ABL Roundtable 2014: More of the Same Amid Signs of Improvement
Regular ABF Journal contributor Lisa Miller spoke with five ABL leaders to get their take on the outlook for ABL in 2014. All agree the environment continues to be impacted by excess liquidity and the challenge of finding new money opportunities; however, there is general agreement that clear signs of improvement are emerging.
Economic confidence continues to improve slowly as U.S. companies step up hiring and plan for capital investment. According to the recently released Middle Market Indicator, 60% of U.S. middle-market firms reported improved overall company performance during first quarter 2014. That’s good news, because the health and outlook of these companies is considered a solid indicator for the U.S. economy as a whole.
We asked five asset-based lending professionals to weigh in with their outlook on the ABL industry. “Our deal flow in 2014, so far, is about equal to last year,” starts Bill Kosis, executive vice president at PNC Business Credit. Echoing that observation, Bob McCarrick, chief commercial officer, Lending at GE Capital, Corporate Finance says, “Last year we had a slow first quarter, an active second quarter, an acceptable third quarter and an incredible fourth quarter. This year we are starting off on a similar trend, and hopefully it will remain strong for the remainder of the year.”
“Our loan utilization went up modestly in the first quarter, so that gives me some reason to think that overall economic activity may improve,” shares Sam Philbrick, president of U.S. Bank Asset Based Finance. “But over the last 18 to 24 months, we have seen quarters of improvement, then it softens, and then it improves.”
In an environment that has been heavily driven by refinancings for the past five years, Barry Bobrow, managing director and head of Loan Sales and Syndication at Wells Fargo Capital Finance, states, “M&A volume has shown a nice increase in the past few quarters, but it is not back to where it was in 2006-2007. However, it has gone up every year, and so far looks to be doing the same in 2014.”
“We are excited about our business, and TD Bank is excited about being in this industry,” said Joseph Nemia, executive vice president and head of Asset Based Lending at TD Bank. I am optimistic that we will see an increase in activity, though I can’t predict when it will happen or in what segments. We are happy with the improvement in credit quality, and that provides us with an opportunity to focus on growth and new business opportunities.”
ABLs Earn Halo Effect
Senior management teams recognize that the ABL product is an important component in a broad range of client solutions. “GE Capital got its start in asset-based lending,” explains McCarrick. “It is a product we use across our other lending platforms such as our bank loan, sponsor finance and healthcare financial services groups. It’s been a core product; we have great domain and a great book of business that we will continue to expand.”
“The PNC executive management team backs our business 100%, and the business has performed well,” affirms Kosis. “They’ve supported the business through ups and downs, with the capability to lend through all the cycles.”
“Although TD Bank does not have a long history within the commercial finance industry, I have seen a willingness to understand the benefits of asset-based financing within all markets,” encourages Nemia. “These efforts are highlighted by meaningful investment, not only in deals but also in the commitment to train and develop the next generation of ABL professionals.”
“Our relationship managers across the various banking groups have the same incentives to deliver an asset-based loan solution as they do for any other commercial loan product,” remarks Philbrick. “In addition, senior bank management has taken a leadership role in terms of embracing what we can provide for clients. For example, the vice chair of wholesale banking gathers all his business heads quarterly for a conference call during which we talk about the past quarter’s asset-based finance activity.”
“Our senior leadership particularly likes the deep client relationships we enjoy and our ability to translate those into opportunities for other parts of Wells Fargo,” reports Bobrow. “They like how we manage capital as well as the fact that we make leveraged loans but our loss experience is extremely low. We are efficient users of capital with low overhead and an impressive efficiency ratio.”
The Challenges of Too Much Liquidity
The banks are anxious to put their money to work and build earning assets. We asked our panelists to comment on the current environment of excess liquidity and whether the need to increase earning assets might cause some lenders to take more risks.
“Across the business cycles, we see aggressiveness move up and down the spectrum, but we stay well within our mission,” claims Bobrow. “We want to grow our business by doing the hard work of blocking and tackling, marketing and underwriting. You can work with pricing, yield compression and structure, but if you move either one of them too far, the risk return doesn’t make any sense.”
“Many institutions try to compete on price, so we’ve seen a decline in price over the last three years,” says Philbrick. “People are also competing on structure, which usually manifests itself by putting greater reliance on non-working capital assets within the ABL structure. This includes fixed assets such as real estate, equipment, and sometimes trade names and other intangible assets, as well as loans that are not supported by collateral.”
“Part of what is driving the excess liquidity is the fact that the consumer side of the banking industry has not rebounded as much as other areas have,” instructs McCarrick. “The asset-based product is a good risk return product for all of us, so it is a natural place to put money to work. Another area impacting liquidity is the number of refinancings. If you look at the ABL market in the first quarter of this year, there were roughly 70 deals done with $21 billion in capital put to work, but 75% of that volume was recycling existing cash. Without new money deals, you can’t have the significant growth in the overall loan market and deploy the bank’s excess liquidity.”
