Anticipating and Minimizing the Impact of Regulatory Shifts on Asset Valuation and Loan Portfolios
Date october 2012
Featured in The Secured Lender
For companies that require substantial investment in supply chain and production infrastructure or inventory – and for the asset-based lenders who finance them – regulatory changes can be among the most difficult extraneous factors to predict, as well as the most significant. Adapting to such shifts can be a nebulous and somewhat daunting challenge, since modifications to regulatory requirements often introduce a new element of uncertainty to asset valuations and, accordingly, to loan portfolios.
There is no one-size-fits-all solution for companies and lenders facing regulatory change. The impact of new rules and regulations varies by industry and by the nature of each new rule or law. The following framework, however, may help companies and lenders who find themselves in this difficult position to plan for, adapt to, and minimize potential negative impacts from changes in oversight structures and requirements on asset values and loan portfolios.
In basic terms, we recommend that borrowers and lenders bear in mind three key points:
- Although it may be arduous, asset-based lenders and borrowers alike should understand that the impact of regulatory change on asset values can be substantial. In extreme cases, new regulatory requirements can make entire generations or categories of products and equipment obsolete. Taking a “hope for the best” approach may mean that lenders and their portfolio companies are caught unprepared when new rules eventually take shape.
- Anticipating the form and impact of regulatory change may seem a vague and inexact process; however, there are some basic steps that asset-based lenders and their borrowers can take to get ahead of the challenge. These include regular monitoring of relevant regulatory and legislative proposals and scheduling ongoing appraisals based on the calendars of relevant rulemaking bodies.
- Once a potential threat has been identified, lenders and borrowers should have a solid game plan in place to minimize the impact on asset values and loan portfolios. Establishing such a plan means mapping out the relevant time frames, thinking through potential “unknowns,” and identifying the specific borrower assets that may become impaired, among other steps.
Below, we examine each of these topics in detail.
Facing Facts: Regulatory Impacts on Asset Valuations Can Be Substantial
For companies whose lending facilities depend on the valuation of collateralized inventory or production equipment, it may be tempting to underestimate the potential impact of new regulation in order to avoid jeopardizing the company’s financing in the short term. This approach may not be in a borrower’s best interests, however, as heightened regulatory requirements may result in much more extensive consequences than originally envisioned, including driving entire generations of products and equipment into accelerated obsolescence.
As one recent example, consider the heavy truck / vehicle manufacturing industry, a sector that was effectively informed in 2008 of new emissions and greenhouse gas regulations, to be implemented in 2010 by the US Environmental Protection Agency (EPA), consistent with the Clean Air Act.
In effect, the legislation and attendant regulatory changes required cleaner engines in heavy motor vehicles that reduce sulfur and mono-nitrogen oxide emissions, which contribute to acid rain and general air pollution.
Additional regulatory changes are expected in 2014 and 2017 that, collectively, will render a significant number of trucks and heavy vehicles produced before 2010, as well as engines and aftermarket replacement parts, outdated from a sales perspective within the United States.
Manufacturers with extensive inventory of this product – as well as their asset-based lenders – have been compelled to recognize that the accelerated obsolescence of this inventory has a clear and negative impact on asset valuations.
In addition to impacting the value of inventory, regulatory change can also significantly erode the value of machinery and equipment utilized in its production. One example of such a far-reaching piece of regulation is the Food Safety Modernization Act of 2011, which aims to shift the US Food and Drug Administration (FDA) away from a reactive posture to a more proactive approach in preventing contamination to the food supply. When the FDA modifies regulations to align around this comparatively new legislation, food production companies may need to undertake expensive overhauls of production and storage facilities in order to meet the new standards.
As a result, a substantial quantity of equipment and infrastructure utilized as vital parts of the supply chain and production process, and valued as important assets to the company, could become rapidly devalued if it falls out of usage.
Getting Ahead of the Problem: Establishing Processes to Identify and Evaluate the Impact of Regulatory Change
In an environment with ever-increasing regulatory complexity, asset-based lenders who develop strong processes to identify, prepare for and minimize the potential negative impacts of new regulations on loan portfolios will be able to best serve their clients in minimizing asset valuation disruptions and related asset-based lending issues.
When it comes to identifying potential regulatory risks, there are a number of steps that lenders should take to protect themselves and their loan portfolios early on:
- Comprehensive Monitoring. Asset-based lenders should consider establishing a monitoring process in conjunction with borrowers to track regulatory and legislative proposals that may impact portfolio companies’ businesses and the value of attendant assets as early as possible.
When dealing with a company in a tightly regulated industry or facing potential regulatory change, at the outset of each new lending relationship, the asset-based lender may request from the borrower a list of potentially relevant legislative and regulatory issues, placed within a timeline or calendar format so that all parties can remain attuned as to what may be coming in the future that could impact assets / inventory values. This list would form the basis of an evolving master document that would be updated regularly by the borrower, and reviewed quarterly with the asset-based lender. This list would also assist companies and lenders as they work to anticipate various potential outcomes of each legislative and regulatory proposal.
