The economy skipped a beat when the Bureau of Labor announced the latest job numbers in early April. For the first time in more than a year, the pace of hiring slowed down, even though business revenues still showed signs of growth. Most agree the slow but continuous economic growth of the past two years seems to have stabilized, but signals are mixed. Middle market leaders have confidence in the U.S. economy but feel less sure of the global economy.
Asset-based lenders struggle against excess liquidity, compressed margins and fierce competition, but many continue to exceed their numbers. We asked five asset-based lending executives to describe today’s landscape from their perspectives.
Barry Bobrow, managing director, head of loan sales and syndication at Wells Fargo Capital Finance, cautions that supply and demand are not in balance. “The demand is stronger than ever for loans that are within the regulatory framework. For loans on the cusp or on the wrong side of our regulatory guidance, there is little to no demand.”
“The landscape is still very competitive,” says Bill Kosis, executive vice president and group head at PNC Business Credit. “It varies by region, but it is competitive everywhere. The funds, B lenders, and BDCs direct a lot of the deal flows now. As far as originations, there are different ways to get to the deal. Everyone is under pressure to grow, do well and keep margins up.”
“ABL continues to be an asset category that banks really like because of the low-loss-given-default and collateral characteristics of the product,” explains Burt Feinberg, president at CIT Corporate Finance, Commercial & Industrial. “Banks continue to flow into ABL, and smaller banks are creating groups. There are new entrants, and others have fortified their teams.”
“There are pockets of areas that are getting stronger and weaker — certainly there is less demand in the oil patch — but overall I have not seen any market change in the amount of deal flow over the course of 2014 or 2015,” reports Michael W. Scolaro, managing director and group head of Asset Based Lending at BMO Harris Bank.
“When you look at the first quarter numbers for ABL issuance, you can see that 2015 is not off to a great start,” observes Sam Philbrick, president of U.S. Bank Asset Based Finance. “Competition continues to be keen, focused and everyone is open for business. It is all about execution right now. We are all bringing a strong product to market; it just gets down to who brings the right answer to the client first.”
New Money Vs. Refinancings
At year end, Thomson Reuters LPC reported that the 2014 ABL volume of $93 billion was up from $82.5 billion in 2013, setting the second highest annual total on record. However refinancings put the squeeze on lenders as spreads tightened and terms and conditions loosened early in the year.
“The Thomson Reuters report nicely shows that new ABL volume was up sharply from 2013, but Thomson Reuters looks at new money from a perspective that is different from the way others might look at it,” clarifies Bobrow. “For this index, new money is not necessarily a measure of new financings; they also include the upsized portion of any existing transaction. There were 20 deals last year of $1 billion or more that went through the league table, and only one or two of them were truly new money. In that sense, the market volume was up and showed a lot of new opportunities for lenders to lend — or at least to increase their exposure to existing names.”
“The refinancing market is ultra-competitive, especially on the low end,” says Kosis. “M&A business in asset-based industries is up a little, but the numbers may not show that year to date on the general tables. It has been active, though, and we have seen some good deal flow in that area.”
Tempered M&A Results
“I think M&A is going to continue at a solid pace, but its impact on ABL demand does depend on which industries it is happening in,” reminds Philbrick. “The Staples acquisition of Office Depot is a good example on M&A driving ABL demand. If asset-intensive industry sectors continue to be active, that will be good for our business.”
“In the past, there was a supply and demand point of equilibrium,” recalls Scolaro. “Now banks have more capacity to increase the size of their hold levels, and we see more asset-based lenders. As a result, there is much more supply, and banks are competing on what had once been non-traditional terms such as advance rates, which are going up, and springing levels, which are going down. We have not seen a dramatic difference in M&A activity one year over the other. We are not counting on that to deliver our market growth in 2015.”
“Much of the reported M&A volume is corporate-to-corporate and investment-grade stock-for-stock transactions that don’t involve much leveraged debt,” points out Bobrow. “Sponsor-driven M&A activity may be at the lowest level since 2009-2010. With high equity markets and competition against strategic buyers for assets, sponsors continue to think the risk return is not attractive, so they aren’t buying as many companies. You could also read into that that there are concerns about this relatively long economic expansion, softness in the international markets and the strong dollar hurting the prospects of the companies they might want to buy.”
“The other thing that impacts ABL volume is when there is deterioration in credit quality, and an incumbent lender with a certain risk appetite becomes fatigued,” adds Feinberg. “This allows another lender, more comfortable with that particular asset base or credit story, to come in as a replacement lender. There have been a couple of large, multibillion dollar transactions that provided participation opportunities to a lot of the ABL players, but we haven’t seen many new money deals related to M&A in the middle market so far in 2015. We are starting to see more opportunities through our private equity coverage team, and we hope they will translate into new financings.”
