The Infamous Five Cs of Credit
All lenders are taught the five Cs of credit at the onset of their lending careers. These five factors are fairly and evenly balanced by most commercial lenders as they assess the risk of lending opportunities.
The 5 Cs of credit are:
- Character: skill and integrity of leadership
- Collateral: Assets that secure the loan
- Capacity: ability to repay the loan
- Capital: accumulated net worth
- Conditions: Industry, economic, and regulatory impacts
Three Big Cs and Two Little Cs
The lending approach of asset-based lending applies much greater weighting to Character, Collateral, and Capacity (the big Cs) and much less weighting to the other two, capital and conditions (the small Cs).
Here is why asset-based lenders look at credit this way:
1. Character: I’ve learned through the course of my career that this is the most important factor. Businesses are run by people, and those in charge direct the people. It is imperative that management is capable and operates with integrity. This combination is called character.
Circumstances are constantly changing, and management must be capable of innovating and adapting to change so that the business remains viable.
Integrity is crucial in maintaining a level of trust that enables the lending relationship to work. Leadership that operates with integrity will provide maximum protection to the lender if circumstances put the loan at risk. On the flip side, leadership that operates with little integrity will put the lender at unnecessary risk, given the same circumstances.
2. Collateral: Businesses fail. Proportionally, start-ups and young companies with limited capital will have a higher failure percentage than more established and better capitalized companies. Collateral provides protection to the lender to mitigate (or hedge) their loss in the event of a business failure. The strong focus on collateral of an asset-based lender enables it to recoup all, or most, of its money in the event of failure. This enables the lender to assist clients that have a higher risk of failure than the more balanced 5C approach used by the majority of lenders.
3. Capacity: The ability of the borrower to meet all of its obligations, including the loan. Although collateral will provide a method of repayment if the business fails, it’s not the preferred method. The sale or liquidation of assets is a very expensive and uncertain process that puts significant strain on the lender. Lenders much prefer that the borrower meet all obligations based upon its generation of cash from its business activity.
4. capital: Accumulated net worth of a business. Net worth is what is owned minus what is owed. An asset-based lender does not put a lot of focus on this. They are willing to work with clients that have very little – or even zero – net worth if the asset-based lender views the three Big Cs of character, collateral, and capacity favorably.
5. conditions: Asset-based lenders aren’t very concerned about the impact of these factors on a borrower. Let’s review the Great Recession in 2008-2009… the flow of capital came to an abrupt halt and most lenders were looking at ways to reduce their loan portfolios. Borrowers were severely restricted. During this period, the loan portfolios of ABLs grew as they moved in and filled much of the financing void left as lenders using the balanced approach pulled back.
Where is the Future of Asset-based Lending?
The lending markets are extremely accessible today. Economic conditions are steady and reduced company leverage has resulted in an abundance of money available to borrow. This does not, however, call into question the long-term viability of the ABL industry. The shift of jobs and GDP from mature companies to a much greater entrepreneurial base will continue to provide opportunities for asset-based lenders. In addition, economic cycles are inevitable and we will see future recessions. History has shown that the ABL approach is critical during these times.