When the next recession hits, we are all going to find out whether the emperor really has his clothes on. The stock market is still at an all-time high while ABL losses and liquidations are
at a multi-year low. Competition is strong across bank and non-bank ABL lenders, and the market is undeniably frothy. This is, in part, driven by appraisals based on subjective/fluctuating market data and assumptions under current market conditions, enabling increased availability.
Right now, the ABL market is frothy and overly competitive, with players from all market segments entering or trying to grow. Lenders without the required expertise, such as local community banks, are coming into the market. ABL hybrid lenders are doing first-in, last-out loans (FILOs) plus stretch term loans on top of traditional revolvers. Pure ABL lenders are just trying to compete with lenders offering traditional structures. These dynamics have resulted in a market with few liquidations (outside of retail), a reduction in bad debt and stress, stronger borrowers and an increase in leverage across the board. These trends suggest the market is peaking and an onset of ABL liquidations in the next downturn may have dire results.
Appraisals Stood the Test of Time
A fair amount of credit for this situation is due to the appraisal industry, as its valuations have, by and large, stood up over the past 10 years. The question is, what will expected values be in a downturn and will values decline as quickly as they did during the last recession? An appraisal is only as good as the proverbial paper it’s written on. We are now living in a world
where 70% of the economy is consumer driven, and tastes change overnight as do household spending and general trends. The other 30% of the economy, which is not driven by consumers, is also subject to fast-moving market changes and major commodity swings.
The question lenders really should be asking is will current data be relevant in a market downturn, and will current data even apply to a market downturn? Many large deals now have FILOs in place, on top of advancing the lesser of a percentage of cost or 90% of net orderly liquidation value (NOLV). The appraisal firms don’t have the liquidation data they had five years ago since we are now 10 years into an upmarket cycle. The last time appraisals were tested across the market was during the Great Recession and average assumptions and reasonable liquidation value returns went out the window. Otherwise normal assumptions clearly don’t hold up in a black swan event.
Appraisal firms don’t and should never try to time the market. Information should be current, but it’s hard to not notice we are in a frothy period. It will also be interesting when the downturn occurs, and businesses need a smaller amount of inventory to operate. At that point, they will have more inventories on hand, relative to what would be sold in liquidation. And they will assume liquidation values are similar to those from the last appraisal. This would imply that a portion could liquidate at less than what was assumed, using values from the current appraisal.
Good asset-based lenders know how to get the most from an appraisal to maximize availability, thereby offering the highest availability at the lowest cost. This push-and-pull, or dirty dancing, goes on in each deal across the country in today’s heavily-regulated market in the ABL bank world and from more aggressive non-bank lenders — everyone is looking for an edge. This is certainly not news to the market-leading firms: Hilco Global, Great American, Tiger Group and Gordon Brothers. Regional firms offering a similar product are aggressively trying to make a name for themselves.
Fewer Appraisals Each Year
Borrowers and their respective advisors are taking advantage of the current market. Two appraisals per year has long been a market standard, which has been more than tested over the past few years. Many ABL firms now have to agree to one appraisal per year, springing cash dominion, covenant(s) and reporting, among other things, as part of winning deals. More sophisticated ABL firms have negotiated triggers to force multiple appraisals per year if certain liquidity triggers are not met. All are fairly aggressive giveaways on behalf of ABL firms. Borrowers clearly don’t like the time and invasiveness of appraisals, but one appraisal per year is really a big change from years past when firms would have stood their ground and insisted on two appraisals.
The market is primed for a reset. The liquidations conducted today are, by and large, at the top and bottom of the market, with not so many in between. Much has been made of large retail liquidations and sub-scale businesses, with very few liquidations that comprise the middle market ABL market, which is currently a battlefield of competition for new business. Retail has liquidated very well, thanks to quality data and the consistency of liquidations over the past decade. It obviously helps when the data is current and sound.
Impact on Airball Lending
Interestingly, appraisals drive a good amount of Super G’s airball lending practice. If an appraisal comes back on the high end, then no airball because there is no need for incremental capital. But the opposite is true when an appraisal comes back on the low end. There is some correlation between the economy and appraisals, especially if you compare appraisals in today’s market to the 2007-2008 timeframe, but it is not all economic driven.
As great as the Big Four appraisal firms are at providing strong appraisals, obtaining and using data that will stand the test of time can be difficult since no one knows when the data will be tested. The economy continues to motor on with no end in sight, and appraisals continue to be competitively aggressive. ABL firms are responsible for driving this, given the need to provide availability except for specific commodity-driven businesses that are too volatile.
The market will get more conservative again when the economy changes, at which point the airballs will start flying once again.