Asset-based lenders serving middle-market and large corporate companies operate within a demanding environment of excess liquidity, compressed pricing, competitive product options, ever-increasing regulatory oversight and fierce competition. To get the insider’s perspective on the changing ABL landscape, we sat down with Bill Kosis, executive vice president of PNC Business Credit; Bob McCarrick, chief commercial officer, Lending, at GE Capital, Corporate Finance; Kurt Marsden, head of Business Finance at Wells Fargo Capital Finance; Joseph F. Nemia, executive vice president and head of Asset Based Lending at TD Bank; and Sam Philbrick, president at U.S. Bank Asset Based Finance.
The ABF Journal published a Fitch Ratings report in March that highlighted positive news about U.S. asset-based lending options. It said, when present in a defaulted issuer’s capital structure, asset-based loan facilities demonstrate complete recoveries in a bankruptcy scenario. This was good news for asset-based lenders who often find themselves defending their product.
“The Fitch Ratings study is completely consistent with our experience,” concurs Marsden. “It is something we have known about, but nevertheless it is nice to see the affirmation coming from a third party.”
“In a default scenario, the asset-based loan loss ratios are far lower than most other commercial banking loan products, because of the way we can monitor the collateral and the control characteristics of the loan structure,” explains Philbrick.
Nemia says the report helps validate the low loss given default metric that is used as one of the predictors of credit risk for borrowers. “Independent reports such as this provide a broader measure of comparison of our own ABL credit experience history with other ABL lenders in the industry. Strategically banks can use the data to help support the decision to calibrate their activity within the ABL segment.”
“We welcome other studies of this nature, because they help promote the asset-based product against the perceptions that people may falsely have about it,” relates Marsden. “As long as you are lending under good fundamentals, it is a good viable product that can recover on most of the loans you put out there. Perhaps others are reading those studies and surveys, because we have seen additional banks entering the asset-based lending market space. There has been expansion, so clearly the message is getting out!”
Indeed, there are a lot of new entrants in the asset-based lending world along with the excess liquidity in the market. The loan-to-deposit ratios of insured commercial banks in the U.S. was less than 70% as of December 31, 2012 versus more than 90% at December 31, 2007.
“U.S. savings rates have gone up, and those deposits are sitting in the banks making the banks anxious to put that capital to work,” notes McCarrick. “Due to the decrease in merger and acquisition activity and related financings, there has been a lack of new money and renewed debt transactions on existing deals.”
“The direct impact of new entrants has added to the market depth for syndicated loans,” adds Nemia. “The liquidity in this market is plentiful, and the depth in the syndicated market has cleared transactions approaching $2 billion.”
Facing Down the Competition
When middle-market businesses and large corporations have a plethora of financing options, how can experienced ABL players stay competitive? “When everything is as hyper-competitive as it is now, rate is not necessarily going to be the differentiator, so you have to find other creative ways to win mandates,” says Marsden. “You need to develop a creative loan structure that solves a problem in a unique way. At Wells Fargo, I have the benefit of being part of a large institution that has product offerings and capabilities that others may not have, so we use this to our advantage.”
“We take a relationship approach to our business and have experienced a large growth run over the last five or six years,” reports Kosis. “Equity sponsors and referral sources drive a sizeable portion of our business, and we’ve built up many years of steady lending to those units. We were a very active lender during the last recession, and people have not forgotten that.”
The excess liquidity has been beneficial to borrowers, because there is a greater supply of capital coupled with less demand, so competition is fierce. “Regional banks are taking more of a presence in the ABL market, and the larger money center banks are being more aggressive in terms of hold size and flexibility,” asserts McCarrick.
ABL activity has come primarily from existing clients during the first four months of 2013 at U.S. Bank. “Customers are amending and extending, and locking in today’s advantageous terms to ensure they have the liquidity to handle whatever their business execution is going forward,” conveys Philbrick.
At PNC Business Credit, mergers and acquisitions as well as private equity sponsors will make up a big piece of this year’s activity — probably more so than in prior years — because the refinance market has gotten tougher. “We will team up with the collateralized loan obligations (CLOs), the B lenders and others while also doing our own financing within the M&A market,” says Kosis. “We also have a lot of financing activity with our own customer base as they do add-ons.”
Wells Fargo Capital Finance has an asset-based group that covers transactions $35 million and under, and Marsden says that adds to its visibility to the overall marketplace. “We have not seen any real change in the level of mergers and acquisitions, which means to us that the available deal flow is likely going to be refinance-driven by existing customers looking to restructure their capital. Customers are out in the marketplace seeking to lengthen the maturity of their deals. They are tapping into the bond and institutional term loan market, and they are looking to take advantage of historically low rates.”
“Unfortunately, we do not see any significant signs of expansion in the market environment,” laments Nemia. “The potential growth of ABL portfolios will be a function of economic expansion and increased M&A activity. We recently have seen ABL revolvers coupled with term loan B debt tranches, which is good news for the future growth of the business.”
