One of the basic concepts of economics is the role of supply and demand, and it’s no secret that the supply of money in the U.S. economy has been plentiful. Because supply determines pricing, today’s lenders work hard to find opportunities that reap rewards. While money rules the day, our roundtable participants agree that perseverance, caution and creativity are the best ways to succeed.
ABF Journal invited five industry executives to share their perspectives on today’s ABL environment. They talk about supply and demand, competition and opportunity, merger and acquisitions and various economic factors that define the marketplace.
John Goldthorpe, head of Chase Business Credit and Equipment Finance, began with a general overview of the situation. “There continues to be an imbalance in favor of borrowers, and several factors contribute to that. Large financial institutions, which include regional banks, have strengthened their capital bases and want to deploy that capital. In addition, there are a lot of private funds that have access to capital through CLOs or bank line leverage. We also have new entrants that continue to emerge in the market because they see ABL as a safe asset class.”
“There is a strong demand from ABL lenders for funded assets, and market pricing and structuring reflect the modest supply of new opportunities,” continues John Todd, regional portfolio head of Bank of America Business Capital. “For us, the number of new deals booked is up year over year, but the dollar size per deal is smaller. Spreads on average are a bit lower.”
“When you look at the size of the transactions in the overall market, deals in excess of $500 million make up just 20% of the deals in the first half,” says Joe Nemia, head of Asset Based Lending at TD Bank. “Last year, deals of that size were up about 12%. As a significant market lender, we see most of the transactions done within our segment. The market activity and the forward-looking pipeline are flat, or down a bit, compared to a year ago.”
“I don’t foresee the supply side changing significantly over the coming year,” says Sam Philbrick, president of U.S. Bank Asset Based Finance. “On the demand side, it is all about the level of economic activity. I don’t think anyone is predicting more than ‘slow and steady’ at best. Also, by historical standards, we have to be getting into at least ‘the late afternoon’ of this expansion.”
“The supply of money is definitely exceeding the demand, and that will continue to drive spreads down and cause structural issues,” says Michael Sharkey, president of MB Business Capital. “As a result, credit has gotten looser, and pricing has gotten worse. That forces you to employ all your asset-based lending skills to walk a fine line as prudently as you can.”
Elements of Change
Though refinancing has fueled asset-based volume during the past few years, a pick-up in M&A brought hope for more new money deals. In a borrower-friendly environment with low interest rates, could the market be ripe for opportunities?
Todd agrees it is a good environment for lenders with broad product offerings and flexible structures. “The current market is changing quickly, and the big asset-based lenders such as Bank of America, Wells Fargo, JPMorgan and others have the capital base that affords us more opportunity to offer a broad array of products and innovate in terms of pricing and structure to gain desired growth.”
Nemia points out that refinancing continues to drive a large portion of market activity, because pricing, facility tenors and structures are favorable. Philbrick adds that ABL market participants continue to take larger holds as a way for lenders to counter the continued reduction in pricing and weak issuance. “Not too long ago a $100 million to $150 million financing was clubbed up with two or three banks, but now it is a sole lender execution for the large players in our market.”
“The M&A business is hurting us, because it’s very difficult to get a traditional ABL deal done on the buyout side,” states Sharkey. “It used to be that you couldn’t find a cash flow deal for a company with EBITDA under $10 million. Today we see cash flow deals done on companies with $3 million. It’s startling how much liquidity there is in the buyout market. Our customers look at the multiples today and think about selling their business. When they are sold, they are sold in a fashion that does not include ABL.”
“The 2015 M&A activity is not as robust as prior years in both number of transactions and size; however, the activity seen is in large corporate and retail transactions where TD ABL is an active lender,” Nemia says.
Goldthorpe agrees. “Certain industries are going through some level of consolidation, and that’s exciting, but equity sponsor-driven M&A feels less vibrant than we’ve seen in the past. A good example of consolidation, which we have played an active role in financing, has been in the retail and consumer space that comprises more than 30% of the ABL market.”
“In the first half of 2015, 82% of ABL volume was refinancing and 18% was new money of some sort,” says Todd. “New money for all of 2014 was 26%, so that has dropped since last year. We are actively engaged in the M&A market, but that cuts both ways. We lose a certain amount of clients that are bought by companies that have no need for asset-based financing. However, client payouts attributable to being sold are down about 15% from the prior year, which indicates some M&A softness in this asset class.”
