The High Interest Rate Glitch
Back in June when one of our funds was planning to make its mid-year distribution, we went hat in hand to our portfolio companies to see what they could pony up. One of the businesses, which works in construction, had had a great year to that point, earning almost $2.5M. But when they looked at their bank account, there was only about $500K there they could reasonably distribute. That’s because the earnings were not yet beer money and had piled up in IOUs.
“Pick up the phone and kick those loose,” we said. And after doing an analysis of which customers it would be most impactful to call most aggressively about their non- and late-payments, they did.
One of the calls they made was to a customer who was a pretty big offender who said, “Hey, sorry about that. Let me look into it.”
Before I get to the punchline here, I should note that commercial construction, generally speaking, is a low margin business. That’s because it’s not only hard work, but also because there is a lot of competition.
Further, commercial contractors usually have to agree to 10% to 20% retainage, which is payment that is withheld by the customer until a project is substantially complete. Because that 10% to 20% retainage also happens to be roughly the profit margin of your average construction business and because construction projects always take longer than expected to complete and because the definition of “complete” can be squishy, a consequence for construction businesses is that they can’t predict when they are going to get paid their profits. This means that most of the time these businesses are cash flow breakeven at best. To solve for this and smooth cash flow, many draw on lines of credit from banks.
Now, unless you’ve been living under a rock, you know that interest rates are up and therefore the cost of these lines of credit has in some cases more than doubled. And with many construction businesses borrowing at prime or prime-plus, they can expect to pay 8.5% to 10.5% or so on that borrowed money. If you’re already only netting 10% to 20%, paying that expense to finance your customer will take a big bite out of profits.
So we were hardly surprised when our customer called back a week later and said they had found the problem. There was a glitch (a glitch!?) in their payment software that was preventing them from transmitting money to us. It would take a little time to fix, they said, but then they’d make us whole.
We were not amused.
“Weird,” we said, “that after years of working together, this glitch is only popping up now, when borrowing costs have spiked.”
“Yeah, weird,” they agreed.
“Well, you’re pretty late on some pretty big amounts,” we politely told them, “so we’re about to get pretty aggressive with liens if you’re not able to just cut us a check.”
We got our beer money.
There has been a lot written about the impact of higher interest rates on the U.S. economy. Add to that list a proliferation of payment software glitches. Weird.
-Tim
