May/June 2016

Rebounding From a Slow Start: ABL Lenders Look Ahead to a Strong Finish in 2016

ABF Journal contributor Lisa Miller spoke with five leading ABL lenders about the current landscape. After a lackluster 2015 and a slow start in 2016, they share their thoughts on changes in the economy and challenges that ABL lenders face. They look into their collective crystal ball, predicting a stronger second half for 2016.

Barry Bobrow, Managing Director, Wells Fargo Capital Finance

Barry Bobrow, Managing Director, Wells Fargo Capital Finance

Today’s asset-based lenders must stay at the top of their game, ready to respond to a dynamic marketplace at a moment’s notice. In a highly competitive market that includes new players, fluctuating commodity prices, increasingly creative financing options and potential fall-out from global unrest, lenders must be fast thinking, flexible and flawless in their delivery of financing solutions. We asked five ABL lending executives to share their recent experiences.

“It was another year of very strong competition with modest economic growth,” says Sam Philbrick, president of U.S. Bank Asset Based Finance. “Most of us were not expecting such a precipitous decline in commodity prices, so it was a surprise to see both the petroleum and metals industries affected so dramatically. Also unexpected was the continued strong competition from the cash flow lending market that put the ABL product’s share of the leveraged loan market under continued pressure. The ABL industry’s market share ended the year at close to all-time lows.”

Although business grew substantially on a year-over-year basis, Michael W. Scolaro, managing director and group head of Asset Based Lending at BMO Harris Bank, says expectations for 2015 were not fully met. “Loan demand was not as robust as it had been in the past, and because of that, supply and demand got out of whack around the middle of last year. The supply of ABL product increased, and the demand from borrowers decreased.”

“The first half of last year was strong with a lot of M&A-driven activity, but the second half of the year became very choppy; then it ended with a disappointing whimper,” says Barry Bobrow, managing director and head of Loan Sales and Syndication at Wells Fargo Capital Finance. “It was hard to complete new M&A and sponsor-related transactions due to the challenges in the high yield and leveraged loan markets. In the second half of the year, the overwhelming impact of dropping energy prices and the global economic slowdown caught up with the U.S. markets. We continued to grow our assets in 2015, but with the spread compression driven by strong competition, it’s hard to gain ground from a net income standpoint.”

Bill Kosis, Executive Vice President, PNC Business Credit

Bill Kosis, Executive Vice President, PNC Business Credit

“We had more referrals from equity sources than we had in previous years,” says Bill Kosis, EVP at PNC Business Credit. “The competition is always there, and it was intense, especially in certain categories. We have been developing our recurring revenue product over the last several years and that was an area of growth for us last year.”

“We are a traditional asset-based lender, so while the products we deliver are fairly standard, the embedded advance formulas and term loans can be tailored to a specific situation,” explains Michael Sharkey, president at MB Business Capital. “We can be more aggressive than the banks on many deals where EBITDA is weak or suspect. However, there are a handful of institutions that will lend a multiple of cash flow over long periods on a fairly low level of EBITDA if it appears to be steady and sustainable. Our focus therefore was helping private equity firms with weaker investments and individual owners with growth and improving companies.”

Finding Room for Growth

“I have said in the past that borrowers can dictate one term but not all terms in this environment, and that situation has continued unabated,” says Scolaro. “So many of the terms have continued to erode into the borrower’s favor. Deal flow did slow down somewhat mid-year in 2015, but we have a healthy pick-up in 2016 so far. We are ahead of last year’s pace substantially.”

“The lack of growth in the overall market makes competition that much more intense, but fortunately we continue to have opportunities for us to grow,” says Philbrick. “The first quarter of 2016 met our expectations for new business, and we are beginning to see some modest signs of improvement in market activity as we enter the second quarter.”

“In 2016, the first half of the year has been slow, but I feel optimistic about the second half, because there are some strong technical factors that are starting to turn in our favor,” says Bobrow. “The high yield bond market has staged a resurgence, and we’re starting to see the ability to use that market for financings again. More recently, the same turnaround is also occurring in the institutional loan market. At the end of last year we were almost entirely reliant on private capital to complete a buy-out structure, but now the markets have become more liquid, which will enable more transactions in the second half.”

Fluctuations in energy prices and changing values in commodity markets threaten the risk/reward landscape, and bankers keep a watchful eye on the numbers. “When you have sudden disruption, such as the decreased commodity prices experienced earlier in 2015, I liken it to a python swallowing a rabbit,” says Scolaro. “It takes a while for that shock to be absorbed by the system, but now the commodity businesses are selling product they purchased in the same environment as the one they are currently operating in.”

“Most of the asset-based energy exposure is focused on the commodity side: the refineries and pipelines as opposed to services and production assets,” says Bobrow. “People are still buying gasoline, and airlines still need jet fuel; those deals are doing fine. It’s the exploration and service companies that are hurt by the stunning drop in commodity prices.”

“The credit deterioration also creates opportunities,” says Kosis. “We look long term for companies with good fundamentals, a good business model and experienced leaders to work with us through the downturn. We’ve picked up some new customers in those spaces.”