“From year to year, we screen a fairly constant number of M&A deals, but the percentage that we are able to win is falling,” says Sharkey. “In a way, our market is being defined for us. We are squeezed by the alternative BDCs and the hedge funds as well as by the commercial banks. I have seen very aggressive banks do cash flow multiple deals with very long terms on the loans. As a result, the asset-based lenders are squeezed into more distressed situations and story credits. We can handle those, but you have to remember that today’s turnaround situations and story credits are not the result of broad, sweeping problems with our economy. The economy is fine, so the story credits are more likely due to bad management, and you have to be careful. It’s not like it was in 2009 when everyone was doing poorly; today’s story credits are real stories.”
“There continues to be a fair amount of M&A activity, but not necessarily in those sectors that tend to be financed with the ABL credit product,” says Philbrick. “In addition, we have seen several existing ABL borrowers purchased by investment grade companies. When this occurs, the M&A activity actually reduces the level of ABL activity.”
“There has been a decided tilt away from private equity buyers in the direction of strategic buyers,” continues Todd. “Valuations are high for public companies and successful niche private companies. For those targets it is difficult for private equity firms to achieve expected returns if they are paying high prices up front. The current environment favors strategic buyers, particularly those who are investment grade, because they can borrow on more favorable terms and in many cases issue stock to the target’s shareholders. The result in the ABL business is that large-sized private equity acquisitions have been relatively quiet, yet mid-size and small deals continue to move forward.”
Lost in the Froth
In a market that has been described as frothy, cash flow loans continue to be an aggressive alternative to the ABL product. “It really comes down to which credit product will provide the greatest debt capacity for the client,” says Philbrick. “With corporate earnings stable or improving, and with the cash flow leverage multiples approaching all-time highs, the cash flow product offers an attractive option for borrowers.”
“For the first half of last year, the cash flow leverage loan issuance covenant-type deals made up about $250 billion in volume,” says Nemia. “That number this year was down to $117 billion. Equity contributions on larger deals increased to 40% from 35% last year, and the middle market deals went from 42% to 47%. These statistics tell you the cash flow market is not as frothy as it was a year ago. There is more equity going into deals, deals are not as leveraged, and the structures are tighter given that there are less covenant-lite transactions in the market.”
“The word I would use to describe this market is ‘accommodating,’” says Goldthorpe. “We find that we are often competing against a cash flow type loan when we feel the right solution is ABL. The challenge becomes the need to prove two things to our clients and prospects. First, we need to show them how flexible our form of finance can truly be. Second, we need to demonstrate how we can compete with creative use of the ‘ABL alphabet’ that includes SOFAs, FILOs, Term Loan A, Term Loan B and others.” (SOFAs are seasonal over formula advances through which a retailer may receive an additional advance rate to build inventory ahead of the holiday season, for example.)
“Bank of America Merrill Lynch competes in both cash flow and ABL markets and often provides side-by-side proposals,” says Todd. “Clients are appreciative of the dual pitch, but we have not seen a shift in decisioning one product over the other. Our net transfer profile is nearly flat on that account, although some aspects of the leveraged obligor guidance do favor asset-based structures going forward.”
“With regulators focused on overall leverage multiples, it seems that some of the market’s frothiness has moved away from the banking sector to the direct lending alternative asset managers where they don’t have the same regulatory oversight,” says Philbrick. “I believe this is especially true in the middle market segment.”
Sharkey and his team do an exercise where they look at deals from the beginning of the year that are still around at the end of the year. “We look at their aggregate loan balance from January to December to determine if they are borrowing more or less. We want to know if they are succeeding, if their balance sheet is growing, if they are adding capacity or doing buyouts. In 2013, for example, those balances were basically the same: zero growth.
“We did the same exercise in 2014 and saw that aggregate loan balances grew by 2%. That means we only got 2% growth out of our portfolio in 2014 — that’s not acceptable if we are going to meet our growth target. Organic growth in our portfolio is relatively absent and that tells me there is a lack of confidence in the market.”
So what about a recent report, based on Thompson Reuters LPC data, that characterized the first six months’ issuance as the “weakest first half in five years”? Is the economy stumbling?
“We have not experienced weakness in the market,” says Todd. “For Bank of America Business Capital, the number of new deals booked is up year over year, though the dollar size per deal is smaller; but overall we have had good portfolio growth thus far in 2015.”
