Gita Thollesson, SVP for Client Success and Market Insights at PrecisionLender, returns to the podcast to discuss more winning tactics of top commercial relationship managers. In this episode, she focuses on structuring deals with performance-based pricing or grid pricing.
RM Performance: Proving Impact and Dispelling Myths
Are You the Bank of Last Resort?
Winning Tactics of the Top Commercial RMs, Part 1
Winning Tactics of the Top COmmercial RMs, Part 2
How Banks Can Uberize Deposit Pricing
Jim Young: Hi, and welcome to the Purposeful Banker, the podcast brought to you by Precision Lender where we discuss the big topics on the minds of today's best bankers. I'm your host, Jim Young, Director of Communications for Precision Lender.
I'm joined again today by Gita Thollesson
. Gita is an SVP for Clients Success here at Precision Lender. She's made a couple of very popular appearances on this podcast where she shared some of the winning tactics of top commercial relationship managers. And she's accumulated much of this knowledge during her previous position as Director of Analytics for S&P's Commercial Loan, Middle and Lower-Middle Market Business.
We invited her back on the show today to discuss in more detail, one of those winning tactics, which is structuring deals with performance-based pricing, or also known as grid pricing. Before we dive into that, though, I wanted to let our listeners know about another place where they can get valuable insights from Gita about RM tactics.
In that report, Gita looks at all the ways in which top commercial RMs provide value. She also goes through some of the tactics and strategies they use. Okay, now, onto the show. First, Gita, welcome back.
Gita Thollesson: Thank you, Jim. Good to be here.
Jim Young: Okay. Can you start off, Gita, by explaining for our listeners who may not have used performance-based or grid pricing exactly what it is?
Gita Thollesson: Sure. Grid pricing, or performance-based pricing, some banks call it matrix pricing, it's basically where the pricing on a deal is tied to some measure of risk. In other words, instead of having to wait until maturity to adjust pricing, if the borrower starts to head south, the pricing will automatically adjust based on the change in risk and really is a way of implementing risk-based pricing protecting the bank in the event that the borrower's credit quality starts to deteriorate.
Jim Young: Okay. That seems pretty straightforward. For our purposes, I'm going to go with performance based as our terminology here. How common is performance-based pricing in the commercial loan market?
Gita Thollesson: Well, surprisingly enough, it's not as common as you might think. Probably I would go so far as to say that it's one of the most under-utilized best practices in the market. It's very rarely used in the middle market, almost nonexistent in the business banking market. Where we do see it, quite widespread, is in the large corporate or syndicated loan market. I mean, there it's almost standard. You see it on investment-grade deals, you see it on leveraged deals, the risk metrics will vary depending on the type of the deal. It's almost standard there. It's more rare in the middle market and certainly not even used in the business banking space.
Jim Young: That brings to mind a question of why that is, why usage varies so much across that, but let's hold off on that for a little bit later. Can you kind of walk me through the mechanics of it?
Gita Thollesson: Yeah, absolutely. The grids are typically set up with risk measures, and those risk metrics are specific to the company's business. If you were to look at, let's say, an investment-grade deal. There it's fairly common for the performance-based pricing grids to be tied to the company's senior debt rating, so the Moody's rating or S&P rating. If you look at a non-investment grade deal or a leverage deal, there's usually some measure of a leverage ratio. It could be total debt to EBITDA or senior debt to EBITDA or in some cases it's a coverage ratio, so maybe it's fixed charge coverage or interest coverage.
In the middle market, the grids would be tied to whatever key financials are meaningful to the specific borrower's business. Some borrowers that might be funded debt to EBITDA. Some borrowers, it might be debt to tangible net worth. It just depends on the specific company and what's relevant for their business.
Jim Young: I would think that what you just mentioned there would present some logistical challenges/burdens. I mean aren't we talking about things that are basically provided annually?
Gita Thollesson: Yeah, you know, depends on the borrower. But absolutely, there are a lot of companies out there where the full risk analysis that a bank does, is done once per year and that's done based on audited financials. That said, the grids can be set up with whatever monitoring frequency makes sense for the borrower.
In some cases, for a larger borrower maybe it is monthly. It is more common to see those grids be monitored on a quarterly basis and I've even seen one case where it was an annual monitoring. The whole idea is to not place a process burden on the customer. I think a good example, last time during our last podcast we were talking about a case where there was a customer that had a process burden from their incumbent bank because there was a borrowing base on the deal.
That borrowing base required so much monitoring and the company just didn't have the staff to do that (monitoring), that they were shopping the credit. Well, the RM that ultimately won this piece of business actually did implement a performance based pricing grid but what he did was he set the repricing frequency to be on an annual basis to align with the company's audited financials.
In fact, he gave the customer a way down but it wasn't a process burden because the monitoring frequency was so limited just to the annual frequency. If you set it up in a way that's really burdensome to the customer, the benefits of having the grid are outweighed by the cost.
Jim Young: This is where I was a little bit confused and be patient with a non-banker here on the other end. Cause it's sounding like a little bit more to me like I get the clear benefit from the banker prospective, I'm not quite as clear on the benefit to the borrower here.
