Problems with Construction Loans – A Banker’s Perspective

We interview special guest speaker, Mike Matousek, Senior Loan Officer at BrightBridge Capital, sharing his insights on financing construction companies from his 14 years in the banking industry, discussing inherent risk factors, the importance of matching up sources and uses of funds, progress billing issues, and why options like factoring are also attractive financing options.

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Lisa: I’m here with our host Brent Chambers, Executive Vice President of CapitalPlus Financial Services headquartered in Knoxville TN. And we have a special guest today, Mike Matousek. He’s the Senior Vice President with BrightBridge Capital in Chattanooga TN. Mike has spent nearly two decades working in both commercial banking and construction-related industries. Before joining the banking industry, he was a CFO for a construction firm, where he oversaw a period of 100% revenue growth and the formation of three additional construction-related businesses. He has also worked in commercial finance at Pinnacle Financial Partners, and BB&T. Brent and Mike will be discussing construction financing from the bankers’ perspective. So, Brent, I’ll turn it over to you.

Brent: Lisa, thank you for the introduction. And I’d like to say good morning to Mike and welcome to the Construction Insider Podcast.

Mike I’ve got to share with you that I’m always excited to have a guest speaker on our show, but I’m especially pleased to have a guest who not only has a banking background, and as a banker, but who has worked in the construction space, as well. So, your background gives you a unique ability to discuss financing in the construction space. And again, I’m just excited to have you here. So if you’re ready, let’s dive in. Good morning.

Mike: Thanks. I’m happy to be here and really looking forward to participating.

Why do banks see construction lending as risky?

Brent: So Mike, the first question is related to the banking community and the fact that they see the construction space as very risky. I know that, you know, working with a referral network and the referral network is lenders that are traditional and non-traditional. We’re always talking on the phone with these guys and most every discussion we have with a new prospect, we hear them tell us something or say something like, “Oh, I’m glad you guys are here, it’s good to know that there are folks that will lend in construction, because they just won’t do it. It’s too risky.” So put your finance add your banker’s hat on. And if you want to answer the question, why is it that most lenders see construction as overly risky, and they avoid lending in the space?

Mike: Sure. And for any bankers or financiers listening, you know, just to kind of differentiate. There are construction loans and lending to construction companies. And I think we’re going to be focusing on lending to construction companies or contractors, specifically. And the reason I want to point that out is you both have elements of credit risk, and operational risks which are higher than in other sort of lending products, but the key differentiator is control. So when a bank is providing the actual construction loan, we have a great deal of control over the process, over how the funds are dispersed and spent. When we’re lending to construction companies, though, I think banks have a lack of control that presents a paramount risk issue. The reason I say that is unless bankers work exclusively in construction or do it a lot, it’s very easy to not understand the finer points of structure, documentation, process, and perfection of the security interest. And bankers are thus reliant on “tribal” knowledge and internal processes to manage that kind of risk. Unless those internal processes are very well defined, established, and enforced through some back-office functions, then there’s probably a lot more risk being taken than the bank is aware of, and I think management is aware of that. And it makes them very skittish. I’ve found that management typically has very long memories when it comes to losses on construction loans and loans to contractors. So the lack of control is really important, because the bank is not really aware of the details concerning the source of repayment, which is progress billings, and can potentially be structurally subordinate to several other players, that the bank just has no influence over.

Why does progress billing scare banks?

Brent: One of the things that we hear routinely, whenever we are out in the space talking with, especially with our referral network, the thing that comes up most of the time is they don’t like or they don’t do progress billing. So can you explain to the audience why progress billing spooks the lenders?

Mike: Sure, and I think just for our conversation, you know, if we just want to come up with kind of a hypothetical example, to keep referring back to you know, if we’ve got a basic case of $100,000 contract, and a progress billing at 10% complete, that becomes a $10,000 receivable for a construction contractor. So there are several things about that receivable that make banks uncomfortable lending against them. And like I said, you’ll hear me say this a lot, first among those is lack of control. A banker funding a contractor against that $10,000 receivable has no control over matching up the sources and uses of funds, which would be materials purchased, and subcontractors employed. Contractors are notorious across the industry for “robbing Peter to pay Paul” and a banker is not going to know for sure that their loan funds being advanced against that receivable are going to pay for all the vendors and subcontractors associated with that particular project.