“The market for new opportunities was certainly muted in the first half,” reveals Philbrick. “Not surprisingly, pressures on pricing continued as lenders tried to enhance demand by redoing deals with lower pricing. In addition, market participants continued to increase hold levels to make up for the lack of issuance and the lower revenue due to the re-pricing activity.”
“If you look two or three years back, you can see that 2014 is an outlier, versus both 2012 and 2013,” says Sharkey. “Comparatively, deal activity is down year over year, but if you exclude 2014, we are consistent with the two years prior.”
“The first half was generally healthy and felt about the same as last year, but recently business activity has accelerated rapidly,” says Goldthorpe. “This performance encompasses just about every element of our business from middle market to large corporate, including refinancing of existing deals as well as the conversion of new prospects.”
“The fact of the matter is that we closed more business with larger deals in the first half of this year than we closed in the first half of last year,” says Sharkey. “Though we had some nice growth in our portfolio this year, we have been fighting the run-off from companies selling out. More often than not I would say it is strategic buyers rather than private equity groups that are buying those companies. The strategic buyers will pay the highest multiples, because they look for synergies. They usually don’t need financing at all, and they certainly don’t need an ABL lender.”
Consider the Alternatives
Alternative lenders increasingly show up on the playing field, particularly where traditional banks may be hampered by stricter capital requirements and leverage lending guidelines. Do our panelists feel the heat?
“The alternative lenders are filling a need on these buyouts with their aggressive loan structures,” says Sharkey. “The bank isn’t willing — and shouldn’t be willing — to match those structures. I don’t think the problem is caused by regulation or capital requirements. It’s just that these alternative lenders have a high cost of capital, and they have to get a high return. To do that, they take risks that no one else is willing to take.”
“They are yield-hungry and looking for funded term loans,” adds Nemia. “Most of the ABL deals are working capital financing with revolvers that fluctuate, and the yield on those transactions is usually not sufficient enough for an alternative lender to participate in.”
“A few notable alternative lender platforms have entered into the ABL business, typically by buying smaller shops,” says Philbrick. “These lenders are focused on the small end of the ABL market, where they can get the yield to support their higher funding costs. With those yield requirements, I do not see the alternative asset managers in the segment of the ABL market where we are primarily competing. The question is where can they find sufficient yield in the ABL market to make it attractive to their investors? I think that chapter hasn’t played out yet.”
“Capital requirements have not had a significant impact on the ABL market,” says Todd. “However, the leveraged lending requirements have changed the way U.S. banks underwrite ABL facilities in conjunction with arranging term loans and/or high yield bond offerings through their investment banking teams. As a result, some foreign and non-regulated investment banks have seen more activity.”
“There are always times in the cycle when alternative lenders emerge, but there aren’t many that can truly compete with us doing senior secured ABL debt,” says Goldthorpe. “It takes a lot of commitment to establish an ABL back office, agency capabilities, field examiners and more. There are some second lien funds that are providing competitive capital solutions through unitranche transactions, but an ABL provider usually ends up financing the first-out component, anyway. Overall I welcome these players. They are very good partners and can cover parts of the capital structure where the risk return equation happens to work better for them than it does for us.”
The Institute for Supply Management reported manufacturing orders at the lowest level since May 2013. Is this a sign of economic change? Perhaps it is not yet time to raise interest rates.
“We believe the economy is doing pretty well, except for softness in certain commodity-priced industries such as steel and energy,” says Todd. “In general, clients have managed their working capital and decreased borrowings in line with commodity price reductions. We predict that interest rates will go up over the next five quarters, but I don’t believe that increase will hurt our business or cause people to stop borrowing.”
“The consensus seems to be the U.S. economy will continue to expand at a modest pace over the coming year,” says Philbrick. “Overlaying this view, however, is concern about the slowing global economy and its potential impact. Economies and companies are now interconnected around the globe in a way that they were not 20 years ago. We know there are outside influences that affect the U.S. economy, but we don’t necessarily know to what degree or in what direction. A prime example is the global softness in many commodity-based markets that seems to be driven to a significant degree by the slowing growth in China.”
“My view on the economy is pretty simple,” states Goldthorpe. “We have steady GDP and job growth, and the vast majority of companies I see have a good amount of cash on the balance sheet. I think the economy is fine and believe the Fed will and should raise interest rates now. It is more overdue than it is timely.”
“A rise in rates would be very helpful, but I don’t see a dramatic increase coming until after the 2016 elections,” says Sharkey. “There will probably be small increases. The economy is nervous, and there is very little rate growth because of the uncertainty.”