“Right now borrowers can dictate any point they want, as long as they don’t try to dictate every point,” insists Scolaro. “They can dictate a larger term loan or a looser covenant package, the number of field exams or advance rates; they just can’t dictate all of them at the same time. In prior years, these were relatively fair trade items, but all of them are now under attack in every transaction we work on.”
Low Rates, Tight Margins
It’s hard not to stifle a yawn when talking about the possibility of an increase in interest rates. “I don’t see the economy gathering enough strength to make the Fed feel confident enough to push rates up in the immediate future,” says Philbrick. “Bankers believe that an increase in rates will help margins and be beneficial for our overall industry.”
“German treasuries are near zero, and some Euro rates are actually going negative,” states Bobrow. “Continued softness in Europe means we may not see a rate increase any time soon. The Fed just doesn’t have inflation concerns, especially with energy prices remaining low.
“To date there has been no impact on M&A with modestly rising rates,” shares Scolaro. “From everything I am reading, it will be between 10 and 15 basis points between now and the end of the year. That is not going to drive whether somebody is or is not buying a business, refinancing or making significant capital decisions.”
“An increase in rates would help our margins, and that would be a positive, but it would be a mixed situation regarding our credits,” relates Kosis. “Based on the current economic data, it seems that a rise isn’t going to happen anytime soon. We are waiting.”
In its report on 2014 U.S. bank performance, the FDIC said the Q4/14 average net interest margin of 3.12% was the lowest quarterly average margin since the 3.11% reported in Q3/1989. We asked our lenders how this reality affects their lending environment.
“In this type of environment, we have to focus on execution and make sure expenses stay in line,” instructs Philbrick. “Importantly, the pressure on interest margins also puts a premium on continued strong asset quality to keep our credit costs low.”
“Last year our customers had the best credit they’ve had in the last 10 to 15 years, but interest margins are still under pressure,” remarks Kosis. “Our client performance is better, and we’ve accommodated that with improving rates which have hurt the overall margin in the asset-based group. But margins are under pressure across all the credit businesses.”
Bobrow agrees there is continuing compression. “It is not so much a lowering of the lowest level as it is deals converging around the market. As things re-price with all that refinancing activity, it puts a weight on the yield in bank loan portfolios. Without the higher priced deals in your portfolio, the average net interest margin continues downward. It’s very challenging for the banks. If it’s a company that is established as an accepted borrower from a regulatory standpoint and there is reasonable usage, the competition heats up. That results in continued erosion of pricing and term for those names.”
“BMO Harris has probably lost 25 basis points over the course of the past year in terms of spread,” admits Scolaro. “That just means we have to make up for decreased spread in terms of volume while being very particular on the credit quality we maintain — and you need to avoid adverse selection of accounts.
“We have to look for other ways to make our returns, through structural elements and other products that can supplement the actual interest margin,” sums up Feinberg.
Managing Stretch Risk
According to a recent Beige Book commentary on banking and finance, credit quality has remained largely unchanged, but several districts report relaxed or lowering standards. Philbrick affirms that credit structures have gotten more aggressive. “While the initial credit structure and underwriting are important, the truth is that much of our credit losses is driven by how we manage the credit after it is booked. Credit quality should stay strong despite the aggressiveness in the market, as long as we all understand the risk we take and properly manage that risk as the deals go forward.”
Scolaro confesses it is tempting to lower credit standards, because the larger term loans are being done with longer amortizations and higher advance rates. “We see real estate brought into the borrowing basis when it has traditionally been held as boot collateral. People are ignoring things such as wage lien reserves and other typical reserves. The competition is bringing very aggressive structures to the market, but we will be very circumspect of those types of transactions. We are certainly not going to lose market share, but we will pick the right spots to play.”
“The deals and companies that are widely accepted by the banks continue to obtain more aggressive terms as they come to market,” emphasizes Bobrow. “From deal to deal, that might mean the definitions or level of the covenants, the restricted-payments tests and baskets, the conditions precedent to closing or certain events they might want to undertake. It’s a forgiving market, because credit quality in the bank’s portfolio continues to be very strong; and for the names that banks are really interested in, credit quality is still in the relaxing mode.”
Feinberg doesn’t see any relaxing or lowering of credit standards. “In fact, under the current regulatory guidelines that banks are mindful of, there is more discipline self-imposed by the bank lending community in terms of leveraged loans and criticized assets. The banks we compete with have been pretty consistent, and so have we. In my view, the more liberal credit is being provided by non-bank players.”
