The lending landscape in which traditional lenders operate has changed since the recession and is most notable with the establishment of the “Interagency Guidance on Leveraged Lending,” which was drafted by the Board of Governors of the Federal Reserve, Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency. Since its establishment, and subsequent interpretations and clarifications, it is beginning to have a meaningful impact on traditional senior bank lenders. Many senior banks have seen their flexibility in providing creative financing solutions diminish, and in many cases the impact to borrowers can be material. In light of these new challenges, the role of the non traditional or alternative lender is becoming more important, as they can offer comprehensive solutions in partnership with senior bank lenders in this ever-changing marketplace.
The banking industry is still adjusting to these postrecession regulatory guidelines and changes to leveraged lending thresholds. Many of the nation’s largest banks will see their loan portfolios affected, leaving senior lenders to reexamine many loans as they mature. This has led to non replicable capital structures and the need to reduce overall leverage levels. According to the Federal Reserve, approximately $800 billion of institutional loans are now outstanding and will eventually mature and need to be refinanced under the new regulatory guidelines.
Further complicating matters is the fact that we are once again entering the later stages of another credit cycle, which will compound challenges for certain existing borrowers and lenders. The recent years of abnormally low interest rates, which led to a glut of capital chasing yield, should give way to a significant need for restructurings and financial flexibility as rates begin to rise and volatility increases.
We have already started to see macro-economic factors begin to erode. Specific sectors, such as energy, metals and mining, and retail are experiencing stress, which is creating a challenging environment for borrowers in these sectors. Disappointing growth from China and the attendant contraction of demand for major commodities is disrupting the broader commodities markets and companies that operate in this sector. Energy markets were already reeling from last year’s production decisions by OPEC, while the U.S. shale industry is experiencing production rates that justify many participants’ decisions to continue drilling even at such depressed prices. However, hedging contracts for their offtake with locked in prices will begin to expire and producers will be forced to sell at a much lower current spot price. As yet another example, a number of recent specialty retail closures during the past two years provide a strong indication of the prevailing environment in which lackluster performers are falling by the wayside.
For these collective reasons, it’s a very different market today than it was five years ago. At a time when flexibility is becoming crucial, senior lenders are being constrained by the myriad of regulations that have impacted the industry. The result to the borrower is a financing gap.
This gap can be filled in one of two ways — with additional equity financing (which is expensive and restrictive) or through alternative lending companies.
Necessity is the Mother of Invention
Alternative debt financing solutions can help address these challenges by solving the financing gap and turning to collateral coverage when business performance is lacking. Unlike most traditional financing options, alternative debt financing solutions rely on the value of the underlying assets. Doing so allows the alternative lender to be agnostic to the short term financial performance of a given business. At the same time, by exclusively relying on a company’s collateral, the capital structure can be stretched beyond what a senior bank may provide, while doing so at a much cheaper cost than equity.
Understanding the source of an alternative lending company’s capital is also critical. Those lending companies with patient, private capital can be more supportive and understanding partners to their borrowers. This is particularly crucial when an industry is undergoing cyclical change or secular pressure.
For those borrowers for which the alternative ABL financing product makes sense, it can and usually is less expensive in the long run. This is because it entails fewer financial covenants, which may lead to fewer restructurings and associated fees and expenses to the borrower than other financing alternatives.
A Case in Point
A recent Gordon Brothers Finance Company transaction with a specialty gift retailer provides an example of the financing gap situation. The company experienced extreme seasonality, requiring debt financing to fund the company’s uneven cash flow between its peak performing periods. The senior lender was lending at conservative advance rates against the accounts receivable, inventory, intellectual property and real estate.
In trying to fund the gap, the senior lender could not be more aggressive and the borrower did not want to raise additional equity. In order to meet the borrower’s capital requirements, Gordon Brothers Finance Company teamed up with the senior lender. Due to asset class knowledge, we were able to extend advance rates beyond those of the senior lender.
In this particular transaction, the partnership formed between the alternative financier and the senior lender not only staved off competition from other senior lenders — thus retaining the business for the incumbent senior lender — but also resulted in an attractive, lower cost solution to the borrower.
Bringing It Home
This new environment has drawn great interest throughout the industry and many new players have begun to enter the alternative ABL lending marketplace. It is important to understand, however, that not all partnerships are created equal. To make an effective partner, alternative lenders must have true institutional knowledge of the assets they lend against. Lenders that have the expertise and knowledge to view a borrower’s various asset classes from all angles can leverage that knowledge in order to lend against those assets. Having these skills enables an effective alternative lender the ability to maintain a reasonable risk profile while retaining the ability to engage in attractive opportunities.
Additionally, to make an effective partner, an alternative lender should have a track record of successful partnerships with senior lenders. As the lending landscape continues to change, and perhaps become more challenging, alternative lenders can deliver effective solutions to both the senior lender and to the borrower clients.