Gita Thollesson: Well there's absolutely a benefit to the borrower. I mean, certainly from a bank's perspective you're implementing risk-based pricing and getting paid as the risk deteriorates. From a borrower's perspective though, you know it can be very favorable. What we've heard from so many bankers is that borrowers tend to be optimistic about their future financial performance.
They really focus in on the low end of the pricing grid. You could actually structure a deal where the initial pricing is higher than what the customer is seeing from another bank but you put a grid in place, where you're giving the customer a way down and quite often they'll just focus in on that low point in the grid.
It's almost like in the old days people used to talk about country club pricing. You go to your country club and brag that you were getting paying Prime flat. It's very much the same thing. You put a grid in place where there's a way to get down to some crazy low price and that's what people focus on.
Jim Young: Okay, gotcha. But then you've also got that element built in there in which it's going to work both ways, right? You just mentioned putting it in there, offering them a way down but you're obviously offering protection for the bank in which you can raise it as well, correct?
Gita Thollesson: That's right and typically you're going to start somewhere in the middle of the grid so that it's beneficial for both the bank, as well as the borrower. I've seen so many cases where banks have done that. I remember one example where a banker told me, to be perfectly honest, he said the borrower is never going to get to this level. It's unobtainable and yet he put a price point out there based on the company's own financials and they absolutely believed that they would get there.
That's not necessary a negative thing for the bank. If the company improves to that point, they will have other options. By giving them a lower price, it's going to minimize the extent to which that borrower is going to go out and shop the credit and look for other options. They know that they can stay where they are and still get a better price that's reflective of their risk.
Jim Young: I guess what you're saying is that they're doing that well at that point. Yes, the price is going down but the risk is now dropping as well.
Gita Thollesson: Absolutely.
Jim Young: Alright, so you've convinced me. It sounds like a win-win. If that's the case, let's go back to what I sort of teased a little bit earlier which is, so if this is such a great thing, why isn't everyone doing it?
Gita Thollesson: In some cases it is an awareness issue. I think for the most part, it's just easier said than done. I mean, right now most commercial loan systems don't have an automated way of implementing performance based pricing grids. There is a manual component there.
It requires monitoring, it requires oversight. It can be a bit of a manual process to implement the adjustments in the loan system. If you think about it, most banks commercial loan systems will generate the invoices, right? For the interest payments and in some cases even fees.
The interest payment, the system will calculate the average balances and it will calculate based on the rate that's put into the system and the invoice will be automatically generated. I've seen, just as a parallel, banks that where their commercial loan system is not set up to generate bills for things like unused commitment fees. Those banks tend not to charge those fees. Those are some of the most straightforward fees to negotiate and yet, if it's a manual process then people just don't even bother.
I remember one bank where, to charge those fees, somebody had to manually key them into an Excel file and manually generate invoices. Nobody wants to do that. It works the same way. When you've got to have a human keep track of when it's time to monitor the financials, what the change in pricing is, and then somebody's got to physically go in and put that into the system, most people wouldn't really be bothered.
It's just something that a lot of banks don't do. That said, I would say that for a larger deal where there's enough revenue at stake, it's absolutely worth the manual effort. It can be a real competitive advantage to put a grid out there and then plus a way, of really making sure the bank is getting paid appropriately for risk.
Jim Young: I would also think that doing this in sort of the way you kind of walked me through that, putting myself in the shoes of the non-banker, the customer here, it seems like it's a good way to kind of communicate, 'hey, here's our rationale behind our price. We're not just giving you this number and throwing it out there and saying take it or leave it. We're explaining to you how this is going to work and how this going to work in conjunction with the performance of your business.'
Gita Thollesson: Yes, that's exactly right, Jim. Really, the whole concept of risk-based pricing. It may seem intuitive to bankers but it's not always that readily apparent to the customer. Really as an industry, we just tend not to do a very good job of explaining our pricing rationale to customers.
If you think about any other industry, think about the airline industry, we all sort of understand where the price of flights comes from. It's based on distance, it's based on supply and demand, and it's based on the cost of fuel. But in banking, quite often, when we're going to quote a price to a customer, it almost feels like we're just pulling a number out of thin air.
It's, "Your price is Prime flat or your spread is two and a half over LIBOR or there's a half point fee. There's very little explanation as to where that number is coming from. When you put a grid in place, it's a way of explaining the concept behind risk-based pricing. Not making it feel quite so arbitrary. If you can explain that rationale, whether it's based on risk or based on cost, the customer is less likely to start negotiating down or to start shopping the credit.
It's a very effective approach, and it would serve bankers well, to have more of a deliberate conversation with their borrower about the cost of doing business.
Jim Young: Yeah, I really think it adds a level of, we talk about bankers wanting to be seen as advisers and not order-takers, and it really adds a level, it increases that feel of an adviser. It's not just, 'hey this is what the market rate is and this is what I can offer you' but rather we understand essentially as a business-owner you're betting on yourself by coming in here and asking for this.