“In these cyclical industries we focus on financing working capital that will contract and grow in concert with the borrower’s business,” says Philbrick. “Asset-based lenders can get into trouble if we lend extensively on fixed assets in the sectors, since the values of these assets can decline precipitously in a sector downturn.”

“There are viable situations and opportunities in every troubled industry,” adds Sharkey. “You just have to know how to recognize them and apply sound ABL lending techniques to help the situation.”

Michael W. Scolaro, Managing Director, BMO Harris Bank

Michael W. Scolaro, Managing Director, BMO Harris Bank

Portfolio & Market Performance

Our panelists had different experiences with utilization rates: some were up, some were down and others were the same. “The pace of our business remains about the same,” says Scolaro. “Commitment activity was up substantially over 2014, but it didn’t meet our expectations for 2015.” Kosis reports less M&A to start the year but more add-ons and increases for the portfolio.

“Our new commitments were up substantially last year, primarily because we focused on larger transactions,” says Sharkey. “The number of deals closed was not up dramatically from the prior year, but the commitments were.”

“Economic activity is our biggest driver, so for a significant improvement in opportunities, there has to be a strengthening of the economy,” Philbrick points out. “It affects new business opportunity and dramatically affects the utilization rates under our credit facilities. Going into 2016, utilization rates have not firmed up like we typically see at this point in the year.”

“Credit quality has migrated slightly, but that’s normal in a slowing economy,” says Bobrow who is experiencing an increase in both utility rates and amendment activity. “Everyone I talk to feels pretty good about overall portfolio quality. There are economic cycles, and these portfolios are full of cyclical businesses, but the performance of the portfolios has actually been strong so far this year.”

Thompson Reuter’s LPC report on 2015 ABL activity showed some interesting numbers, including a hefty amount of refinancings and a downturn in new issuance. “The number of deals we closed last year was up slightly over the prior year, but we enjoyed nice growth due to a larger average deal size,” says Sharkey. “It doesn’t surprise me that the statistics show a large percentage simply refinancing another lender; about 30% to 40% of our loans last year were for change of control versus refinancing another lender. I don’t think that is because there are fewer buy-outs; I attribute it to the proliferation and ongoing aggressiveness of cash flow and non-ABL bank lenders, such as BDCs, in the space.”

Scolaro agrees that new issuance is down in the marketplace, but BMO Harris also closed some large ABL transactions at the end of last year. “As lead agent we closed $350 million for Blommer Chocolate and $700 million for Chelsea Petroleum. One was a refinance and the other was a buy-out, but they were both new money ABL deals that spurred our fourth quarter in 2015. That momentum carried over into 2016, and Thompson Reuters rated us No. 3 in their First Quarter ABL Bookrunner Volume.”

According to the league tables, PNC Business Credit was No. 1 in asset-based loan syndications in the middle market space and No. 1 in volume and number of deals. “Direct activity was tremendous last year,” says Kosis. “Our new issuances were up in 2015, driven by private equity and the middle market. We are a little slower out of the gate this year, but things are starting to pick up.”

Michael Sharkey, President, Mb Business Capital

Michael Sharkey, President, Mb Business Capital

“Syndicated asset-based loan volume was about $10 billion lower than it was in 2014,” says Bobrow. “The deal volume was down even more sharply. The reason for the weakness in yearly volume was the lack of new acquisition volume during the year. The deal volume is off more than the dollar volume, because the dollar volume was buffered by significant jumbo loan activity. That is one of the bigger stories from last year. In the volume reported by Thomson Reuters, there were 22 deals of a billion dollars or above. Those 22 deals made up a pretty small percentage of the overall deal volume but represent about 43% of dollar volume — and none of them were new issuance. They were all existing asset-based borrowers that upsized or extended their facility or did some combination of each.”

“We tend to be transfixed by the LPC data and what it tells us, but we should remember that it represents only a subset of the ABL market,” warns Philbrick. “It does not capture middle market activity: the sole lender deals and the small club deals that don’t reach the threshold of the syndicated market measured by the LPC data. While the report may serve as a proxy for the overall market activity, it does not include the entire market. What is interesting is that we are seeing our very largest competitors drop down into the smaller end of the middle market in search of additional business. It seems that this activity in the non-LPC space is becoming more and more relevant to the big players.”

Sam Philbrick, President, U.S. Bank Asset Based Finance

Sam Philbrick, President, U.S. Bank Asset Based Finance

Unregulated Competition

“It has become more difficult for a regulated institution to compete for asset-based loans to companies with performance issues,” says Scolaro. “The non-bank ABL lenders have stepped into that breach and are beginning to thrive. To compete with them and with non-regulated cash flow lenders, asset-based lenders have paired with second lien and split lien lenders to provide comprehensive lending solutions. These solutions might include an ABL piece paired with a term loan from a non-regulated institution. We have done a lot of these over the past year.”

PNC has been working with non-bank finance companies for several years to offer a more comprehensive capital solution. “Unitranche structures, first and second lien loans and the like have allowed us to expand our solution set to meet the changing capital needs of middle market companies and private equity groups,” says Kosis. “Though more complex and with more technicalities to be addressed, working with these companies significantly expands capabilities and broadens the market for ABL.”