Brent: So Mike, let me interject here. So when you say they rob Peter to pay Paul, what I think you mean is taking funds from one project, even one debtor when one job and using it for another? Is that correct?

Mike: Yes. And you know, again, just actually use a hypothetical example: if you’re submitting a progress bill on the 25th of the month, and you’re getting paid 30 days later, as soon as that cash comes in, you may be using it to pay invoices, bills or subcontractor invoices for something from the previous month. So now if I’m in the banker’s shoes, and I’m advancing money against that $10,000 that was just invoiced to the contractor’s client, and the money’s right back out the door to cover another project, and for some reason, something goes sideways, then now I’m presented with some risks that I was not intending on taking.

Brent: I would interject at this point in time when as a lender in the space, in receivables financing, when we purchase a receivable, we make sure that we take funds control, and we’re going to pay all the substance suppliers on that particular invoice, just to avoid that. So, that’s a great point. The only way we can get comfortable is for us to pay those subs and suppliers so that down-chain we don’t have anybody that’s going to file a mechanic’s lien and put our receivable in jeopardy.

Mike: Absolutely. Construction is a very opaque process and progress billings are a claim on money/work, with some economic value. And that value is predicated on several things occurring in a usual and customary way. And what you just described Brent is how it should work. But absent you’re taking that kind of control, which event typically won’t, then there’s no control over that usual and customary activity. And that kind of opacity, I think speaks again to the broader lack of understanding and knowledge about construction in the contracting process. The bankers just don’t have it unless they’re doing it all the time. Because I mean, I know y’all do this stuff nationwide. You know, construction is a separate body of law governed by each individual state, even across different trades, and different types of projects.

Brent: You’re right. Now you mentioned opacity. And obviously, that means “hard to see into” or “hard to see through.” I believe that’s what you meant earlier when you said bankers live by tribal knowledge and not being able to see into that process, they’re not comfortable.

Mike: Yeah. So I think first your reliance on what your client is telling you, and most clients are always going to tell you what they think you want to hear or whatever is going to allow them to keep doing what it is they want to do. So you’re very reliant on what they’re telling you. If you did actually try and peel back all the layers of the onion, you can probably arrive at the answer, but you’re going to work very, very hard to do it. And you’re going to spend a lot of time doing it, which goes back to kind of a cost issue — the amount of time and money you’d spend doing that versus the earnings you’re making on that loan probably don’t match up and again, the level of risk if you did discover something that isn’t going the way you wanted it to is not commensurate with what you originally underwrote.

Brent: That makes absolute sense.

What specifically about progress billing scares banks?

Brent: So is there anything else with regard to progress billing that jumps out that just you think spooks them?

Mike: Yes. And there are kind of two factors there. And one of them I think, is that a progress billing really isn’t worth a whole lot until it is accepted by the general contractor if you’re loaning to a sub, or the owner if you’re loaning to a general contractor. And once that is accepted, it then becomes payable. There can be a material lag in timing between the submission of those progress billings and that acceptance by whoever ultimately approves it, and then having it become paid. So again, looking at the opacity into it and not really knowing what you’re looking at. As a lender, I wouldn’t know if my client who’s a subcontractor isn’t being paid by the GC, if say that progress billing is disputed, because either the subcontractor isn’t performing and there’s a dispute over quality of workmanship, or the amount being billed. Or if it’s simply the general contractor trying to beat up on all the subs to make up for some cost overrun that happened somewhere else and their change order isn’t being approved by the owner. And they’ve got to squeeze those savings out of the total budget somewhere. Unless I’m making the phone calls to the GC and understanding that, I’m just not going to know that. And in either case, my progress billing, which is my collateral isn’t going to turn over and convert to cash as expected. If there’s one thing that you can rely on banks to not like it’s things not going as expected.

And then one other possibility is that a great contractor, a really good contractor is going to have billings in excess of costs. And they’re going to be using that as a form of working capital. But those liabilities can ultimately turn into true costs that are unintended. When that happens, the bank probably won’t know there’s a problem until it’s probably already too big to contain.

