January/February 2016

Fierce Middle Market Competition: Creating Opportunities From Challenges in Senior Secured Lending

Many challenges exist in the ABL industry today, including increased regulation and a growing number of competitors. Mike Sharkey shows how lenders can turn these challenges into opportunities for new business.



Mike Sharkey, President, MB Business Capital

Mike Sharkey, President, MB Business Capital

The fundamentals of asset-based lending (ABL) have changed little over the past few decades. Though the ABL industry has remained relatively constant, the nature of the companies that are financed and the competitive landscape have changed dramatically. The challenges and opportunities facing lenders today are multifaceted.

Virtually No Growth

In 2013, MB Business Capital looked at organic growth in our portfolio from January to December and net loan balances were virtually unchanged with zero growth. In 2014, we duplicated the exercise and aggregate loans rose 2%. In today’s competitive lending environment, can successful companies afford to have a nominal 2% budget growth? The primary explanation for this minimal growth is that companies have not been adding to capacity or growing their assets, which would have created increased borrowing needs. This troubling trend continued in 2015. Our loans to existing customers were up only 1.6% through June.

Although growth has been scarce, ABL companies can still find opportunity in some key sectors, such as health and e-commerce. We have seen a number of internet retailers looking for financing. These are similar to the catalog retailers we have financed for years. Our retail finance group just closed a deal for a company that sells entirely through Amazon.com, and most of its inventory is under Amazon control. They have a very successful sales model, and inventory turnover is great. Finding companies with similar models is a good way to take advantage of growth opportunities in this limited lending environment.

Competition

ABL shops are being squeezed between commercial bank lending areas and the alternative lending by hedge funds and business development companies (BDCs). Liquidity is abundant, credit standards seem to be at an all-time low and pricing for the asset-based lenders is the softest its been in recent memory.

For example, we had a small deal where a recent startup never had a year-end profit. The company was profitable year-to-date and had a borrowing base that would support $3.5 million in loans. Two days before closing, the company reported that a bank capital markets group was willing to provide a $10 million term loan in addition to the revolver so that the startup could take a $10 million dividend. This deal was offered to a company that had never seen a year-end profit! This type of competition has altered the ABL space and requires adaptation.

Despite competition posing further difficulties, opportunity still exists. The primary opportunity in overcoming competition is in employing unique skills for tougher deals. As lenders move into the riskier end of the market, as some would term the turnaround end, they must be equipped to handle it.

We recently approved an allocation for booking classified loans where we felt we were well collateralized and believed there was a high probability of upgrade within a year. Historically, we wouldn’t book a new classified loan. The ABL industry must remember that distressed situations today are not due to broad sweeping problems with the economy, but can be attributed to weak management or an inability to deal with some unique company specific issues. In those cases we must either lean on, or require, the involvement of a good consultant to help fix these problems.

Liquidity in the Buyout Market

In the late 1990s, approximately 70% of our deals were private equity-based buyouts. The 50 or so BDC’s active today didn’t exist then. It was difficult to find a cash flow solution for companies with EBITDA under $10 million. Today, not only are the BDC’s and the alternative lenders doing smaller cash flow deals, the commercial banks have come roaring back into that space. It is not unusual to see 10- or 15-year term loan on deals where EBITDA is far less than $10 million.

Senior debt multiples are also at all-time highs. Cash flow solutions mean certainty of close, which is very important to most buyers. In the last three years, our mix of LBO’s in new business has softened, and about half of our runoff came from companies sold to strategic buyers.

The opportunity for ABL lenders in the buyout space lies in the proliferation of fund-less sponsors. We are seeing a number of fund professionals operating independently. Often we can help those isolated fund professionals by bringing an equity partner or one of the SBIC funds that we invest in to fill out their capital structure. We have a broad list of key partners that allows us to add that kind of value, which helps win a spot in the capital structure.

Regulatory Environment

Leveraged transactions continue to be significantly impacted by the current regulatory environment, providing further obstacles to the ABL industry. This will also continue to pose challenges to commercial banks, particularly as it relates to cash flow structures.

Lenders can overcome the stringent regulatory environment by exercising discipline to structure deals properly and to monitor them correctly if lenders want to enjoy longevity into the future. Over the years, we have seen many ABL lenders fail due to a basic inability to coexist with an increasingly involved regulatory environment. Generally, these lenders did not have the proper personnel to manage the risk they were taking.

To enjoy successful financial growth, ABL lenders need to have the right personnel, they have to be fair and they have to be reliable. A commitment is needed to ensure that, as a lender, your company is able to close what it proposes with no surprises and no re-trading. This will provide confidence and successful results for all involved.