Why Your Business Structure Matters In Financing

“Thus it is said: Know the other side (the enemy), know yourself, and your victory will not be threatened. Know the weather, know the terrain, and your victories will be limitless.” Lines 10.56 and 10.57 of Chapter 10; Sun Zi Bingfa (Sun Tzu’s essays on The Art of War)

Any properly informed view about a business has to be based on an understanding of the landscape – the business itself; the other players in the industry, their relative strengths & weaknesses, potential disruptive changes (ie opportunities & threats) and so on.

To really understand the financial standing and risk profile of a business, it is essential to be able to have a picture of “who’s who in the zoo” in that business’ “ecology”, especially where diverse business activities and complex group structures are involved. In such situations, consolidated accounts for the total group – even if such were available – are meaningless: they are just a bunch of numbers which provide little in terms of strategic insights.

I will focus the discussion here on the use of “mud maps” in achieving improved outcomes in finance proposals. However, the concepts can be applied for other types of strategic analysis.

Mud Maps: A Tool For Strategic Analysis

No, that’s not a typing error for Mind Maps although mind mapping software has made mud mapping significantly more efficient than hand drawing on an A3 sheet.

Financiers always require the provision of the ownership & corporate structure of the borrower as part of a financing package. Understanding “who’s who in the zoo” is a critical part of assessing credit risk associated with loan facilities for a business.

A Mud Map^{Note 1} is a strategic “who’s who in the zoo” diagram that goes beyond the standard hierarchical diagram of legal entities within a group. The purpose of this type of mud map is to assist your financier(s) to get a helicopter view of the credit risk “landscape” of your business at a glance. It highlights where the points of potential “value leakage” or “weak links” (from the credit risk perspective) are in the group.

Constructing a ‘mud map’ is one of the first things I do when I am preparing a financing proposal. There are no hard and fast rules – it varies with the nature of the business or group.

My usual approach is as follows:

• If it is a large complex group with a corporate & ownership structure that looks like a computer chipboard: distill the structure to show only key entities/businesses whilst still noting that there are numerous other entities in the group which may be dormant companies or which have not economically significant in the context of the total group.
• Ensure that the map highlights the following key information:
  • Who does what in the group
  • Who owns major assets
  • Which entities has debt facilities & who the lenders are
  • What securities, including guarantees, have been provided
• There may also be occasions where it is useful to include key suppliers or customers, particularly if they are related parties, or even key elements of the supply chain. It depends on the circumstances: you don’t want to over-clutter the map but if there are critical relationships, it may be appropriate to include them.

How Mud Maps Add Value In Financing

This type of strategic mud map provides context for the detailed analysis in the financing proposal. Benefits include:

• assists the financier in understanding your business or various business activities
• provides clarity about the key risk points & accordingly assists in developing satisfactory risk mitigants
• facilitates structuring of the right types of facilities for the different aspects of your business. Having appropriately structured facilities protects your business as much as it does the bank, as discussed in “Staying Power: Enough of the Right Kind of Money“

All of this helps improve the probability of a “yes” to your financing request.

Illustration of Use of Strategic Mud Map for Financing

Below is a strategic mud map together with explanatory notes to illustrate how strategic mud mapping adds value in credit assessment and structuring of financing facilities. I realise that the size of the image makes it difficult to read: you can also download a pdf of this map (46kb). [This example is a mish-mash of a range of real life mud maps that were done as part of financing proposals for privately owned groups both small and large.]

1. TomDick Group is a privately owned group with an ownership & corporate structure that looks like a computer chipboard. There are in excess of 100 entities in the group. This mud map is a distillation of the structure so as to enable focus on the key entities & business activities of the group. As such, non-active or non-signficant companies are shown simply as “15 Other Entities” and “Other”. Their existence is acknowledged but they are not critical in the scheme of things.
2. To keep this example simple, assume TomDick Group’s financing request to NewBank is only for facilities in relation to the FMCG business, in particular, working capital for the retail operations and financing the purchase of land and construction of more retail outlets for the FMCG business.
3. Consolidated financial statements at the TomDick Group Holdings level would be meaningless given the diversity of activities. The focus would be on understanding the business and the financials of FMCG Co.

   Assume that FMCG Co is profitable and has very strong cash flows. It’s the cash cow of the TomDick Group of companies.