What is billing-in-excess-of-costs?

Brent: Let me interject. You’ve got an accounting background and a banking background. I suspect that there are listeners who really don’t understand what billing-in-excess-of-cost is. So before you go forward, can you explain this to the audience, and also where you see that is in the balance sheet?

Mike: So going back to our example of a $100,000 contract, and billing 10% against it for an invoice of $10,000 – A billing-in-excess-of-cost item would be where that $10,000 has been billed based on 10% completion of the total contract amount. But the actual costs that were either estimated or known at the time when that contract was set up, the costs incurred are significantly less. So that could be something as simple as you as the sub are allowed to bill for materials, once submittals are approved, or once drawings are complete. You may be preparing shop drawings, or you could be doing any number of things that don’t actually have any sort of requirement to purchase materials, but you’re allowed to bill for them at that time. So now you’ve got $10,000 coming in, but your actual costs may have been significantly less than the cost associated with that line item. And now you have a billing in excess of the cost. And that becomes a source of financing. It’s cash in your pocket that isn’t associated with an actual vendor, a material, a subcontractor, supplier. So like we said earlier robbing Peter to pay Paul, you’ve now got on that particular project, some excess cash that can be used to float something else, to provide the initial funding you need for a new contract. So it can be used to fund growth. But if you’ve got a contractor that’s growing very, very quickly, and is using their buildings and excess working capital, to do other things, or potentially using it to fund a project that’s underwater, those buildings-in-excess when it actually comes time to order those materials can be a real cost. And it may come out of nowhere, and they will surprise everyone.

Brent: So it comes down to marrying up your costs that are associated with that specific revenue. And that’s something that a banker cannot see.

The banker’s biggest nightmare…

Brent: I would assume that probably the biggest hiccup, let’s just say the really bad day in a banker’s life is when a contractor gets upside down and you’re looking at liquidation or some type of collection effort.

Mike: That’s right. So if we’re sticking to the example I just described where there was some working capital generated from a project due to billings-in-excess, or any number of other things where the funds that were used on a project went to somebody else, and now the subs of my client are not being paid, the vendors from my client are not being paid on the contract which they have billed for, and I have provided funding on, and now those subs are those material men are putting liens out on on the project. Until those liens are cleared, the GC or the owner is likely not going to actually pay on that progress billing, which means again, my collateral is not going to convert to cash. The only way for me as the lender to clear that is to throw good money after bad and to lend more money in so that they can pay those subs, pay those material men, get the liens cleared, and get that progress billing paid. But you know, again, that’s not what was anticipated. That’s not what I underwrote. And you know, progress billings, because of that have very little tangible value to anyone else except the contractor who’s billing them. And I think if you were to look at like your RMA statement studies, and kind of see the typical ratios and numbers for contractors, you’re going to see that most of them don’t have much else in the way of unencumbered assets, or products and inventory that can be liquidated. And kind of tying all that together, it means that most contractors don’t have much in the way of going-concern value if they were ever to get into some serious trouble.

Brent: For the listeners, I think what you mean by going-concern, you, the banker is having to assume that there’s some value associated with the company being able to stay upright, stay in business, and be profitable, correct?

Mike: Yes. So if someone else were to step into the ownership of that company, what value would it have? And that means total assumption of all the assets and liabilities. And if you’ve got a couple of projects or even one big one that is going underwater or sideways, like we’re talking about speaking back to the opacity and the whole process, there might not be anyone willing to take on or assume those liabilities. They might want to cherry-pick some things and buy assets, but not necessarily buy the entire company.

Brent: And so it’s also tied to basic goodwill. All right.

>> RELATED READING: The Process of Getting a Bank Loan in Construction

Why are construction companies afraid of banks?

Brent: So, Mike, you know, as a lender in the construction space, we know that traditional lenders are wary of construction firms and the construction space simply because of the risk. However, we also know that many of the construction firms, our clients, are actually wary of the banking community. Now having been in finance and a construction firm, what is it about the banks and you know, and other traditional lenders that cause them concern?

