Out of the Penalty Box — But How Long Until the Ice Melts?
Once again, ABF Journal checks in with five ABL industry executives to find out their take on the state of things. This year, the consensus is quite clear: In an effort to book loans to their institutions’ balance sheets, asset-based lenders have skated back into play … and fiercely at that. But just how willing are borrowers to engage to keep structures sound and price rational levels?
Sam Philbrick, President, U.S. Bank Asset-Based Finance
Bill Kosis, President & CEO, PNC Business Credit
Scott Diehl, President, Corporate Finance Group, Wells Fargo Capital Finance
Perry Vavoules, President, Capital One Leverage Finance
Rich Pohle, Division Manager, KeyBank ABL
Like a roughed-up right-winger who’s done his time, asset-based lending has burst from the penalty box and skated back into play. If not the most glamorous of commercial finance players, ABL has certainly been one of the most talented and consistent — and now comes recognition. “With its simplicity of product, lack of covenants and greater flexibility, ABL can be the right capital solution,” says Sam Philbrick, president of U.S. Bank Asset-Based Finance in Boston, MA. “People are for the first time embracing it as the right loan.”
Indeed so: first-quarter 2011 posted a strong finish across the sector, with merger and acquisition activity coming off the bench when several large, good-quality deals came to market. “But the vast majority of volume is still amend and extend,” says Philbrick. “Companies are coming back, repricing and taking advantage of the borrower-friendly market conditions.” Even so, such transactions allow ABLs to reposition themselves in a credit relationship and potentially play a more meaningful role. Thus, Philbrick says he is hopeful that second-quarter results also will be healthy.
Bill Kosis, president and CEO of PNC Business Credit in Pittsburgh, shares that sentiment. “We’ve been very busy in 2011, and the quality of portfolios and customers has been better than for the last couple of years,” says Kosis. “We’re starting to see some more attractive deals, so I’m optimistic.”
“The market is still pretty good,” agrees Scott Diehl, president of the Corporate Finance Group of Wells Fargo Capital Finance headquartered in Santa Monica. “We’re addressing it in a couple of definable segments, while also looking for underserved segments. I think we’ll see ebbs and flows throughout the year, but there’s still a fair amount of activity with new deals or amendments and extensions.”
Lenders may be wise to celebrate those deals now, because leaders at several ABLs say they’re already seeing price drops in some transactions. “We’ve definitely seen pricing decrease and it happened fairly rapidly,” says Kosis. “We’re certainly not anywhere near where we were before the recession, but we’re starting to see structures weaken a bit.”
Perry Vavoules, president of Capital One Leverage Finance based in Melville, NY watched pricing decline during the first quarter, “and the general consensus was that it was at a good level,” he says. “In the last few weeks, though, we’ve seen it notch down even more,” he adds, “and that is troubling.”
The current market is “definitely a buyer’s market, and the supply of capital is clearly outstripping loan demand,” Vavoules says. “Evidence is reflected in the desire of many lenders to underwrite larger deals and take bigger hold positions,” he continues. “Money on the ABL side is largely coming from banks, and depending on deal size and credit quality, they’re being very aggressive.”
Rich Pohle, division manager of KeyBank ABL, in Cleveland, has observed growing aggression for the last six months. “Banks are focusing more on assets than on credit issues,” says Pohle. “They’re looking for earning assets, and because of the utilization ABL deals usually have, they’re attractive.”
Pohle sees large, syndicated deals leading the market. But he’s also seeing middle-market deals, which typically are one- or two-bank deals, become highly competitive. “The banks get all the ancillary [business] and can price the loan cheaper,” he says.
How long this trend will last and how low prices will go is anyone’s guess. LIBOR+200 is usually the bottom, Pohle says, although some deals may go as low as the high 100s. “As long as banks have good credit quality and their focus remains on earnings growth, revenue growth and balance sheet growth, pricing will continue to move down,” he says. “It’s just a question of how quickly it happens.”
He may be right. But who are the borrowers benefiting from this rush to market? Roundtable participants agreed that, excluding firms involved in housing or construction, companies across the spectrum of the commercial and industrial space are seeing improved demand for their goods and services. As a result, they need the amends and extends Philbrick mentions to provide capital that will support the build-up of inventory and greater revenues. “If you look at the period before the recession, people were investing in anticipation of business,” says Philbrick. “Now they’re investing in response to new business.”
Thus for now, caution among borrowers remains the rule. As Pohle observes, “There’s still not a lot of positive news that gives business owners the green light to add another plant, or more manufacturing capacity or new people.”
This is understandable, since most businesses that survived the recession trimmed every ounce of fat to do so. Pohle believes it will take more than a little coaxing to get them to change their ways. “We just haven’t seen the bump in revenue to get them out of that,” he says. Vavoules agrees. “Most companies are still cautious about embarking on new spending projects,” he says. “We’re just hoping to see more upside in our utilization rates as the year goes on.”
Diehl thinks that will happen. “Corporate America still has a significant amount of cash,” he says. “But ultimately, with the availability of credit lines or cash on the balance sheet, and with the need to drive stock price or increase value, companies will eventually need to determine when will be a good time to utilize those resources. Ultimately they’ll need to believe that the consumer is there for the longer term, so at some point, businesses will invest. It’s just a matter of when they feel they’ve taken enough of the risk out.”
In such a scenario, M&A activity would likely increase, driving more business to the ABL space. A percentage of deals would be covered by the cash-flow market, but Diehl suspects many others would be drawn to the advantages of asset-based financing. “It’s not unreasonable to think this will start to happen before the end of the year,” he says. “There will be a collision of confidence and opportunity — and an overarching need to increase value.”