“Whether or not the Fed raises interest rates is not going to be significant enough to have an impact on the lending side of our business,” says Nemia. “Borrowers aren’t rushing to do loans because they think interest rates are going up, and borrowers are not going to stop doing loans just because the rates do go up. If interest rates rise and we see an economy that is starting to grow, our customers tend to react by expanding inventory. That’s positive growth on the portfolio side.”
We asked our panel to comment on their business performance as well as where they are finding success. “Our new business activity certainly has reflected the level of economic activity and the overall ABL market,” says Philbrick. “We have seen the most growth with middle market customers, especially where our bank enjoys a strong market position. Utilization remains stable, again reflecting the level of growth in the overall economy.”
“We have seen a nice increase in our portfolio, and we’ve had good profitability every year since we started the business,” says Sharkey. “There has been growth in building products and health and wellness, and the e-tail industry has been interesting for our retail finance team. It’s similar to the financing we used to do for catalog companies. The e-tailers basically have a retail inventory loan without the retail bricks and mortar.”
“Our volume of transactions is up, and we have seen positive growth in mid-sized deals that fall into the $30 million to $100 million range,” says Todd. “The recent decline in commodity prices has softened utilizations under the lines. From a credit perspective, clients are diligently managing working capital levels.”
“One of our main growth areas is the international market,” adds Goldthorpe. “Europe, in particular, is coming into its own; our international client base is growing quite rapidly. We have also spent time thinking about and making our ABL product easier, more seamless and cost-effective for our clients and prospects, and that is starting to pay off. We are looking for opportunities to help some of the cyclical industries, too, such as metals and energy. Instead of using ABL as corporate finance where we help a company pay a dividend or acquire another company, we would use ABL more as a commercial finance tool to help that company through the down cycle.”
“TD ABL established a retail vertical in 2014,” says Nemia. “Our go-to-market strategy is to develop direct relationships with retailers that are typical TD Bank customers. We leverage our calling efforts by collaborating with our banking partners to strengthen our relationships with these customers and prospects and grow our potential share of wallet. We booked some marquee names over the last 12 to 18 months, including Hudson Bay Company (owner of Saks and Lord & Taylor), Brooks Brothers, Barney’s New York, American Eagle and Restoration Hardware. Earlier this year, we did a large commitment for Albertsons’ acquisition of Safeway. We won senior managing agent roles on a number of transactions and continue to play a significant role in the larger transactions.”
The Year Ahead
Todd thinks growth will continue to be steady and sees no reason why the ABL market will not increase at, or be slightly better, than the rate of GDP growth. Goldthorpe expects loan growth in the high teens and forecasts a similar level of activity for 2016.
“If liquidity in the market stays at the current high levels, and the economy remains stable with low growth, it’s going to be a battle to increase the portfolio,” says Sharkey. “Margins will continue to be under stress, and we will keep trading deals with each other. We are probably going to rely on growing our average loan size to meet our projections.”
Philbrick doesn’t believe market conditions will change significantly for 2016. “The key will be to optimize your business performance in the current environment without counting on conditions improving. There is no silver bullet. You have to do the best job you possibly can, retain your clients and run your business as efficiently as possible while delivering for your customers.”
“My primary concern for 2016 is to expand our presence in the market by focusing on areas of expertise that we can leverage similarly to what we have done with our retail effort,” says Nemia.
“Looking at the current market, my biggest concern is to ensure that our industry accurately reflects its cost of capital through pricing,” says Goldthorpe. “This will be a challenge, given the competitive nature of the market that is showing up in spread compression and given the capital levels required by various regulatory authorities.”
A major concern to Todd is the ability to attract young, diverse people to asset-based lending. “Right now, experienced but aging lenders dominate most ABL shops. There is a significant retirement cliff coming up, so we work hard to bring new people into the sector much more than we ever did before.”
On the bright side, Sharkey says the only good part about this economic environment is the lack of non-accruals and charge-offs. “When we do have a problem loan, there is no shortage of lenders to buy me out of my problem!”
Nemia agrees. “Rather than focus on the negatives, we should realize and appreciate how our portfolio is affected by our borrowers’ performance over the last 12 to 24 months. That performance has been terrific, and credit quality has improved across the ABL sector.”
“The new year will require flawless execution on the opportunities that are there while being smart about the risks we take,” says Philbrick. “That’s how you maintain forward momentum in a very challenging market.”