How Commercial Lenders Evaluate Equipment Collateral

Commercial lenders such as banks, credit unions, and alternative financiers each may have unique approaches to risk tolerance and lending parameters. But they tend to look at industrial machinery and equipment through the same lens: “If this loan defaults, how much will I recover from this collateral?”

An independent equipment appraisal helps lenders understand collateral strength and liquidation risks.

The Commercial Lender’s Perspective

For borrowers, equipment is a contributing factor to business earnings. Business owners see each piece of equipment as a revenue-generating asset. This often causes a disconnect between lenders and borrowers, because lenders are not generally concerned with the value of individual assets in a going concern.

The reality is that at a high level, lenders are focused on two broad outcomes: either the borrower performs as agreed, or the lender will have to evaluate alternative recovery options.

In Situation 1, the market value of the business assets has limited relevance to the lender. Cash flow and payment performance take priority as long as the loan is current. Whether a particular machine is worth $1 or $100,000 is not particularly important.

In Situation 2, the lender may have to decide whether to renegotiate the loan or whether to liquidate their collateral.

In either situation, lenders focus on repayment and recovery outcomes rather than maximizing the operating value of the business itself. If a borrower defaults, the lender is generally not going to repossess and operate the business as a going concern. They are in the business of lending and finance, not business operation.

They are going to either restructure and work toward repayment, or they are going to cut their losses and liquidate the business.

Special Assets and Workout Departments

If a borrower defaults on their commercial loan, the loan often moves to a department of the bank called “special assets” or “workout.” (Special Assets refers to the lending team responsible for managing high-risk or distressed loans. Workout is the active process used to restructure a loan or recover collateral.)

In smaller banks where employees may wear multiple hats, the two terms are often used interchangeably to refer to the same concept: a loan that is in default. In these cases a lender’s mindset may shift; the loan is no longer a certain revenue-generating asset, but rather a puzzle which can only be solved with information, consideration, and thoughtful decisions.

The lender’s priorities are complex. They must balance minimizing risk, preserving community reputation, preserving borrower relationships, maximizing return potential, and minimizing legal battles, among other concerns.

When commercial machinery and equipment (M&E) collateral is involved, the first step for the lender is to understand the market value of the assets.

Realistic Outcomes for Machinery and Equipment Collateral

There are many ways to consider market value for business equipment.

• “How much would it cost me to replace these machines?” This is useful for insurance purposes.
• “How much life does this facility have left before major replacements are required?” This is useful for transactional due diligence.
• “Are all of these machines active and earning income for the business?” This is useful for Fair Value and financial reporting appraisals.
• “What would I get if the business closed and we sold these machines?”
• Fair Market Value estimates what the equipment may be worth if offered in a willing buyer, willing seller situation, and an extended period is allowed for resale.
• Orderly Liquidation Value estimates what the equipment may be worth if offered as-is, where-is, with a reasonable time allowed for liquidation, such as 3-6 months depending on the equipment type.
• Forced Liquidation Value estimates what the equipment may be worth if sold as-is, where-is, in a public auction or in a similar environment where buyers are assuming all risks and required to purchase immediately.
• A low M&E appraisal may encourage the lender to allow the business to continue operations as the most likely way to recoup some financial return. However, a low appraisal may also push the loan over a minimum debt-to-equity threshold which could send the borrower further into a special assets spiral.
• A high equipment appraisal may allow the borrower to claim more collateral than expected and restructure their loan favorably. However, a high appraisal may also convince the lender that an immediate liquidation will provide their easiest and best financial return.

But for a commercial lender, only one question is important:

The reality is that if a loan defaults, the lender is not often able to sell an entire facility as a going concern. In the majority of cases, the business is liquidated and the personal property, real property, and any other business assets are sold piecemeal in the open market.

The M&E can be sold under varying terms and timeframes, which create the different levels of value commonly used by lenders:

Because of the different levels of risk and timeframes involved, FMV tends to be the highest value, with OLV and FLV each lower. The differences between each value type can be very large or very slim depending on the equipment type and situation.

The M&E Appraiser’s Role

The lender cannot determine the most appropriate path forward for a distressed loan without understanding the likely outcomes of each alternative. Collateral value is only one input in that decision. Lenders must also weigh borrower cash flow, guarantees, customer concentration, management quality, and other factors that influence recovery outcomes.

The equipment appraiser’s role is to advise the lender of the likely results of an equipment liquidation, including risks, potential complications, and financial return.

The equipment appraiser does not always know how their assignment results will be utilized. Oftentimes borrowers will believe that a higher or lower value will help their cause, but the reality is more nuanced.

The appraiser must be unbiased and disinterested in the outcome. Their job is to provide professional opinions and informed context to their client; the commercial lender has the ultimate job of deciding how to utilize the appraisal results.