Enter the Regulators
Though increasing regulatory oversight adds to the costs of systems and manpower, our panelists accept its presence as part of doing business in today’s financial environment. “We’ve had a partnership with the regulators for years, and overall they have been a positive influence,” expresses Kosis. “We have good dialogue as part of a transparent, open relationship, and they are very knowledgeable about asset-based financing. It never hurts to have another set of eyes on your operation.”
“Government regulation of banks is not a new phenomenon,” agrees Nemia. “After the 2008-2009 financial crisis, we have adapted to the higher levels of compliance required. Whether you like them or not, the rules are clear, and we are all under the spotlight to compete with a solid understanding of any new regulatory guidelines.”
“They use the same standards and forms of analysis that other leveraged products are reviewed by,” remarks Marsden. “We are seeing, especially in a banking environment, an increase in overall regulatory requirements as Dodd-Frank gets implemented and as people start to interpret the Basel accords and implement them across the institution.”
McCarrick explains that ABL borrowers are designed for higher volume, lower margin type credits. “Typically they are not investment grade companies. Nevertheless, asset-based loans tend to be safer, because they are secured on the assets of the company and there are typically fewer loan losses over time. In spite of this, regulators have a tendency to view all loans as the same. This has forced some banks to shy away from some of the tougher ABL credits.”
The Changing Landscape
With so much liquidity in the marketplace and the need to deploy it, banks and other lenders are taking a closer look at asset-based lending. Banks are setting up ABL shops by hiring expertise or by redirecting existing resources. “Part of the phenomenon is driven by the fact that many banks invested in commercial and residential real estate pre-crisis and still steer away from that asset class,” suggests McCarrick. “They need to redeploy capital elsewhere while still getting a decent return for the risk, and ABL fits squarely into that strike zone.”
“Until recently the number of active market participants had been relatively stable,” says Marsden, “but we have seen a number of new entrants in 2012. We haven’t necessarily bumped into them in the marketplace, but we are aware that institutions are starting asset-based lending groups. We see it from a staffing perspective, because there are attempts to recruit our team members.”
“As far as pricing competition, asset-based competition is heavy,” laments Kosis. “With the resurgence of the banks, we are getting a tremendous amount of competition from the commercial lenders as well. CLOs often control where a deal goes because, in most cases, they take on a riskier piece of the capital structure than the asset-based lender does. When teamed with an asset-based lender, they can enlarge the deal market that would traditionally have gone to banks by enabling the asset-based lender to play in those fields. But the relationships and documentation are quite complex. We have a lot of experience in dealing with them; I estimate that a quarter of our deals annually are with some type of fund or CLO.”
“Given the liquidity in the market, drawn spreads continue to reflect the re-pricing of large deals,” cites Nemia. “It is interesting to note, given the strength of the leveraged loan market, that the ABL price advantage over double-B rated institutional loans has narrowed from 140 bps in the fourth quarter of 2012 to 72 bps in the first quarter of 2013.”
“Regional banks are exhibiting an increasing appetite, and money center banks are aggressively pursuing ABL credits of all sizes,” continues McCarrick. “The result is a recycling of cash and existing credits that are lower in price and offer borrowers more flexible terms. It’s very good from an issuer perspective, but for banks it is a highly competitive environment, and I don’t see it abating any time this year or even in 2014.”
Time to Shift Market Strategy?
Going into 2013, most asset-based lenders were faced with a diminishing pipeline and an uncertain M&A environment. To differentiate one lender from the next and stimulate deal flow, lenders can wrestle with the wisdom of sticking with an existing go-to-market strategy or revising it to fit new conditions.
“We’ve remained consistent,” declares Kosis. “We have our own product fund, Steel City, through which we do $10 million and $20 million B loans. We also team up with the CLOs on a number of deals and have an extensive direct marketing campaign. Our philosophy is: If we have a solid relationship, we support that relationship through thick and thin. When we deal with good people, we generally come out okay.”
In markets such as this, Philbrick stresses the need to understand how an institution positions itself to compete. “We are trying to build a business that will grow through the cycles over the long term. We implemented a ‘client advocacy’ process in which we train our client-facing employees to focus on one thing: understanding what we can do to make our clients more successful. By approaching a customer relationship through their lens, we can provide a solution that will make them more successful in getting where they want to go.”
GE Capital advertises its “we are builders, not bankers” approach to business. “Through Access GE, clients have access to the GE toolkit that they can use to make their businesses better, whether we conduct eco-treasure hunts to evaluate their energy needs or help them with organizational structure development,” states McCarrick. “The toolkit is a strong differentiator for us, and it is the benefit of being a financial services company inside a large industrial parent.”
“The current lending environment has allowed us to execute on our strategy, and we continue to cover the market, bringing deep expertise and the entire TD Bank suite of products to our customers,” says Nemia. “This helps deepen our relationships and improve client retention.”
