A legal or regulatory investigation, lawsuit or a government audit has a voracious appetite for records. Records often show what people did and what they were thinking when they did it.

But the quantity of records in any enterprise is swelling thanks to the incessant growth of computer processing and storage capacity, increasing modes and usage of digital communications and the proliferation of multimedia applications. According to a 2008 study by International Data Corporation, around 1,200 exabytes (1.2 trillion gigabytes) of digital data will be created this year. But managing all those records is challenging. It is easy to lose them or render them practically unfindable.

In a surprising way, the rise of electronic records is changing the law. Legal authorities are increasingly suspicious, even frustrated, when an enterprise (private or public sector) fails to keep good e-records. For the authorities, the attitude is that all those computer records are critical for accountability and dispute resolution, and therefore they should be kept available for electronic discovery. Further, if records have been buried or destroyed, authorities are prone to sense wrongful intent.
 
As more legal rulings declare that e-records must be retained and organized, corporations and government agencies are in a quandary. Trying to keep everything forever is absurd. Traditional record retention practices, which were developed when paper dominated, now seem out of date, but there is little consensus on what practices to follow instead.
Meanwhile, though courts are not the most tech-savvy institutions, neither are they clueless. The court system is learning fast about topics such as digital forensics and backup tapes. Leading judges such as U.S. Judge Shira Scheindlin are issuing thoughtful opinions on the growing responsibility of counsel to locate and preserve e-evidence as soon as a lawsuit is anticipated – and those opinions quickly become famous via the Internet.
Two other ideas are gaining currency among judges. One is that the discovery of electronic records should be a cooperative process, where litigants are expected to be candid and forthcoming, even in an adversarial court system like the U.S. Another is that records should be found and revealed in phases, such that the easier-to-find records (e.g. more recent emails) are divulged promptly, and other records are resurrected later, but only if the progress of the lawsuit justifies the effort.

Although U.S. courts have been at the vanguard of e-discovery, the phenomenon is global, as the timeline below shows.

What does the future hold? First, the interest of legal authorities in electronic records will only grow. Second, as businesses continue to embrace social networks such as Twitter and rich media such as video conferences, the quantity of e-data will continue to skyrocket. 

At the same time, the cost of storing and searching records will continue to fall. Technologies such as cloud computing promise to make enterprise archiving more effective for internal control and for responding to e-discovery. It’s not all good news, though. The pressure on corporations and governments to improve the way they preserve data is only going to increase.

From authorities, one message rings clear: they tolerate early record destruction less today than in the past. For management, this message means the enterprise must re-examine its policies on which records to keep and how long to keep them. Although no single solution fits every enterprise, simply to stick with historical practices is dangerous. Those who do not up their game should expect to be penalized (see the implications in the Philip Morris case on our timeline).

What’s more, among enterprises that hold records, an old idea is losing favor. The idea that records are dangerous – and should be purged quickly – holds less merit. Plentiful, computer-searchable records are a valuable asset, which can help management maintain control and be marshaled to defend against bogus allegations.

Many enterprises are retaining more records, especially emails, for longer time periods. These records can constitute a valuable day-to-day journal of activity. Retained records present the opportunity to demonstrate that a corporation is a good organization, employing good people, trying to do their best. Sure, people will make unfortunate utterances in email. But in an enterprise of largely well-intentioned people, there should be a negligible number of smoking guns.

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According to the 2009 Survey of Credit Underwriting Practices, the U.S. Comptroller of Currency’s annual bank poll, 96% of the banks polled expected credit risk in their middle market loan portfolio to increase over the next year. The same poll had 67% of banks tightening their middle market underwriting standards this year, the most since the poll’s inception.

Middle market lending picked up smartly in the last quarter of 2009 but remains far below the levels of the mid-2000s. With money center banks focused on larger clients and relationship banking, and many regional banks still capital-constrained by poor loan performance, it’s unlikely that middle market lending will return to these volumes any time soon.