- Align Asset Appraisal Frequency Around Legislative / Regulatory Calendar. Once the borrower has developed the groundwork for proactively tracking relevant legislative and regulatory issues that could impact its business, the next step is for the asset-based lender and borrower to work together on aligning the frequency of asset appraisals with the legislative / regulatory calendar to the extent possible.
Implementing frequent asset appraisals and valuations that come before, during and after regulatory events are implemented brings a greater level of clarity for both the borrower and lender, enabling proactive planning versus reactive decisions, all of which reduces the disruption that can occur with regulatory changes.
From Anticipation to Action: Establishing a Game Plan
Once an asset-based lender has identified a risk to its portfolio as a result of regulatory or legislative changes, it should be ready to implement a well-thought out game plan to minimize the potential impacts, based on consideration of various possible outcomes. The following are the four key “building blocks” of any successful game plan:
- Understand the Relevant Time Frames. New regulations can take months or even years to move through the approval and implementation processes. Even in instances where the process of regulatory change happens more rapidly, the vast majority of new regulations will typically incorporate a “ramp-up” period to allow affected businesses to adapt.
Asset-based lenders and borrowers should seek to jointly develop an understanding of where new regulations stand in the approval process and how much “lead time” is in place before the new rules translate into a tangible effect on the borrowers’ businesses. For example, in the HVAC industry, recent regulations increasing air conditioner efficiency ratings and outlawing R-22 refrigerants were implemented gradually. While the changes were dramatic, many borrowers and lenders that worked together to update processes and product offerings experienced little disruption.
While the first reaction among both borrowers and asset-based lenders upon learning of a regulatory threat may be to respond as quickly as possible, reacting too quickly may lead to premature asset dispositions and other value-impairing disruptions.
- Game Plan for “Unknowns.” One of the most difficult aspects of responding to a changing regulatory and legislative environment is that such changes introduce a host of “unknowns” for both borrowers and lenders. The most obvious “unknown,” prior to the final passage and implementation of a new rule or law, is the regulation itself – anticipating the final form and extent of a new rule as it works its way through the often byzantine approval process can be, in a word, impossible. Other “unknowns” include potential unintended consequences of the new regulation; competitors’ and customers’ responses; and how the new rule will be implemented and enforced.
To game plan for these potential outcomes, asset-based lenders and their borrowers may consider meeting with experienced partners to “white board” various potential outcomes based on the factors mentioned above, then, as realistically as possible, assign probability weightings to each outcome. This exercise, while basic, can be extremely useful in informing further response planning by each party.
- Identify and Quantify Potential Impacts. Asset-based lenders should seek to work with the management teams of each of their borrowers to help them identify assets that may become impaired as a result of new regulations and to quantify these potential effects.
Central to this process, the asset-based lender, the borrower and the lender’s appraisal and valuation partners should work closely together to develop an understanding of the entire supply chain related to portfolio companies’ products. This is essential in order to develop a comprehensive view of the new regulations’ effects and to identify all assets that could be impaired.
Importantly, this analysis should also take into account the prospects for accelerated disposition of each of the potentially vulnerable asset groups. The key question for lenders and borrowers to understand with this option is whether such an approach would require heavy discounting and, if so, the potential impacts on the borrower’s margins.
Additionally, it is always worth exploring overseas disposal alternatives, which may be available if those markets have less restrictive regulatory regimes in the industry sector in which the borrower operates.
Four key questions that can better inform this process are 1) whether the inventory can be sold through before regulations prohibit the sale; 2) whether there are brokers who specialize in disposition of the impacted assets; 3) whether the assets in question have a scrap value; and 4) if not, what the disposal costs would be.
- Consider Enhancements to Future Loan Covenants. When developing a game plan for coping with potential regulatory changes, asset-based lenders and their valuation partners should work closely together to understand the impact of new regulations on loans currently in the pipeline, and to determine an agreed-upon blueprint for how to structure future loan covenants in order to most effectively and transparently capture the impact of these shifts.
One form of protection that lenders may consider implementing more broadly is the right to demand substitute collateral when the original assets backing a loan become impaired due to regulatory change. These provisions would incorporate requirements for fresh asset appraisals and valuations in circumstances where the lender has a reasonable expectation that existing collateral may be impacted by pending changes to regulatory structures. Replacement collateral would be identified when the loan is originated.
For a manufacturer or other borrower, shifting a new set of assets into the collateral pool to bring the total collateral value back to the amount on which the underlying loan was originated can, of course, cause significant disruption. By spelling out the adjustment process and “backup collateral” as early as possible, however, lenders can give borrowers greater visibility into the potential implications of impairments in asset valuations and prompt them to strengthen their own contingency planning as well.
Changes to government regulation are an ongoing fact of life for asset-based lenders and their borrowers. As various industries and their attendant regulatory structures become more complex, asset-based lenders that have strong processes in place for working closely with borrowers to identify, map out and minimize the potential impacts of new regulations on loan portfolios will enjoy a significant competitive advantage.
Asset-based lenders should seek out strong valuation and appraisal partners that can help them monitor regulatory trends that are relevant to their portfolio companies, understand and plan for the impacts of those regulations, and work quickly to minimize the downside risks when these shifts in regulation become reality.