But even if Diehl is right and U.S. businesses again take to the rink for expansion, increasing the need for ABL, there’s no guarantee lenders in the ABL space will “play fair” by behaving responsibly. “I think we’re all faced with the same set of business facts with lending capacity exceeding current demand,” says U.S. Bank’s Philbrick. “To grow faster than the market, participants are pushing on price and structure.” Philbrick doesn’t see a lot of new market entrants causing pricing deterioration; he thinks: “It’s everyone trying to be competitive.”
Vavoules thinks similarly. He sees traditional ABL players competing for hard to win customers that will bring a steady flow of business in the long run. “The key to success going forward,” he says, “is to maintain an appropriate balance between risk taking and getting paid for it. Among bank lenders, we’re all trying to generate ancillary product revenues loan activities and take a larger share of the customer’s wallet. It’s becoming a more important consideration than in the past.”
Vavoules knows whereof he speaks. But Pohle doesn’t see this or any other trend as a new normal. “The norms don’t last long enough to be norms,” he says. “You have pockets of markets, but they’re constantly evolving. Today, it’s about people reacting to the economy, about their own institutional requirements for credit or growth. And now it’s really growth driven.”
Diehl is also skeptical that lenders will remember “recession lessons” as they go forward. “Ideally, you hope the industry does a good job of articulating to those borrowers that qualify for credit that transcends a traditional borrowing base, based on their ability to repay,” says Diehl. “But in a competitive frenzy, you’re stretching, and that has historically created more stress in the lending environment.” Diehl doesn’t buy into the concept that rationality will prevail; he thinks now it’s just a question of far things will go.
He also sees more players that are viewing ABL as an attractive lending segment and are looking for a way in, including Regional and Foreign banks. “If you look back to the credit crunch of mid-2007, and were handicapping ABL distribution capacity, you’d be taxing your brain to get $500 million,” he says. “Those days are gone. Today there’s more capacity for bigger deals, which has prompted borrowers to have confidence to pursue less costly arranged deals in lieu of underwritten financings that had created a higher fee environment. More regional players are competing to win business, becoming a game of survival on the front end by writing the most new business.”
Yet, what could distinguish post-recession asset-based lending from pre-recession lending is discipline, shown by a handful of influential lenders. According to PNC’s Kosis: “We’re in the field every day and things change constantly. Good management and sound structures let us get paid back and do all right. But if we deal with inexperienced management or loosen structures beyond the norm, we might not get paid, and we know that.” What’s more, Kosis says, PNC Business Credit will resist any onslaught of cash-flow loans. “If the market gets flooded with these,” he says, “we’ll have to remain disciplined, which in many cases means we’ll have to pass.”
The crystal ball is still dense with fog for 2012, but there is one condition on which every Roundtable participant agrees: Sharp changes in commodity prices could skew the game for everyone. “Inflated prices in oils, metals, resins and food products — all of which some of our customers have in their borrowing bases — have increased those customers’ business, so we’re lending more against them, and this has increased our portfolio,” says Kosis. “If there’s a sharp decline in commodity prices, this could create a large market disruption. We have to watch this carefully.”
Pohle concurs, noting that many KeyBank ABL borrowers have close connections to steel prices. “We have to be aware of commodity prices in general, and also understand the sensitivities that accompany them regarding liquidity and borrowing,” he says.
Regarding commodity pricing, Capital One’s Vavoules believes oil prices will have the biggest effect going forward. But he also thinks economic recovery could stall due to an unforeseen event, as previous capital market disruptions were caused by unexpected events like the Asian debt crisis or bursting of the technology bubble. “That’s why you need to maintain consistency throughout the cycles,” he says. “You never know when the next downturn will occur.”
Philbrick subscribes to that philosophy and adds: “With the trends in pricing, we’re going to have to learn how to profitably manage our businesses with a lot less yield than we did in 2010 and the first part of this year.” He believes credit costs can be lowered by understanding and managing risk better. He’s also certain that aggressive use of technology can boost backroom operations and enhance customer support. “We have to make sure we can manage the risk we take, meet customer needs, and do it as efficiently as possible,” he says.
Philbrick sees three main influences on future ABL profitability and activity: the level of credit-line utilization; the disposition of capital markets, particularly the high-yield market; and the alignment of buyers and sellers that leads to M&A activity. “If those three things line up, it could be a better run than even I anticipate,” he says.
Yet, with all possibilities considered, two questions remain to be answered: why is the situation in asset-based finance so different from other sectors of the industry, and why is it developing so fast? Kosis has these thoughts: “I think the large asset-based lenders are in a box, structure wise. And the one-off deals, which we do a lot of in the under $50 million market, are being pursued by corporate banks, other banks and firms coming into the market that may be more open to a deal we probably wouldn’t do.”
“I think there’s a lot more volatility in life in general,” says Philbrick. “The pace of change in many aspects of our business has increased dramatically.” But he adds this about leading ABLs: “We want to be positioned as banking the best companies that use ABF in their capital structure. This should mean we’ll deal with stronger-rated credits, which lead to lower credit costs than most others have in the market place. So you stay focused, you do as much business with these companies as you can, and over the long term, that’s how you win.”
Such knowledge and experience on both sides of the rink may also contribute to the current quickening. “Companies have seen the cycles before, and those who’ve done well have learned how to scale their businesses quickly and manage their inventory well,” says Diehl. “As lenders, we need to make tough decisions about when it’s over-heating, when to stop chasing structure, and when we’ve gone too far. That will be the challenge for all of us as we build up our books.”
Holed up in chilly Chicago, Susan Hodges stays warm writing about asset-based lending, equipment leasing and other hot business topics. She is an associate of Susan Carol Associates Public Relations.