One thing is clear: middle market companies seeking bank loans need to be prepared for a limited appetite for leverage, tighter financial covenants, lower advance rates, shorter tenors, and higher spreads than in recent years. Above all, reluctant lenders are looking for another “C” from potential borrowers:

Credibility

While the balance of power between borrowers and lenders has shifted, borrowers should remember that they are far from helpless bystanders. Here are some of the key issues that bank underwriters are most focused on in evaluating a middle market financing:

Collateral Is King – Right now, collateral is crucial and most senior debt will be secured. Companies with tangible assets of determinate and material value are in a far more favorable position than those with fewer tangible assets. Valuing collateral is also a key issue, as real estate and some types of equipment have been severely depressed over the past year. Those seeking financing should go into bank negotiations with a clear understanding of the value of those assets to be pledged, preferably verified by a third-party source.
Remember that assets are only useful as collateral if they can be controlled by a lender in the event of default and subsequently monetized in a timely and cost-effective manner. 

Evidence of Quality Management Is Crucial – Often overlooked, this factor is of paramount importance in the underwriting process. Banks need to be comfortable with a management team’s qualifications and character. Banks are also scrutinizing managerial performance, since in many cases this provides an extreme data point. Management should have answers to the following questions when approaching lenders for financing: How have revenues held up in this downturn? How were costs kept in line with falling sales? How was working capital managed in the face of the recession?

Ensure Your Financial Data Is of the Highest Quality – The integrity of the borrower’s accounting information is critical. Financial statements must be audited, and controls must be strong. Demonstrating the internal control systems in place should be part of a presentation to lenders, as emphasizing the reliability of the company’s financial reporting systems can go a long way in mitigating any skepticism.

Understand the Role of Projections – Lenders generally expect a sluggish economy to impact the financial performance of middle market companies to a greater extent than large firms, negatively affecting cash flow and staying power. For this reason, upbeat projections are greeted skeptically and it is up to the borrower to convince lenders that realistic economic conditions are incorporated. Management should be prepared to provide detailed support for their projections and underlying assumptions. Even if banks accept these projections as reasonable, financing is unlikely to be provided at anything greater than a senior debt-to-EBITDA ratio above three times.

Use Scenario Analysis – Borrowers should have a firm understanding of a worst-case scenario and a detailed plan to deal with it. Many private equity firms started undertaking scenario planning in early 2008. This planning enabled sponsors to reduce the amount of additional equity injected when refinancing. In 2009, one large European private equity firm was able to refinance more than $1.5 billion of debt with additional equity of less than $10 million. Management should follow suit and prepare a line-by-line plan of how costs will be cut and debt will be serviced if sales fail to meet expectations. In the same vein, management should evaluate potential liquidation scenarios as banks will certainly need to understand them thoroughly.

Understand Your Industry – Traditionally, attractive industries for underwriters are those with low cyclicality and low technology/obsolescence risk because cash flows are more predictable. This downturn has spared few industries, but the risk of obsolescence and the intensity of competition continue to be heavily scrutinized in the underwriting process. Additionally, due to the renewed reluctance of banks to underwrite cash-flow loans for middle market borrowers, companies in asset-light industries such as software, technology, and services may find it more difficult to obtain financing, particularly if there is more than one lender. Those seeking financing should have a firm understanding of their industry, and be prepared to make a strong case to lenders on its attractive aspects, while explaining the company’s plan to mitigate risk from its negative elements.

Know Your Business – Attractive borrowers have compelling products and services, a strong brand name, little customer concentration, and highly credible management teams. Even in lean times, bank funding is usually available to high-performing companies with solid track records. Those seeking financing should know their business inside out, and be prepared to present a strong case on how the company stands apart from its competition. Unfortunately, most middle market companies currently in need of refinancing are doing so in the context of weak demand and stagnant revenues. These companies need to demonstrate how well they have been able to reduce costs and rescale their businesses to maintain margins and profitability. Management should also understand and be able to explain the company’s positioning relative to competitors in the event of a normal recovery and a prolonged downturn.

Reconfigure the Capital Structure – Banks are trying to cushion their exposure to the total leverage in a borrower’s capital structure, often requiring principals to have more “skin in the game.” Additionally, many middle market companies seeking refinancing are faced with weaker recent operating performance and more conservative covenant ratios, meaning less debt will be available to them than when the previous financing was put in place. As a result, companies may need a high equity or junior capital contribution to obtain bank debt. Personal guarantees may be required for smaller companies. In this case, the owners’ finances and credit history will be on full display and can be prepared in advance. Make-whole or capital call agreements, particularly in companies with non-public fund-held equity, may be required.