   Question: Who will/should the borrower(s) be?

   As the proposed facilities will be for the FMCG Co business, the borrower(s) may be FMCG Co or another entity which handles finances of the FMCG Co group, not TomDick Group Holdings.

   From a credit perspective, financiers prefer to position their loans as closely as possible to the assets and cash flows that will secure and service the debt.

   Note: If TomDick Group Holdings was the borrower, NewBank’s facility would be what is known in banking parlance as “structurally subordinated” ie it is a debt of the shareholder of FMCG Co and therefore ranks behind any of the creditors inside the FMCG Co group itself by virtue of the corporate structure. Whilst guarantees etc could be obtained, it is generally NOT a preferred way of structuring borrowings from financiers’ standpoint. Credit policies of financial institutions usually deem loans to holding companies as policy exceptions. Why create an additional hurdle of having to mitigate a policy exception for your financing?

4. Whilst the risk exposure for NewBank will be FMCG Co group and that group looks hunky-dory (great cash flow, strong profits etc), it is still important for NewBank to understand what the rest of the group looks like.

   Prop Invstmt Holdg Co group and Shopping Centre Co group are significant businesses in the context of the total TomDick Group and there are borrowings from other lenders in these sub-groups.

   Issues that should be examined include:

   • How strong are these parts of the Group? Are they capable of sustaining the borrowings taken on by themselves or will they potentially be a drag on other parts of the TomDick Group or more importantly, a drag on the FMCG Co group’s cash flows?
   • Have any guarantees been given by the FMCG Co group companies to Bank A and Bank B to shore up debt service & repayment by the relevant entities? That’s a potential point of “value leakage” from the proposed borrowing.
   • What’s the story with Bob? He’s a business ‘partner’ in the PInvCo1. Bob has contributed his 40% share of the ‘equity’ in the investment in the office building in the form of a $1 million loan from BobCo1.
   • Could Bob be a weak link? NewBank may not be able to find out what Bob’s personal or business financial position is are but it would want to be comfortable that PInvCo 1won’t be adversely impacted if Bob has business or financial difficulties. If Bob’s business got into trouble, PInvCo may end up with Bank C – or a Bank C appointed receiver or liquidator – demanding the repayment of the $1 million loan that BobCo1advance to PInvCo 1. What is TomDick Group to do then?
5. Who do FMCG Co companies sell to? Who do they buy from? The TomDick Group has a construction business within the group that undertakes construction work for the FMCG Co group. That’s another potential point of value leakage out of the FMCG Co Group.

What Does All This Mean For The Request For Financing Facilities For FMCG Co?

This mud mapping exercise should highlight all the likely questions that may be asked. Ensure that your financing proposal package is as complete possible from the start. Drip feed of information simply drags out the credit approval process and is not productive for either lender or borrower.

NewBank is likely to want the FMCG Co group (as its borrower) to be “ring fenced” from the rest of TomDick Group. Therefore in addition to physical security of charges over all assets owned the FMCG Co group companies, cross guarantees etc, expect there to be covenants put in place to achieve this.

Such “ring fencing” covenants to prevent ‘value leakages’ out of the FMCG group are likely to forbid any loans by any of the FMCG Co group companies to other TomDick Group companies, require that all construction works undertaken by the Construction Bs for FMCG Co group be done on an arms-length basis and at market (possibly with verification by independent experts) etc.

It’s entirely up to Tom and Dick as to whether they can or are prepared to allow FMCG Co group to be “isolated”from the rest of the total TomDick Group businesses.

The financier-borrower relationship is a 2-way street: if Tom and Dick want NewBank to rely on the standing of FMCG Co group alone to secure the proposed facilities, then NewBank has the right to expect that all potential “value leakages” will be plugged.

Has this article been useful in better understanding the credit thought process? I welcome comments and feedback on other ways you may find this technique useful.

If you’d like to discuss any issues about financing for your business, please feel free to contact me.

Note 1: The name “mud map” for this strategic diagram arose from a comment by the Head of Credit of one of the large financial institutions where I working many years ago. In his approval comments for a complex financing proposal which I had submitted, he noted that the accompanying “mud map” had been extremely useful in understanding the credit risk of the group (which had in excess of 100 entities in the corporate structure).

It has also been invaluable in other instances including an extremely complex litigation matter.