In a Market Awash With Liquidity and Thin on the Demand Side… What’s a Lender To Do?
While it’s no revelation that asset-based lenders have provided middle-market borrowers with flexible loan structures that both accommodate growth in times of plenty and allow for more patience during downturns, today’s recovery is calling for a new degree of creativity on every front. With a debt capital market awash with liquidity and competition at an all-time high not to mention a systemic “shift of power,” Crystal Financial’s Colin Cross contends while things might be tough, unique opportunities still exist.
It’s mid-2011, and this year is shaping up as one of the most competitive ABL markets ever. Lenders are stretching on credit and lowering yield, wondering what next week will bring. Will it bring yet another deal closing on increasingly aggressive terms and pricing? You bet. What is surprising to most of us in the industry is how quickly the credit market turned this time around. Past credit cycles historically have been heavily influenced by the banking system, with commercial lending to middle-market companies controlled by the mindset of credit officers and senior risk management running the banks. Typically, sustained evidence of an economic recovery preceded the gradual easing of credit.
Times have changed though, and banks no longer control the loan market like they used to. The emergence of a syndicated loan market that can feed non-bank entities such as CLOs, prime rate mutual funds and hedge funds has changed the competitive landscape and shifted the balance of power. The structure and pricing of loans in the market today is driven by the liquidity in the market and not so much by the seasoned credit officer in the corner office. And today the debt capital market is awash in liquidity.
Supply Up, Demand Down: Not Good for Lenders
The supply of debt capital has been steadily expanding over the past 12 months and a couple of key macro factors are behind the numbers. First, low interest rates have caused investors to increasingly chase yield. After the Great Recession beginning in the fall of 2008, investors moved their investments into the safest investments they could find, including treasury securities, FDIC insured accounts banks, money market accounts, etc. Safety did not result in much yield, but at the time, investors were more interested in “return of principal rather than return on principal,” as Will Rogers famously said.
As a result of the Fed actions and quantitative easing, the yields available for these investments have been declining and, for some accounts, are now approaching zero. Meanwhile, investors’ risk appetite has shifted as the economy appears to have stabilized and is turning around. Willing to take more risk, but still a bit leery of the stock market, investors are pursuing fixed income investments at a record pace, particularly the high-yield and the senior leveraged loan market. This trend is evidenced by the record level of funds flow into HY funds and prime rate funds (See Figure 1: Weekly Bank Loan Funds Flows).
The second macro factor involves the banks and the continued improvement in their earnings and balance sheets. This has shifted the credit pendulum from contraction to expansion, resulting in a change in mentality from working on the portfolio to searching for new loan opportunities. Moreover, most bank asset-based lenders performed very well during the downturn, showing nominal loan losses and excellent loan yields. As bank CEOs look over their landscape, which includes a lot of poorly performing real estate loans or low-yielding investment grade borrowers, they increasingly say: “Give me more of that ABL stuff.” It appears that banks’ senior managers are realizing what those of us in the asset-based lending business have known for decades, that a well managed ABL portfolio will exhibit very low loan losses though all credit cycles, even with companies that become distressed. With many of the major banks pushing their ABL groups to grow their portfolio in 2011, there is virtually no limit to the amount of capital they can invest in asset-based loans.
On the demand side, corporate America is still paranoid about taking on too much leverage. No company wants to experience a repeat of the fall 2008 credit freeze that nearly brought down all of the major financial institutions in the country when credit dried up even for investment grade companies. Borrowers continue to be very cautious and, as a result, Corporate America is still fairly liquid and generally credit averse. Cash balances remain high. For middle-market borrowers, average utilization of revolvers held by asset-based lenders is approximately 35%, well below the historical levels, and contrary to cyclical growth usually expected during an economic recovery.
Another major factor limiting demand is the impact of the high-yield market over the past two years. Recently, the one boom area in finance has been the high-yield market, which hit record levels in 2009 ($146.5 billion) and 2010 ($259.3 billion), and is on a pace in 2011 to exceed $300 billion. Unfortunately for the senior loan market, these high-yield loans are typically accompanied by an unfunded revolver, paying off funded loans previously held by asset-based lenders, banks, CLOs and other institutions, causing even more liquidity in the loan market. Finally, the level of sponsor-driven deals has dropped off in the first quarter of 2011 from the frothy fourth quarter of 2010, causing a further drop in loan demand (See Figure 2: Quarterly LBO Activity). With existing companies borrowing less during this recovery, sponsor activity soft and traditional senior secured loans being repaid with high-yield offerings, there is modest demand for senior loans.
What’s a Lender to do?
Senior lenders in the asset-based and leveraged loan market face a conundrum today, namely how to grow a portfolio in the face of a supply/demand imbalance in the debt capital markets. Even in an expanding economy, it is not possible for all lenders to set growth targets that exceed market growth and be happy with the outcome. Something has got to give. For any given level of new business volume, the two remaining competitive levers are price and structure. What’s a lender to do?
The answer may lie in looking for loan opportunities in underserved areas of lending where traditional lenders may have backed away, either because of industry concerns, collateral, structural, regulatory or political considerations. This may not always work for the regulated lenders that feel an increasing pressure to pursue loans that will not be criticized, but it’s something independent commercial finance companies are actively pursuing.
These strategies can be broadly grouped into three categories: targeting companies that are experiencing a turnaround; targeting companies that have out-of-favor asset classes; or, providing loans structured on a FILO or junior secured basis. Sometimes a loan may encompass all three.