“On the other side, we have a lot of unregulated players — BDCs, special opportunity funds, insurance companies — chasing the asset-based market for direct lending,” says Bobrow. “Because these players have higher required yields, they can’t compete against the banks for most of the activity in the market. If a bank can do the deal, there is no competition from non-bank players, though there may be a partnership opportunity. If it’s a deal that the banks struggle to do because of the regulatory guidance, then it’s a good opportunity for the unregulated players.”

Philbrick agrees: “The non-bank competitors are challenged in our sector of the ABL market because their cost of funds is too high versus market pricing that is driven by the banks. They are active in our market but more as complementary financing to a bank-provided ABL deal. We occasionally team up with them to do a term financing piece alongside our ABL piece.”

“The unregulated players make it easier for us to exit our problems,” says Sharkey. “They take the riskier position in unitranche structures where the banks are doing the revolvers and taking a first out. They are also getting aggressive on the refinance of marginal borrowers looking for maximum liquidity and the longest runway on the covenants. That will undoubtedly take a bite out of our refinance market.”

Predictions for 2016

“In 2016, I think the second half is going to be stronger due to the overall strengthening of the U.S. capital markets,” says Bobrow. “The Dow has been over 18,000, and we’re near record territory for all the equity indexes. That has a positive impact on the high yield market, which is what facilitates a lot of the deal activity. It takes a while to rebuild that pipeline, but it feels as if that’s in process.”

“I think we are going to have a good year, and that we’ll grow again,” says Kosis. “There will probably be more deterioration in credit for certain sectors such as oil, gas and the commodity spaces, but overall credit remains strong.”

“Competition is not going to get any easier,” says Sharkey. “We see increased competition from above and below — especially from below in 2016. Our strategy is to cast a wider net, so that we see as many opportunities as possible. It is a numbers game. As your hit ratio on proposals falls due to the competition, you have to propose on more deals to maintain your growth curve.”

“I predict that we will see continued modest growth and strong portfolio performance with subsequent pressure to increase market share, resulting in increased competition on both pricing and terms,” says Scolaro. “Another decrease in commodity prices is the only thing I can see that might get in our way other than general economic malaise. The latter is a double-edged sword for ABL, because it opens other markets to us that were typically closed. The continuing impediment is the mismatch of supply and demand.”

“The real question is, how will our portfolios perform from a credit perspective when the economy slows down overall, and to what degree will our expenses to manage our credits potentially increase?” says Philbrick. “Fortunately, this is usually balanced by an increase in ABL activity in an economic downturn as more companies look to our product as the right solution when their business performance slows.”

“If you look at PNC’s business over the years, we have done well in the downturns, almost doubling our portfolio in 2009 and 2010,” says Kosis. “Every type of economy gives us opportunities, so unless something happens that is way out of bounds, I don’t see anything ahead this year that will throw us off.”

“We tend to make money in good times and bad, for entirely different reasons,” says Sharkey. “I think we will see stress in some new industries this year. The auto bubble could burst, retail may continue to worsen — it is already fairly stressed — and global unrest or domestic terrorism could cause problems. Regardless of what happens, there will always be a need for asset-based loans, and a disciplined asset-based lender that has been structuring and documenting its loans properly should be fine.”

“The economy is what it is,” says Scolaro. “We’ve seen five to six years of 1% to 2% growth, and it’s been more of the same each and every year. There are individual industries that are winners and losers. The energy industry has been a loser over the last 12 months due to decreasing rates, and the metals industry has been hurt by the decreased value of their inventories. We work through those issues as an industry, and we come out stronger on the other side.”

“In the first quarter of 2016, there was a contraction of earnings for the S&P 500, even if you exclude energy-related names,” points out Philbrick. “This makes me question the sustainability of growth in this economy. The decline in earnings is even greater for those companies that do more than half of their business in economies around the world. For companies that sell abroad — and most do — we need to really understand the economic activity in those markets. When considering our U.S.-based customers, we have to realize that global markets will have an impact on them.”
“While the U.S. economy is a lot stronger than most other parts of the world, the relatively low growth is holding back deal activity, and the high liquidity in the banking system is keeping spreads from increasing,” says Bobrow. “If the economic climate stays where it is, it will continue to be challenging for banks to widen spreads and grow assets fast enough to keep up with the pressure on spreads.”

“We remain in a vortex of supply and demand,” says Scolaro. “It’s just a question of which axis on the X-Y graph is moving in concert with the changing market demand. If supply increases and demand decreases, as we have seen, you are going to get pressure on rates and terms. There is not much more pressure that can be exerted on rates, given that 78% of the deals being done are below LIBOR+2. There is not a lot of room there.”
“The market is as competitive as usual, but that’s the same as it has been,” says Kosis. “My biggest concern is the need to find good people and to get better at doing that.”

“It is safe to say that bankers are working really hard right now to grow,” says Philbrick. “I don’t expect to have the economic wind at our backs anytime soon. We truly operate in a global economy, so it’s critical to keep an eye on world events and try to anticipate their effect on our business.”