Wells Fargo works closely with existing customers to make sure their needs are met. “We bring them fresh ideas that reflect market conditions; we may even proactively reach out to them and offer to reduce interest rates in an effort to retain their business,” admits Marsden. “On the prospective side, we have a direct marketing team and have built up a robust calling effort in our originations department. We contact private equity groups and hedge funds, accounting, law firms and prospective customers.”
The Syndications Scene
Today’s syndications market is also changing with the emergence of pension funds, CLOs, unitranche structures, larger lender hold limits and more agent banks spreading business. “Pension funds, CLOS, unitranche structures and other financing solutions definitely help make a very liquid but more competitive marketplace,” proclaims Nemia. “The upside of all of this liquidity allows for institutions to spread their risk and not have to take oversized hold positions.”
Kosis agrees that the syndications environment is active. “There are larger holds now, and we will hold larger amounts on larger deals. Sponsors, such as equity groups, dictate when they want fewer banks in a deal. If the deal is well structured and reasonably priced, generally it will sell easily in today’s market — but not always. The more sophisticated borrowers look to bring in banks, similar to ours, that have been able to work with them through the cycle, so when issues hit again, they have reliable partners to extend them credit.”
“All of our competitors are taking larger ABL positions than they would in other types of financing structures,” emphasizes Philbrick. “In the larger part of the syndicated loan market, the people leading those syndications also play a significant leadership role in the term loan execution. In the larger deals, you see more of an integrated execution between the two products.”
“You do see some fund players come into the market to do first-in, last-out (FILO) tranches where the ‘last out’ piece is an ABL loan,” says McCarrick. “This allows them to stretch advance rates to 85% to 90% on accounts receivable from 65% to 75% on inventory. The banks benefit from the excess deposits they want to deploy. CLOs are more of a leveraged lender that does rated deals to middle market companies and larger non-investment grade credits.”
“CLOs and funds play an important role in the overall leveraged loan market, but we are rarely finding them in asset-based loans,” agrees Marsden. “They just aren’t interested from a risk return standpoint, especially as we continue to see the yields compress. Their main role with the asset-based market, from what we have seen to date, has been more participation in complex financings, particularly when we see a structure with a bifurcated term loan in it. In these cases, we might lend on the accounts receivable and inventory, and they may come in and lend against the machinery, equipment and intellectual property on a term loan basis.”
Lying Awake at Night
When asked about their greatest concerns, there was no shortage of answers. Price compression, lack of M&A activity and new money deals, a future economic downturn, loosening structures and a shortage of qualified personnel ranked highly.
“Everyone is pricing down the credit, so it just gets tougher and tougher,” insists Marsden. “The lower your pricing, the harder it is to cover your overhead, achieve your business plan and attain the growth that is expected of you.”
McCarrick worries about the lack of new money. “We can continue to recycle cash, but at some point, transactions will slow significantly. We won’t be able to finance ABL borrowers down any further in price, and they’ll have done all the recapitalizations they require.”
Marsden also worries about loosening structures. “To win deals, people are reducing pricing or being creative on structuring. They may provide stretch term loans or lend beyond the current collateral. In today’s environment, where there is ample capital, this might be okay; but if a borrower runs into trouble a few years from now in a different environment, we may not be able to find alternate sources of capital with which to repay the aggressive loan structures.”
All five panelists share concerns about finding the right people to do the job and put great emphasis on identifying internal and external talent, supporting them with training and career growth and keeping them engaged in a tough marketplace. “It’s all about the team that we put on the field,” concludes Philbrick. “None of our strategies work if we don’t have the best people interacting with the client, understanding what the client really needs. The reality is that we win or lose at the point of execution, and that gets back to the person who is at the client’s office listening to his needs and coming up with the right solution.”
Looking Ahead: Sunglasses or Umbrella?
“By nature I tend to be an optimist,” confesses Kosis. “Asset-based lending has become a mainstream financing option. We have great relationship partners, and we have great employees, so I see a strong environment ahead. Even with the volatility in the marketplace, PNC can become a steady, fundamentally sound lending partner. Going forward, the opportunity is sizeable.”
“I am generally pessimistic, because the yields continue to compress, and I don’t see an end in sight,” says Marsden. “I could be more optimistic if that leveled out, but we think it is going to continue to be a competitive environment. Unless we see the availability of capital decrease, pricing will continue to compress, and things will continue to be competitive. A significant uptick in mergers and acquisitions could shift pricing by providing new syndication opportunities and lessening focus on the existing ABL client base. Barring that, I think we will see more of the same throughout 2013.”
“I’ve been doing this for a lot of years, and the reality is that the asset-based loan product has never been in a better position to be a solution for clients,” maintains Philbrick. “The AB loan provides unique benefits, including simplicity of financial covenants, borrowing capacity based on the asset levels and larger holds by providers. Today we are viewed as a solution with real benefits to a client who has other choices but chooses the benefits of an asset-based loan.”
Lisa A. Miller is a freelance writer and contributor to ABF Journal.