And we're essentially betting on you and this is how we think through it and this is what we think is a good bet. To kind of keep going with that terminology. So when you do that, how do they open up that black box? How would you walk someone through that methodology?
Gita Thollesson: You don't go into a ton of detail on how our ROE model works but it is a matter of, quite often, relating the cost to the customer's own business. If you were to take a customer, where let's say their own costs are sensitive to the price of raw materials. The minute that the price of raw materials rises, they're immediately passing that along to their customers.
Entrepreneurs understand that. That's how their business works. Bankers will quite often explain to the customer their cost of doing business, in terms of both the risk side of things, as well as, just the cost of getting a deal done, the amount of work involved.
There was one case I recall where the banker explained to the customer there's a tremendous amount of work that we have to do even before we get to closing. We have to get paid for that. We're not a not-for-profit. Bankers will explain, we're not an equity partner. We're never going to really participate in the upside, right? We have no where to go but down. We have to get paid appropriately for risk.
When you have some defined financial metrics, as you do in a grid, it really helps to get that point across. By the way, when you are trying to convey thoughtfulness in pricing, there's nothing that's more effective than quoting a non-standard increment live seven basis points, or nine basis points instead of a nice round quarter point.
That's really interesting because we covered that a couple of years ago, in a white paper we wrote called "Are You the Bank of Last Resort?"
We looked a couple of different sort of tactics that banks that are not that. The terminology being the bank of last resort is the one that people go to as their last resort to see if they'll undercut everyone else and give them a ridiculous price.
We're talking about banks that are smarter than that, one of those tactics is simply and it seems so straightforward, is simply not pricing on the quarters. But if 4.25 is too high, not going down to 4 but talking about 4.18. Which you just mentioned, it's not just giving more profitability to the bank but it's actually showing a level of thoughtfulness, of understanding that these aren't these numbers really matter.
We will put a link into the show notes again for bank of last resort if you haven't already read that one on there.
Gita Thollesson: It's the same as with Uber pricing. Those are always odd numbers. You sort of know intuitively that the price is going to vary based on not only the distance but the time of day and how much traffic there is and supply and demand.
People typically don't question their Uber fare because they think that there is some scientific methodology behind it. So, not withstanding what you just said, about perhaps offering a modest discount in a non-increment, even the initial pricing should be a non-increment.That conveys that thoughtfulness and the science behind the pricing.
Gita Thollesson: Right, and it's a way of helping bankers be more competitive as well.
Jim Young: How so?
Gita Thollesson: In the old days, people used to tell us that relationship alone was worth a half point. It used to be that just based on having a good relationship you could charge a bit of a pricing premium. Now the market has gotten so competitive that people are saying that the market just doesn't sustain that level of premium pricing anymore.
If you are delivering tangible value, you can typically get up to a quarter point not really more than that. We've seen so many cases where a bank is delivering value and what they'll do is they'll charge maybe an eighth of a point above the competition, maybe five or ten basis points even. It's a modest enough premium that if the customer is seeing value from that banking relationship they're not going to walk for just an eighth of point.
I saw one deal where there was a competitor that priced the deal at 2 and a half over LIBOR and the RM that I spoke with was just asking for 260 over LIBOR, so a 10 basis point premium and he was confident knowing that the customer wouldn't shop for just 10 basis points.
So it's in a lot of cases like that. I saw one deal, it was in business banking credit where I noticed that it was priced at an odd level. It was at 115 over Prime and I asked the RM, why that price? And she said, well if I start at 115 and they start negotiating down, I know I can go to maybe 105. Where as if I asked for one and a quarter, I'm almost going to be compelled to go all the way down to prime plus one if they start negotiating.
It allows you to negotiate in smaller increments. It sort of changes the mindset and helps the bank win business while concurrently maximizing revenue.
Jim Young: That's fascinating because you would normally think, anchoring that price higher [inaudible] really better. I think what you're saying is that by putting on that quarter [inaudible] get the whole conversation in to quarter point.
Gita Thollesson: Exactly.
Jim Young: Really interesting. That's a great takeaway. And I guess the theme here, whether we're talking about performance based pricing or explaining pricing rationale or using those nonstandard pricing steps all comes back to, how do you win business while maximizing pricing?
Gita Thollesson: Yeah, that's exactly right Jim. That's the million dollar question and but it is a question that a lot of our customers have started to figure out.
Absolutely, and again Gita goes into depth on a lot of ways that top relationship managers at banks are doing that in the report that I mentioned earlier. Again, that link to that, one more time, is L-E-N-D-R.net/rm
. So lender without the second 'e' dot net slash rm. Well this has been great Gita. Thanks so much for coming on. I look forward to the next time we can talk about some more top RM tactics.
Gita Thollesson: That sounds great.
Jim Young: Alright, and that'll do it for this week's show. Reminder, if you want to listen to
more podcasts or check out more of our content, you can visit our resource page at precisionlender.com or you can just head over to our homepage there and learn more about the company behind the content.
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