Be Prepared to Concede on Covenants – Banks are demanding tighter covenants. Borrowers should now expect tight covenants regardless of their credit history or relationship with the lender. More frequent reporting and valuation of collateral may also be required. Management should go to lenders with a willingness to accept these restrictions on any issue made in the near future, with the understanding that if the company does outperform these covenants, they can probably refinance their way out of this burden. 

Examine and Reconsider the Use of a Bank’s Other Services – A history of using the bank’s services such as treasury management or merchant services helps the company secure lending in two ways. First, it makes the company more attractive for the future fees these services will generate. Second, it frames the financing as relationship banking, based on a history of proprietary information gained through multifaceted business interactions.

Self-Help Can Help – Companies can make the process of refinancing faster and easier by undertaking their own self-diligence prior to discussions with lenders. As well as knowing their own strengths and weaknesses, companies can also prepare a thorough analysis of their operating performance, financial metrics, and collateral. It may be worth asking an external advisor to assist with this – a good advisor can bring independent analysis, industry knowledge, greater credibility, and additional manpower.

As part of economic stimulus legislation passed earlier this year, the U.S. Federal Communications Commission is charged with developing a national broadband strategy “to ensure that all people of the United States have access to broadband capability.” Indeed, even though broadband adoption has incre
ased more than sixfold since 2001, some 43% of U.S. households have yet to adopt high-speed access in their homes. The Compass Lexecon findings underline the potential benefits of accelerating broadband adoption.

Size of the Prize

In a survey of American consumers in April, the Pew Research Center found that around one third of respondents considered high-speed Internet a necessity. And broadband was one of the few items to grow in importance in surveys over the past three years.

But just because something is desirable doesn’t necessarily make it useful. Thus, the researchers at Compass Lexecon sought to quantify the benefits of household broadband for consumers, deploying an array of econometric tools in the process. The goal was to identify the ‘consumer surplus’ associated with broadband access – that is, the value of the service to subscribers above what they actually paid for it. If the actual value of a service is less than its price, nobody will buy it. On the other hand, if the value surpasses its price, buyers receive benefits from the service that are not captured simply by how much is spent on a particular service. 

To determine the actual surplus from broadband Internet access, Compass Lexecon’s researchers analyzed a sample of broadband purchasing data for 30,000 households from the largest 100 metropolitan areas in the U.S. between 2005 and 2008, and then extrapolated up their findings to the U.S. population. Based on pricing and adoption rates in the sample, the researchers could estimate consumers’ willingness to pay for broadband under a variety of conditions.

A 10% rise in the price of broadband would have led to a 15% decline in demand in 2005 whereas, in 2009, a 10% rise in price would result in only a 7% decrease. Thus, growth in the value of broadband to consumers increasingly outstrips a rise in its price, implying that the size of the total consumer surplus is growing. At current prices, the net consumer surplus for broadband is $31.9 billion per year, Compass Lexecon estimates, up from $20.1 billion in 2005.

Onwards and Upwards

There are strong reasons to believe that the true value of broadband is significantly larger than these estimates. The research looked only at fixed-line broadband use at home and estimated the aggregate consumer surplus. Outside of the scope of the study were mobile wireless broadband, consumer gains as the productivity gains from business users are passed on, and the producer surplus enjoyed by broadband providers, as well as firms whose services become more economical or feasible as the speed of Internet access increases.

Finally, broadband access can also be considered an ‘experiential good’ – once consumers experience high-speed Internet access, they tend to value it more highly than if they had not experienced it before. The size of the consumer surplus would therefore grow if the current share of households with dial-up or no Internet access were to try broadband for the first time.

For companies, the case for greater broadband adoption is compelling. Compass Lexecon researchers found that 22% of workers with broadband regularly access their employer’s network from home versus only 8% of employees with dial-up access. Given the well-established benefits to employee productivity and retention that stem from flexible working practices, anything that can be done to make working away from the office easier should be encouraged. Broadband also allows firms to open new sales channels, develop new product markets and expand customer-service possibilities.

The steady expansion of Internet access over the past 15 years has revolutionized the workplace, not to mention the world. The next step is expanding access and affordability to broadband, which promises to deliver billions of new opportunities across all segments of American society.