For the full year 2013, the FDIC reported that the net interest margin, shown by banks with greater than $10 billion in assets, was 3.12%, down from 3.80% in 2010. As a means to deploy capital, is the ABL product a desirable offsetting alternative to other bank lines of business?
“The decision to include ABL as a business line goes well beyond the analysis of the net interest margin,” urges Nemia. “The ABL product allows borrowers to work with seasoned professionals to manage risk in any economic environment. These factors make ABL a strong credit product. Margins will always fluctuate, but protection of the bank’s balance sheet is of equal or greater importance.”
“Certainly the asset-based loan is no different than any other commercial loan product at this point, and margins have come down,” surmises Philbrick. “There used to be a fairly large premium between an asset-based loan and a traditional commercial loan, but that premium has declined.”
“Compression is a challenge for everybody,” emphasizes Bobrow. “We used to say that asset-based pricing tracked to the Double B institutional loan index, but in 2009 when the market was disrupted, the Double B index gapped way out, making ABL a relative bargain. That has now come in quite a bit, but we are still cheaper than Double B. Asset-based pricing is a good deal for borrowers based on their rating.”
Lookout on Leveraged Lending
Maria Dikeos, senior market analyst of Thomson Reuters LPC, recently commented, “Amid the large number of recycled leveraged credits and an uneven calendar of new money financings, ABL represented a thin 7% of total leveraged lending.” Our participants discussed ABL deal flow activity and the significance of that percentage.
“Seven percent is probably the smallest percentage share of the leveraged market that the ABL product has had in a long time, if not ever,” recalls Philbrick. “It points to the fact that, in the M&A market, it is the level of activity in addition to the competitiveness of the cash-flow loan product that drives demand for an asset-based loan. Our deal flow is better than it was last year, but it is still muted by the liquidity in the marketplace and the fact that the economic recovery is not yet robust.”
“The Fed’s leveraged lending guidelines have certainly had an impact on the regulated entities in terms of how they structure transactions,” insists McCarrick. “But in the ABL world, where transactions are typically done for working capital and to fund growth, the deals don’t usually fit the leveraged lending criteria. When ABL does cross over into leveraged loan criteria, it is usually related to the use of proceeds aligned with leveraged lending.”
“ABL deal flow has been dominated by refinancing activity and dividend re-caps,” reminds Nemia. “In the near term, I don’t see a dramatic shift; however, we are starting to see M&A activity increase in the retail, pharmaceutical and grocery segments. The ratio of ABL loans to total leveraged lending of 7% doesn’t surprise me, given the amount of liquidity in the capital markets.”
“From the syndicated side, ABL has been an $80 billion to $100 billion market since 2009,” says Bobrow. “In 2009 when the leveraged lending market contracted sharply, the ABL market remained open and represented almost 30% of all leveraged loans. Now that leveraged lending has picked up again, the percentage of ABL is going down, even though it is operating at the same volume levels.”
Looking for New Money
A recent KPMG M&A outlook survey cited “availability of credit on favorable terms” as a factor leading U.S. corporations, private equity firms and investment banks to expect a pick-up in growth opportunities through acquisitions in 2014. Nemia agrees that availability of credit is indeed a factor but adds, “Potential M&A growth relates more to the acquisition price and the overall cost of the capital.”
“The low level of bank activity isn’t because there isn’t availability of credit on favorable terms,” countered Bobrow. “It’s because companies haven’t wanted to spend the money and therefore haven’t needed to borrow. Private equity firms have only recently become more active on the acquisition side. It is the demand for loans, rather than the supply of them, that is keeping loan levels down.”
Philbrick points out that it is important to consider which industry sectors are active. “It would be a great benefit to the ABL business if the retail sector were to go through a stretch of significant M&A activity. Conversely, increased M&A activity in biotech and pharmaceutical companies does nothing for us; those types of companies don’t use our product. We leverage working capital assets. If businesses get more debt and leverage their cash flow, they aren’t going to come looking to us to finance the deal.”
“With more support from B lenders and the institutional term loan market, there should be plenty of financing opportunities,” encourages Kosis.
“What the ABL market needs is a general increase in economic activity and the perception that the economy is growing and moving in the right direction,” states McCarrick. “This would lead to increased consumer spending and give companies the confidence to grow more. That would drive an increase in ABL activity and a need for additional liquidity.”
“The growing economy, increasing industrial capacity utilization, improving stock market and tighter labor markets are precursors to more M&A activity, so those are the most positive signs,” surmises Bobrow. “The high liquidity is right there, too, making conditions good for M&A. All of these economic variables make it more likely that a company, or a sponsor, will decide to make an acquisition or build a new plant or hire more workers, as opposed to just hoarding cash or waiting for the right moment.”
Regulators & Rising Rates
We asked our panelists if the advent of more regulation impacted their ability to do business and compete with those playing outside the box under less oversight. “American banks are all held to the same set of rules and standards, so the playing field is level,” proclaims Nemia. “I don’t see playing outside the box as a strategy but more of an opportunistic approach. It is not sustainable in the long term.”
