In Homer’s Odyssey, the Sirens were beautiful women whose singing would drive sailors so crazy with desire that they crashed their ships to get closer. But Ulysses wanted to hear them anyway, so he ordered his crew to cover their own ears, tie him to the mast, and refuse his orders until they had sailed out of earshot.
Now, the “Ulysses pact” is the key to a new paper on how companies large and small might sometimes find it worthwhile to let banks tie their hands and steer the ship.
Lenders already impose financial “covenants,” or restrictions, on companies to protect the loan if things begin to go wrong. If a company’s cash flow falls below a certain point, for example, banks often have the right to scale back its line of credit.
But the new paper, coauthored by Dan A. Iancu at Stanford Graduate School of Business, says that may not be enough. That’s because companies can take other kinds of risks — like selling off their inventory at fire sale prices — which look like routine business decisions but are actually Hail Mary passes that jeopardize the lenders.
Avoiding Risky Cash Grabs
If a trendy swimwear company gets in a squeeze, for example, it may try to raise emergency cash by selling a chunk of its bathing suits through bargain-basement discounters. It might not be a violation of most loan agreements, but it could drive down prices, future sales, and the value of the company itself. If the bank’s collateral is the company’s remaining stock of bathing suits, that inventory would suddenly be worth much less than projected.
In fact, says Iancu, it was just that kind of gamble that helped drive LA Gear, once a super-hot athletic shoe company, into bankruptcy in the 1990s.
“If you are running a company and take out a loan, what you do with the money is usually up to you,” Iancu says. “Your main interest is to benefit the shareholders or the owner, not the debt holders. If your company goes bankrupt, that will certainly have negative effects for you, but you won’t fully internalize the liability. You benefit if things turn out well, but you don’t lose everything if it goes bad. So you take riskier gambles.”
High Rates, Small Loans
It turns out, the researchers say, that lenders currently factor in the risk that companies might make sketchy business decisions to stay technically compliant on their loans. As a result, lenders charge higher interest rates than they otherwise would, and companies often borrow less than they should. Result: a less-than-perfect use of capital on both sides.
The solution, the researchers say, is for lenders to impose a different kind of loan covenant based on the company’s borrowing base — the assets it can pledge as collateral. For many companies, inventories are a big part of the borrowing base. Under the kind of covenant proposed by Iancu and his colleagues, the lender would have the right to take over some of the company’s decision-making if the market value of those inventories dropped sharply.
This idea runs against conventional wisdom, because experts have generally believed that operating flexibility is good and micromanaging is bad.
But that assumption isn’t necessarily true, Iancu says. If a company agrees in advance to cede power over inventory decisions under certain circumstances, for example, it will be much less likely to engage in high-risk fire sales in the first place. Meanwhile, the lenders will charge less because they have more security, which means that the company will be better able to borrow the amount of money it really needs.
Monitor Inventory Value
Iancu says such borrowing base covenants are rarely used, in part because they require lenders to have a more sophisticated understanding of a borrower’s underlying business. Banks may recognize that the value of inventories can be volatile, for example, but few keep track of what’s really going on.
The issue is particularly important for asset-based lenders, the financial firms that make loans secured by inventories and other kinds of collateral. “For asset-based lenders, where operating flexibility can be really critical, you want to look not only at how much inventories are worth today, but also how they’re likely to evolve,” Iancu says.
Surprisingly, the researchers argue that advance restrictions should actually be tighter for companies that are booming with strong demand and high profit margins. That’s because those companies generate lots of spare cash flow, which creates more temptation to take risks at the expense of their lenders. A buoyant company might decide to build up more inventory than it needs, which requires borrowing, or keep too much at the end of a season.
In the long run, Iancu says, a Ulysses pact can be a win-win for all sides.
Company executives are more likely to make prudent decisions in the first place if they know that risky moves will jeopardize their autonomy. And lenders, having more security about the ship’s course, are more likely to offer loans on the best possible terms.