Mike: Well, so you know, just speaking to my experience, you know, I was not particularly wary of the banks. And I think, indeed, the ones that I worked with, we had a great relationship because I knew that they could be your best friend and ally because I knew the position they were coming from. But I understand that from the inside looking out there is a lot of hesitation, and probably a self-reinforcing loop of that weariness to an extent. Contractors are wary of banks because banks are wary of contractors. If you look at the Great Recession period when you had a lot of contractors who had business with banks. And then after the housing market collapsed, those banks simply just turned off the spigot and said, “We’re not lending into this space anymore no matter if you’re performing or not.” And that probably left a lot of people very raw. And banks love control. So if you give them or allow them to wrap everything up and get it under control, banks can make portfolio-level decisions and shut down either construction, lending, or loaning to contractors and that can be devastating because it can simply mean your business stops functioning. And I won’t say that that happens infrequently. I mean, it does. So if a bank does end up stepping in and trying to provide financing and be a financing partner, they’re going to want to take control over everything and wrap their arms around all the assets of the business for collateral purposes. And that will invariably limit a contractor’s flexibility. They’re probably going to get sideways with each other because it will be one issue that might be a violation of a covenant, or an event of default and the bank may waive it or turn their head on the first time and say, “okay, well, we understand what happened here” and the second time, they may say, “okay, well, that’s too many strikes for us. We’re out we want all of our money back.” And before you know it, you know have contractors not making payroll.

Brent: So to illustrate your point in terms of banks making portfolio-level decisions, we had a client yesterday that walked in the door, you know, a strong performance they had one year where they had a big project loss, but other than that, cash positive, making good profits. Quite frankly, when I first looked at the data, I’m sitting here wondering, why are you guys coming to us? And so when we finally got down to brass tacks, I asked the question, well, well, why is the bank trying to work you out. And the comment was, the bank has just decided, as a company to get out of the construction lending space. And here you have a, quite frankly, one of the better clients that we get to see from time to time. And that decision left these guys without any financing. And in the middle of a pandemic, when everybody’s, you know, everybody’s quite frankly, got their tails tucked quite a bit. So it does happen and I think that does create that loop that you’re talking about.

Mike: Yeah. And that’s, you know, very unfortunate because I can tell you with certainty on this, that those decisions are not made by the actual bankers that those companies are dealing with. People like me, who are just knocking on doors, trying to develop relationships, you know, those sorts of things are being made, just in the bank boardroom. And it’s just the unfortunate nature of the industry in the same way that, you know, contractors and owners have to do what I said earlier about, sometimes you got to squeeze budget savings out here and there because something happened in the project that nobody could have anticipated it made costs go up. It’s just one of those things that’s unique to construction. And you’ve got to know about that in order to manage your risk.

Brent: Yeah, you’re right isn’t it is unfortunate. Moving on.

Why don’t banks like to work with factoring companies?

Brent: Time and time again, we have construction firms that approach us, obviously, for cash flow support. And they already have a bank line of credit. Now, in most instances, the banks are not interested in working with us through an inter-creditor agreement or some other agreement, and they simply want us to take them out. In fact, we wanted to finance one of the construction firms you are working with. And that’s how we were introduced, but the bank would not cooperate. And I know that was frustrating for you. And it was frustrating for us. We tell all of our clients, and we told you at that time, we’re bridge financing — we’re constantly explaining to our clients that our goal is to help them over that financial hump. And that financial hump can be financial stress from a project or projects or a series of things, or that stress can be growth in the eyes of a banker, and they’re growing too fast, and we just can’t get comfortable. But our job is to get them back to bank money. And you would think the banks would want to work with us to achieve that. But they don’t. So why do you think banks are not willing to work with the factory?

Mike: I think the answer comes down to control once again. You know, if there’s another party in there, and you guys, as a factor are going to be structurally in front of a bank, because of what you do. And I think that is, you know, again, a matter of control and it just spooks banks.

The other answer is that I think banks probably don’t really understand the factoring arrangement on a fundamental basis. And I admit to not really getting it until I sat down with you guys to get underwritten. I’ve worked at banks that had factoring agents and portfolios before and you know, we occasionally sold those products. But I confess, I never really understood it. So if you combine lack of control with not really understanding, it’s very easy for a banker to get to “no pass”.