“We don’t see many unregulated entities competing in the asset-based world, so regulation doesn’t really affect our ability to do business,” agrees McCarrick. “Because unregulated lenders have a much higher cost of funds and require more yield, they usually compete in areas where we don’t.”
“Increased regulatory oversight requires us to put more time into marking data and tracking details, but we have a strong relationship with the regulators,” declares Kosis. “At times they really help us by pointing out things we should mark and follow. We’ve told them how we are approaching the market, and they have been very supportive.”
With all agreeing that the regulatory environment is not a major impediment to doing business, the conversation turned to the probability of rising interest rates. “If rates rise because of strong economic growth that would infer that there is increased economic activity in the market with more M&A, growth and new money deals,” theorizes McCarrick. “That would be a very positive situation. But if rates start to rise based on the perception that economic data is getting better, when in reality it is not, that leads to a higher burden on companies that have to service those loans. As a result, it could add more stress to structuring. That might not be the best situation for a borrower, but it could create more opportunity for the lender.”
“Generally a steepening yield is thought to be good for banks, because our assets re-price faster than our liabilities, and that would be accretive to bank earnings,” speculates Bobrow. “If the 10-year Treasury went up sharply, that might not impact ABL pricing directly, but it would tend to make the fixed income piece of a leveraged buyout a lot more expensive, so that might hinder activity.”
“Higher rates would probably have a slowing effect on the economy, but it will also create financing opportunities,” says Kosis. “A little bit of inflation helps asset values, but we don’t see a lot of asset inflation right now, except in the areas of oil and gas. Down the road, that might change with higher rates.”
“Ultimately, higher rates provide an overlay of additional cost, so if rates go up too aggressively, they will mute the economy once again,” warns Philbrick. “If the economy suffers from a significant increase in rates, our level of ABL activity might decline, too. With economic activity driving growth in working capital and ABL demand, the overall effect of rates on the economy is the important factor for us.”
“In the past, ABL was influenced more by manufacturing, but now retail plays a tremendous role as a percentage of total deals,” conveys Nemia. “If a rate increase indicates that more people have gone back to work and are spending their hard-earned dollars at retailers that we are financing, that is a good thing for us.”
Capital Markets Perspective
“The overall activity in the large syndicated market is similar to the whole market — it is muted,” voices Philbrick. “Many lenders are trying to balance the lower profitability of loan spreads by taking a larger piece. Also, the larger the deal, the more discipline there is on structure. That makes sense — if you are going to bring a lot of different banks in on a very large ABL deal, you have to structure it so that it is last-dollar-in from a risk standpoint. For the smaller syndicated deal with only a handful of banks, structures seem to be more aggressive.”
“New players generally are smaller banks, and they tend to be less active in the capital markets arena, so they are not likely to affect structure,” suggests Nemia. “The larger banks continue to increase hold limits, which eats up capacity. The more deals in the market, the more agent banks will spread business, but that is a function of new business activity.”
“We have seen fewer opportunities to underwrite ABL deals, and some of that is related to the lack of new money opportunities,” concludes McCarrick. “It is also due to the fact that companies have become savvier about clubbing banks together themselves in order to complete an ABL deal. Rather than coming to us to hold $50 million or $75 million, they can now put deals together themselves.”
“There is not enough business to satisfy what everyone wants,” says Bobrow. “It is not that the banks don’t want to lend; there just isn’t enough activity for what they want to do. From an industry standpoint, that probably means there will be winners and losers.”
“With the pressure on spreads, there needs to been a keen focus on balance between investing in growth and managing expenses relative to current revenue growth,” observes Philbrick. “We have all benefited from the pristine asset quality that keeps our credit costs incredibly low in terms of managing problem accounts and actual credit losses. The key question is not only how our loans are performing now but also how they will perform through an economic downturn. Only then can we get a real sense of how difficult the market is.”
“Hiring and training has been an ongoing issue for this industry,” asserts Nemia. “When you consider the evolution of this business, you realize that many of our seasoned professionals such as myself came up through the ranks of credit training coupled with field exam experience. But now, many lenders have reduced or eliminated those training areas, and third parties often perform field examination.”
Kosis concurs, “My biggest concern is being able to get enough qualified people to continue to handle the growth of our business. We have a training program that we populate with desirable candidates who we develop for the long haul. Given our size, we need to have a solid bench.”
“I am concerned about the lack of new money activity and the fierce competition that pushes competitors to drive down price or loosen up structures in order to compete and win,” laments McCarrick. “I would like to see things come more into balance with increased economic activity and a healthier lending environment from the lenders’ perspective.”
“There is a lot more competition right now, but there are always good deals out there,” insists Kosis. “You just have to work harder to find them. The economy is extremely deep, and there are many opportunities.”
Lisa A. Miller is a freelance writer and contributor to ABF Journal.