Many companies have seen a recovery in 2010 after the disastrous economic results experienced in 2009, yet may still be in the workout group of their lender. We have all heard about lender fatigue and how with some borrowers there develops an institutional bias that continues even after the company is well on its way to recovery. Additionally, some borrowers may have additional high-yield or subordinated bonds that cannot continue to be serviced, requiring a balance sheet restructuring, either in or out of bankruptcy court. Asset based lenders are well suited to address this market and there is a long list of companies that have benefited over the years from the flexibility of an asset-based loan structure. A good example of this type of deal is Loehmann’s Holdings, Inc., a specialty retailer highlighted in the accompanying case study.
Case Study: A Safety Line to a Retailer
In fall 2010, Loehmann’s Holdings, Inc. was facing numerous obstacles including tight liquidity and an interest payment on the company’s bond indenture coming due in November 2010. A number of underperforming stores were targeted to be closed. Loehmann’s needed time and additional liquidity in order to negotiate with bondholders and restructure its balance sheet.
In September 2010, Crystal Financial agented a $35 million revolver for Loehmann’s, providing the company some incremental liquidity and time to attempt to restructure its bonds out of bankruptcy. With the majority, but not all of the bondholders in agreement, Loehmann’s filed bankruptcy in November 2010, with Crystal providing the DIP loan along with a commitment to fund the emergence financing under the company’s proposed plan of reorganization.
Existing equity and a bondholder stepped up with additional capital commitments to support Loehmann’s and the company successfully emerged from bankruptcy in March 2011, preserving more than 1,000 jobs and giving Loehmann’s a fresh start to execute its business plan. Originally rejected by other lenders because of their concerns with liquidity, and the possibility of a bankruptcy filing, our firm was able to provide a fully secured revolving loan to support the company’s transition through Chapter 11.
Another area to differentiate as a lender is by providing more debt capital than would otherwise be available from the senior loan market in general. This can be done by providing a unitranche loan structure, representing a stretch beyond the assets, or by providing a junior debt tranche as part of a larger asset-based facility. For companies that have experienced a cyclical downturn in operating results, it is common for many senior lenders to be unable or unwilling to provide enough borrowing capacity to take out the existing lender and still provide enough liquidity for ongoing working capital purposes. In many of these situations, the senior lender will seek a junior debt provider to complement and expand its overall credit facility. A recent example of this type of structure is illustrated in the following case study on Annette Holdings.
Case Study: A FILO Loan to a Trucking Firm
Annette Holdings, Inc. (d/b/a TMC Transportation), an independent flat bed trucking firm in the U.S. As with all transportation and logistics firms in 2009, TMC saw a significant decrease in its revenues as its customers’ activity declined. The management team moved aggressively to cut back on overhead, reduce costs and rationalize operations. The recovery in the economy also helped the company to grow revenues and EBITDA. When TMC began searching for a new lender in 2010, it discovered the senior asset-based lenders could provide some, but not all, of the needed financing.
Our firm was referred by a consultant working with the company. Given the historical collection of receivables and the company’s strong customer base, Crystal was able to increase the advance rate on billed receivables and provide an advance on unbilled receivables. Working with a new senior lender, Crystal provided a $12 million first-in, last-out loan as part of a new revolving loan, in addition to a new term loan secured by the company’s real estate holdings. This enabled the company to take out the existing lender and provide enough liquidity to fund working capital needs.
There are certain asset classes that asset-based lenders historically have avoided, including lending on intangible assets such as customer lists, brand names, royalty streams, etc. One area of lending that has been constrained over the past few years is lending to specialty finance companies. Some lenders, like Textron Financial, have exited the business while others have tightened their credit criteria for such loans. Consumer finance companies have seen a significant reduction in the availability of credit from the debt capital markets, asset-backed securities market and traditional lenders. At the same time, these consumer finance companies are experiencing growing demand from their customer base. This presents an opportunity for lenders willing to underwrite loans to well-managed finance companies. An example of this is a recently funded loan to Wheels Financial Group.
Case Study: Senior Revolver to a Wheels Financial Group, Inc. (d/b/a 1-800-LoanMart)
The credit meltdown of 2008-2009 resulted in banks and their regulators taking a fresh look at the types of asset classes that would be acceptable. The Consumer Protection Act has had the effect of reducing the availability of credit to the subprime market. This is evidenced by a significant pullback in lending to subprime consumers via credit cards, overdraft lines, etc., resulting in these consumers increasingly turning to independent consumer finance companies.
This is the environment that Wheels Financial Group found itself in during 2010. On the one hand, Wheels was experiencing record loan growth resulting in a need for more debt capital to support its growth. On the other hand, it became evident to management that the number of lenders lending to specialty finance companies has been curtailed over the past two years. Given the company’s strong management team and profitable track record, we were able to structure and agent a new $45 million revolver to Wheels secured by the company’s consumer receivables pool, repaying the prior $30 million facility and providing additional capacity for growth.
Through expanding economies and recessionary periods, asset based lenders have continued to provide middle-market borrowers with a flexible loan structure that can accommodate growth in the good times and be more patient during the downturns. Now faced with an improving economy and a loan market awash in liquidity, lenders have to work hard to grow their portfolios. They may also have to be a bit more creative in evaluating credit, collateral and structure to achieve their growth targets, while maintaining overall credit quality, in this highly competitive market.
Colin Cross is a senior managing director and operations manager at Crystal Financial. He joined the company in 1998. He previously was the co-founder of Crystal Capital, and before that Heller Investments Inc. He also held positions at Back Bay Capital Funding, Heller Financial and BankBoston. He was the president (2006) and chairman (2007) of the International Turnaround Management Association. He graduated with a B.A. in Economics from Bowdoin College, and earned an M.B.A. from Southern Methodist University.