“We are watching certain industries: Metals have weakened in our portfolio over the past three to six months, and certainly oil and gas service companies have weakened with the dropping prices,” describes Kosis. “But we have some very good clients — and a lot of experience in all of these industries — so I am confident things will work out.”
When it comes to stretching on price or structure, Bobrow says it can be hard to hold the line when companies ask for something that has already become a market practice. “The situation might be different if you have a long history with a company, and they ask you for something very specific. The emphasis is on relationships, but it is very difficult to hold the line on terms when you are presented with examples you have already conceded to. You have to have a very strong feeling about it, and you have to be willing to walk away because it’s an aggressive market out there. Once you set the precedent, it proliferates very quickly in this world, especially for public companies.”
“There is only so far that we can go,” underscores Kosis. “That being said, you have a lot of springing covenants and less covenants; that seems to be a mainstay in the market now. We have done this and stayed in the market, so there is some stretching, but it depends on the deal and the nature or depth of the relationship. On large syndicated deals we have to be in the middle of the road, but even those have springing features in them. On the lower end, we stick to the basics and haven’t done a lot of stretching.”
“With the advent of the second lien and split lien, your structure is oftentimes the stretch in the deal,” notes Scolaro. “There is always an incentive to close a transaction, and there is always a reason for a customer to choose you over someone else — because there is no such thing today as proprietary deal flow. All of our customers and prospects go out to get multiple bids because it’s easy to do it and the environment is competitive. The incentive we offer to facilitate a close might be a larger hold size, understanding and lending on a piece of collateral that hasn’t been done before, a reduction in the interest rate they are currently paying or a reduced fee structure.”
Feinberg adds, “There are certain structural levers that we use from time to time — adding a FILO tranche or lending against non-traditional categories such as intellectual property — that can still be done safely within the confines of the ABL structural architecture.”
“If we stretch, we’ll be fine, as long as we understand the risk and know the steps to mitigate it if the situation changes,” assures Philbrick. “The people who will have trouble are those who make structural accommodations to win a deal that they can’t necessarily correct if the company’s performance softens. If you do a large term loan and the company’s cash-flow dissipates, there is not a lot you can do. But if you are a working capital lender stretching on your advance rates on current assets, you can typically adjust if things don’t go the direction you were hoping for.”
Data compiled by the Fed showed 2014 was the banking sector’s best period in terms of loan growth since the economic downturn. “We had our best year ever in 2014, and we grew our book by approximately 55%,” declares Scolaro. “In 2015 we are 40% ahead of last year as of the close of March.”
CIT’s ABL group had good volume in 2014, but loan growth was marginal. “We faced a lot of refinancings where we were taken out of some single-lender deals because they refinanced elsewhere at lower rates, or we opted not to chase a lower rate,” reveals Feinberg.
Wells Fargo Capital Finance also had an excellent year in 2014. “We are all challenged by the spread compression, and you need loan growth in order to grow your earnings,” says Bobrow. “As with all banks, we watch our expenses carefully and try not to take imprudent risk. We were able to grow our loans last year, and for us that is saying a lot, since we are a large bank.”
“Our lower end procurement and wins in market have been less than what they were historically,” laments Kosis. “Overall our win/hit rate is down from where it was three or four years ago. That said, our deal size was larger, and we exhibited portfolio growth.”
“We had double-digit loan growth last year, and we continued the momentum into the first quarter of this year,” states Philbrick. “We continue to grow assets, but the revenue per dollar of loan under management is declining due to the pricing pressures in the market.”
Changing regulatory challenges can put a bank at a competitive disadvantage when competing against non-regulated competitors. “Banks are mindful of the amount and magnitude of transactions consummated in the ABL market that are characterized as special mention credits and/or leveraged loans,” stresses Feinberg. “Given the changing regulatory environment, banks are trying to figure out how many of these types of loans they can book. As a result, there are several new players in the ABL community that have picked up the slack, because they have more flexibility.”
Bobrow admits that unregulated institutions have some advantages because they can do things that banks clearly cannot. “But banks also have advantages over non-banks. We carry more leverage and have cheap deposit costs, so for deals that fit within our market strategy, we have a distinct pricing advantage. There may be a wide gap in pricing and terms when a deal leaves the bank universe, and that might lead to more opportunities for non-banks, but it might also lead to fewer deals because not every deal works at a different price or structure.”
Philbricks says the percentage of financing provided by non-regulated competitors is rising. “This is especially true in the leveraged cash-flow market where regulatory guidance limiting total borrower leverage has caused some leveraged cash-flow financings to move to non-bank competitors.”
