Inside The Mind Of A Small Biz Lender

Allied Capital finds that it often pays to look further than the balance sheet

Lewis M. Coco, 58, the chief executive of a small New England manufacturer, was just days away in May, 1996, from clinching a $5 million loan to finance a buyout of the company from its owners when a potentially devastating new problem cropped up.

"I've been having tests done on my heart," Coco remembers telling Philip A. McNeill, an investment banker at Allied Capital Corp., describing the heart attack that struck while he was at the New York City Opera. "It turns out I've got some major blockage," he recalls saying matter-of-factly, "and they're recommending I go in for bypass."

As a principal at Allied, a Washington (D.C.)-based lender to small and mid-sized companies, McNeill had confronted all kinds of obstacles to getting deals approved. But a quadruple bypass on a CEO was a first. Now, it was his turn to feel ill. After months of analysis, background checks and basic hand-holding, the end had been in sight.

Still, McNeill caught something in Coco's long-distance demeanor. Less than a day after hearing such devastating news, the entrepreneur was calm, focused, and sharp--managing this personal setback the way he probably would run his business. Besides, the financials were solid. "We're going to support you," he remembers telling Coco.

NO MISSES. Good call. Almost two years later, Coco is healthy, and so is his company, Julius Koch USA Inc., a New Bedford (Mass.) maker of parts for window blinds. The company hasn't missed a single payment on its 13.5%, eight-year loan.

Not all borrowers are so fortunate. Each year, about 37% of small-business owners shop for a loan and bankers reject a quarter of them outright, according to a 1996 study by Arthur Andersen accounting.

But with competition heating up amid small-business lenders, there's less reason to take "no" from a bank as a final answer. While banks still do the bulk of small-business lending at about $172 billion a year, they're under pressure from Allied, the Money Store, GE Capital, and a host of other nonbanks, which dole out another $96 billion a year to small companies--sometimes in spite of what their regular bankers think.

So who gets the money? What makes a lender agree to finance a company that someone else rejected? The answer--which hinges on the strength of a business, its vision, and the owner's personal integrity--becomes quickly apparent if you spend a day at Allied headquarters.

Allied is among the top 10 nonbanks dealing in loans backed by the Small Business Administration. Overall, the publicly traded company has amassed 800 investments worth about $600 million. Some of that includes simple real estate mortgages, and another large chunk includes commercial mezzanine loans like the one Coco received. The latter are subordinated debt, a risky deal for Allied, so the lender makes up for it by charging up to 15% interest, plus warrants to acquire equity.

Better deals are available from Allied's SBA-backed loans, which offer up to $1 million at only 10%. Why so much less? Because the SBA repays 75% of the principal if a company defaults. It's an attractive niche for Allied, which last year lent $52.6 million to 82 companies after sorting through 1,000 applications.

Mondays at Allied start with the regular weekly partners meeting held in the company's ninth-floor conference room. Eight top officials are huddled around an oval table, including Chairman William L. Walton, 48, and seven top officials.

The 10 deals arrayed in front of them are already survivors of a sort. Sometimes deals come over the transom; others are referred by accountants, lawyers, and financiers who know Allied's appetite. But all have passed through the initial round of digging by Allied's staff into the borrowers' financial and personal backgrounds. Companies stand a better chance if the most recent fiscal year included growing sales, positive cash flow, and a net profit, though turnarounds are also considered.

The meeting itself is a relaxed give-and-take, with Walton presiding in shirtsleeves and red suspenders. The format: One person pitches his or her favorite deal. Everyone else tries to poke holes. Winners move on to the next step, the investment committee, and eventually, the 22-member board of directors.

DOUBLE DIP. It's a rapid-fire affair, with each deal getting less than 15 minutes of fame. The first concerns a pair of women entrepreneurs seeking an SBA-backed loan to buy a grocery store in rural Michigan; they're on the verge of graduating to the investment committee. "The borrowers couldn't be happier, and the SBA loves this deal," reports principal Mary E. Olson. (Olson says the agency favors disadvantaged companies, and this one qualifies twice: it's rural, and the owners are women.)

Walton worries more about the competition. "How far is the nearest supermarket?" he demands.

"About 10 miles," Olson says. "In the middle of winter, 10 miles is a lot."

"How long has the business been around?" Walton asks.

"About 45 years," she says.

"That's a long time," Walton says approvingly. The idea gets the nod. Other deals get quick approval, too: expansion of a successful Popeye's Chicken & Biscuits franchise in Virginia, in part because of its plentiful free cash flow; a broadcaster's plan to deliver foreign-language TV programming via satellite to the growing U.S. immigrant population from Eastern Europe.

A home-improvement products company meets more resistance. It's emerging from a recent bankruptcy.

"How did he handle his creditors?" Walton asks.

"Nobody lost any money," Olson says.

"His suppliers are happy?" Walton presses.

"He's got credit terms from all of them," Olson counters. The team agrees to table this one until they check the receivables.

What is Walton looking for? Sure, a company has to clear certain financial hurdles, including $1.40 earnings for every dollar in fixed costs, debt of no more than four times equity, and return on net assets of 20%. Intangibles such as the power of a brand name count, too. But in every case, there's a single bottom line: "You have to start with great management," says Walton.

After a break, Walton convenes the investment committee, a decidedly less forgiving group. While the earlier meeting was open and creative, this panel is judge and jury. "We need to have all the answers at that point," Walton says.

He isn't getting them today. The deal concerns a promising chemical company that wants to expand. But the amount of unsold inventory seems swollen compared with overall sales--perhaps business is slowing--and the thought nags at Walton as the meeting goes on. "I'm not ready," he finally declares, sending the deal back for more due diligence.

Such probing begins at the first contact and doesn't let up until the loan check is cashed. Sometimes, the questions can get intensely personal. Just ask Henry E. Juszkiewicz, CEO of Nashville-based Gibson Guitar, who got a $25 million, 15% interest loan package last summer. "Allied called virtually everybody I know...dozens of people, and asked very pointed questions about me as well as management," he says.

Good or bad, the answers aren't the kind of data you can get from trendy tactics like credit scoring, a method used by nearly all banks that grades applicants based on statistical norms for small business. Walton says the system can mislead lenders, because the norms are based on business conditions of the past and tend to miss promising aspects of the future. "Over the years," Walton says, "we've discovered that a good entrepreneur can often achieve more than what the numbers suggest." Apparently, vision and passion are still assets you can take to the--well, nonbank.

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