The company attributes this “total economic inversion” to the growth of the knowledge economy, and points out that these implied values are holding up, even during a period when total R&D spend is falling (though it is still increasing slightly if viewed as a % of revenues).

Similar exercises have been done in Europe. The introductory section of the 2006 Gowers Review draws the same conclusion from an assessment of top companies quoted on the London Stock Exchange. The European Commission said in 2010 that “intangible value has accounted for approximately three-quarters of corporate value as far back as 1995.”

None of their findings should surprise us. Rewind to the 1970s, and Western economies were still largely dependent on generating value from manufacturing capacity – multiplying the power of human effort. Now it’s much more about multiplying brainpower, not brawn.

It is also clear that the characteristics that make companies attractive purchases have changed. With so much production capacity offshore or subcontracted, it’s the brands, customer relationships, service formats and software code that buyers want. Recent flotations of technology and web-based companies have generated plenty of initial interest despite very challenging market conditions; and while the initial gloss has faded from some of these offerings, the fact that they got away at all is undoubtedly due to their shiny intangibles, not their shiny servers.

It seems the pendulum has swung decisively towards valuing assets that are unique, rather than types of property that are common across many businesses. Determining an appropriate value for them poses new challenges for investors, lenders, acquirers and licensees.

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Categories: All, Value | Tags: , , , , , , , , , , , , , | Leave a comment

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