“Non-regulated competitors are definitely a major factor in the market and are becoming more so,” allows Kosis. “We team up with several and have started a fund with equity raised by one of those groups. We have a lot of interactions with them right now, and they tend to direct a lot of deal flow, because we can’t do the amount of leverage they can do. We offset the challenges by working with them.”
“A regulated bank is at a competitive advantage to its non-regulated competitor in terms of history, relationship, fiscal presence, brick-and-mortar, convenience and ancillary services that include deposit-taking,” asserts Scolaro. “Banks have substantial advantages, but when it comes to financing non-pass rated credits, the non-regulated competitors have certain advantages over us in terms of ability to execute. But let’s not forget that banks are here for a reason: At BMO Harris, we offer significant advantages to doing business with the bank over our non-regulated competition.”
“I feel pretty good about the volume of new business for the balance of the year,” expresses Philbrick. “Utilization was very strong for the first two quarters but softened in the third month. I wasn’t that surprised at the way the job numbers took a pause in March; that directly shows up in utilization with our clients and overall business activity.”
Kosis thinks they will have less growth in loan volume, because loan utilization is falling with dropping commodity and oil prices. “A lot of commodity prices are dropping, so there will be less use on some of the credit lines. We did less deals last year, but we did bigger credits and made it up with larger holds, which bolstered our growth.”
“BMO Harris ABL is still in the growth phase of our most recent five-year plan,” conveys Scolaro. “We will continue to grow at 25-30% per annum for the next several years. We will do it through increased utilization by our borrowers who are now starting to pick up as they invest in their inventories and capital goods.”
Feinberg also foresees increased utilization as companies benefit from the improving economy. “We hope that will embolden companies to invest in capex, inventories and new projects that would require more funding under their credit facilities. We also hope new money financings coming out of the M&A world will pick up. That would help us achieve loan growth this year.”
“It’s a good economy, and there is still opportunity for banks to grow through new relationships and deepen existing ones,” predicts Bobrow. “In addition to acquiring new names, banks are focused on cross-selling as many products as they can to their existing customer base.”
One of the big changes expected to impact the balance of the year and beyond is GE’s decision to sell off many of its financial assets. “The jury is out on how this will impact our company and the market,” notes Feinberg. “If the businesses of GE Capital resurrect under new ownership structures with lots of capital and low cost of funds, and the businesses are enabled to continue transacting pursuant to their historical practices and culture, a formidable, smart competitor will remain. If the assets are purchased by buyers that have no interest in keeping the GE businesses and culture in place as we know them, the remaining players in the market should benefit. There is also a strong talent pool within GE that would ultimately help other organizations.”
“GE’s divestiture of its financial assets will certainly have a profound effect on the asset-based lending industry, and we will closely monitor all the developments as they happen,” says Scolaro.
“There is uncertainty in the industry and that can mean good opportunity or time to strategize,” counsels Bobrow. “GE’s recent move will definitely change the landscape, and it will be interesting to see how the industry adapts.”
Optimism Through Volatility
Other potential changes to the landscape include regulatory guidelines, world events and ability to retain and attract personnel. “The quality of our people is the key differentiating factor in the market,” claims Philbrick, who is always concerned about keeping and attracting top performers.
Even though they home-grow a lot of their people, Kosis has similar concerns. “Because it’s a big group, people are constantly moving up through the ranks. We strive to maintain our strong people while bringing in new people and indoctrinating them into our culture, so they can make their way and be productive within the company.”
Feinberg worries that some exogenous event could re-trigger a recessionary environment. “We’ve had positive trends in a lot of cyclical businesses for several years, and we have had a bullish equity market for a few years. Mix that with the backdrop of volatile but lower energy prices that are good for the consumer but not so great for the energy industry. Add the international turmoil surrounding terrorism and a stronger dollar dampening exports to already sluggish foreign economies. On top of that we are seeing consumer debt growing again plus huge amounts of institutional dollars chasing debt and equity investments resulting in high valuations. There are many forces at play that could create volatility and a loss of confidence.”
Uncertainty over new regulatory guidance and how to best adapt to the changes concerns Bobrow. “Since the guidance is just that — guidance — very institution has to come up with its own interpretation and policy. Then there is an iterative process that goes back and forth between you and your regulator as to whether or not that policy is the right one. We are in a period of uncertainty and adjustment that will take a while, beyond 2015.”
“What keeps me awake is maintaining a great workplace environment and capturing all that our team has to offer,” finishes Scolaro optimistically. “We have surrounded ourselves with hard-working, intelligent people who want to succeed and are going to. If we create that environment in the right circumstances, we will continue to thrive.”
Lisa A. Miller is a freelance writer and regular contributor to ABF Journal.