Brent: Well, that’s a good point. And I think it is control because there are a handful of banks that we do work with. And after we’ve worked with them for a while, they will inevitably tell us that it was a great experience we bring to the table, our understanding of construction contracts, things that they wouldn’t know to look for they said part of that opacity that you were talking about. And once they work with us, they step back and say hey, this relationship is actually a risk-mitigator. But unfortunately, we’ve we’re just gonna have to get that message out over and over again before we hopefully change their thinking.

The cost of factoring

We’re going to have to wrap it up here, but there’s one nagging question that I have to ask: Construction lending is risky, and we’ve pointed this out here and we know this, but CapitalPlus offers a product solution in the construction space at few can provide. Now to cover this risk, the cost of our financing is higher than what you would see with a traditional lending entity or bank. And that cost turns many away. Do you, having been in finance, banking, and construction, do you have any thoughts on this?

Mike: I do. And I would quote Warren Buffett and say that “price is what you pay, value is what you get.” And you’re right, a factoring arrangement does look expensive if you’re used to comparing pricing for plain vanilla credit products. The APR of a factoring arrangement is going to be much higher than the APR on a traditional bank line of credit. But I think the value of being able to access your working capital in a timely manner when you need it the most exceeds whatever that cost is going to be because the cost of not doing it could result in vendor relationships getting shut down for a period of time. And that could have downstream effects on scheduling, on performance of contracts, and everything else. Contracting is a business with a very chunky revenue stream, you get paid big dollar amounts a couple of times a month, but your expenses are much smoother. So you’re juggling a lot of obligations. And you’re usually carrying a lot of costs well ahead of those revenues being billed, much less actually being collected. So any equity that most of your contractors have is tied up in working capital. And the factoring arrangement allows you to unlock that equity when needed. Because again, I want to just make sure that all your listeners know, the great thing about factoring arrangement is it’s a when-needed type of arrangement. You know, if you have a really big invoice, a really big contract, you don’t have to factor everything, you can just factor that one, and you’re only paying for what you use. And I think that’s a lot more flexibility than you get from a bank in a traditional arrangement. And again, never knowing what’s going to happen when a pandemic strikes and banks are tightening up having that kind of flexibility, there’s a lot of value there.

Brent: Well, I appreciate you saying that. I may have to go back and turn this into some type of presentation or an advertisement per se. I could not have said it better. We do unlock that equity. And we can do that in the form of a spot factor, where you pick and choose an invoice to factor because you have this immediate need for some cash flow support. Or you can factor a contract an entire job and all the invoices on that job because that one particular job, the way it’s laid out, the way the billing is called out by the GC, it’s going to be a cash flow drain. At the end of the job, it’s going to be profitable obviously, it’s what their hope is, but it just drains cash.

And then we have what we would call the factoring facility, it’s a revolver, and that’s the bridge finance where a bank walks away for whatever reason, whether it’s a portfolio decision or whether. They just couldn’t get comfortable with the growth. And we factor for a period of time. And when we factor like that we typically give more aggressive and competitive rates. But we do that until they can get back to a traditional lender and get back to cheaper money. But yeah, I’m glad you said that spot factoring through factoring facilities, it’s a broad range of options for our clientele.

So, Mike, we’re gonna have to wrap it up. I want to thank you for your time and you chatting with us today. I will say to the audience, you know, when you came to us looking for some working capital, we really enjoyed working with you. We knew you understood the business and I knew that you would just be a great guest speaker on our podcast. So I learned some things from you today and I know that our audience has learned things as well. So I’m going to ask you a favor and put you on the spot and ask you to join me here. There are a lot of topics with regard to lending in the construction space. And I’d love to continue this discussion on another day. You are on the roster.

So, Lisa, we’re going to wrap it up there. I’ll kick it back to you.

Lisa: Alright, sounds good. Well, thank you both. We appreciate your insight and your time today.

If listeners would like more information, they can reach out to us at CapitalPlus.com. Thank you for listening to this episode of Construction Insider Podcast and until next time, be well.

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