In his annual year in review and outlook, Hugh Larratt-Smith of Trimingham spoke with experts from across the asset-based lending space to get a pulse on how the industry has dealt with the many economic hurdles of 2022 and how they’ll approach 2023.
By Hugh Larratt-Smith
In 1720, British Parliament passed a bill known as “The Bubble Act.” The purpose of the bill was to regulate the flood of so-called bubble companies that were all chasing money in London at the time. The ebullience of the nascent stock market (conducted in the middle of a London street fittingly called Exchange Alley) enticed new investors ranging from aristocrats to members of Parliament to shoe cobblers. Some of the roughly 100 bubble companies promoted were plausible, like The Globe Fire Office. Others were dubious, like a company that promised to extract silver from lead. And then there was the “infamous company for a project which shall thereafter be revealed,” which sought to raise £6 million, a massive amount of money today, let alone in 1720.
The most prominent of these bubble firms was the South Sea Company, which is infamous for being one of the largest perpetrators of the African slave trade, with the company granted a monopoly in Spain’s South American and Caribbean ports. What was striking to observers like Daniel Dafoe (author of “Robinson Crusoe”) was none of the founders had any experience in South American or Caribbean trade, with Dafoe publicly denouncing the company as “a compleat System of Knavery,” although not for the egregious atrocity it committed against thousands if not millions of African people, but rather for its unscrupulous economic practices.
Between March and August of 1720, the shares of the South Sea Company skyrocketed from £100 to more than £1,050. At the company’s high-water mark, one nascent economist reckoned the market capitalization of the South Sea Company (putatively priced by the Exchange Alley brokers) was nearly equal to the value of all land and buildings in Great Britain and about 50% of the value of every business traded on London’s nascent financial markets.
Now let’s fast forward three centuries.
Putting Out Fires
In 1989, Billy Joel released the monster hit song “We Didn’t Start the Fire,” which was like an audible machine gun listing extreme events during the first 90 years of the 20th century. Today, credit committees may be excused for humming the same tune but instead of Joel’s lyrics, they might substitute words like inflation, supply chain shocks, China’s debt bubble, the Fed, labor shortages, mid-term elections and the war in Ukraine, with there being plenty of other options from there.
“If the Fed continues to raise rates, the curve will continue to invert, even to where the 10-year Treasury yield could be lower than two-year Treasury yields,” Meredith Carter, president and CEO of Edge Capital, says of the impact that some of these factors are having on non-bank lenders. “An inversion would reduce interest margins for banks while they would simultaneously have to set aside substantial funds for anticipated write-downs. As a result, banks would then tighten their lending appetite to preserve the capital on their balance sheet. If this likely chain of events arises in the coming months, nonbank lenders will be particularly well-positioned to help companies weather the storm. Private lenders typically have more accepting credit parameters and the ability to tailor loan agreements to the nuances of how different types of businesses have been affected by the downturn.”
“Borrowers are now being forced to stand on their own two feet, as wallets have tightened since government [Paycheck Protection Program] money and equity investments are harder to obtain and have lower valuations,” Jennifer Palmer, CEO of eCapital Asset-Based Lending, says. “It will quickly become evident exactly how strong borrowers are and will undoubtedly lead to increased utilization and reliance on lenders. This can be good for our bottom line, but we must proceed cautiously. After the supply chain issues of previous years, many borrowers over-bought on inventory to make up for lost sales; however, they are now also dealing with reduced demand. Lenders are caught in the position of having to help their clients work through tight cash flow but must also not overextend themselves. While it’s easier to support clients with strong margins, experienced management and inventory with long shelf life, we must be realistic that not all clients will make it through this. At this point, we need to manage our books carefully, balancing growth and protecting our business.”
“The clouds have been amassing on the horizon for some time now,” CJ Burger, president and CEO of Summit Investment Management, says. “The interesting part is that special assets groups have never been leaner, with many of these younger workout specialists never thrust into a hurricane that is making its way toward us. Banks and alternative funds are beginning to hire some old gray hairs that have been to this battle before and know how to keep a lender group together when dealing with a borrower that hasn’t seen anything go wrong in years due to a benign decade. The question that remains is: How much water the boat takes on and drifts around vs. does it plug the holes and have a quick turnaround?”
A ‘Market Accident’ Looms
Investors and Wall Street analysts are increasingly sounding the alarm about a possible “market accident,” as successive bouts of tumult in U.S. stocks and bonds and a surging U.S. dollar are causing rising levels of stress in the financial system. Indeed, the OFR Financial Stress Index was recently near a two-year high of 3.1, with a mark of zero denoting a normal functioning market. That has added to a growing list of benchmarks which suggest trading conditions in U.S. government debt, corporate bonds and money markets are increasingly stressed.
Economists are also concerned about the significant numbers of central banks raising interest rates simultaneously. The velocity of financial markets spasming around the world, such as the British pound and gilt crisis in October, has experts even more concerned about this seemingly pending “market accident.” Echoes of the Orange County (1994), Long-Term Capital Management (1998), Fannie Mae (2008) and MBIA (2009) “market accidents” have resurfaced after a decade of easy money.
“Companies that limped through the pandemic, fueled by government money and lenient lenders, without addressing some of the shortfalls in their core business model are going to have a day of reckoning,” Kathy Auda, chief risk officer at Great Rock Capital, says. “Fatigued lenders are not good partners for companies who find themselves with tightening liquidity positions. Bank workout teams have started to see a bulge in credits needing remediation, with working capital pressures mounting as companies struggle to juggle inventory and cost issues.”
Corporate defaults more than doubled from July to August, according to Moody’s. Strategists with Bank of America warned recently that their gauge measuring stress in the credit market was at a “borderline critical level” and that “market dysfunction” will start if it rises much further. There were also default events affecting $4.7 billion of bonds and loans in the U.S. market in August, the third-highest total since November 2020, according to JPMorgan Chase. August also marked the sixth straight month of default activity exceeding $3.3 billion compared with an average of $1.3 billion per month from November 2020 to February 2022.
Reflecting on the increasing economic pressures on borrowers, Robert Grbic at White Oak Commercial Finance, says, “Current market conditions, more than ever, require timely and accurate information from the borrower to assess risk.”
Of course, lenders are often challenged in this regard.
“Affirmative and negative covenants remain loose, providing borrowers an opportunity to develop alternative strategies that do not require regular communication with all of their lenders, leading in part to the growth in ‘lender on lender violence’ in matters such Serta, Revlon and Boardriders,” Frederick Hyman, a partner at Crowell & Moring, says. “It is now more important than ever to tighten covenant levels and improve reporting at the earliest opportunity.”
CHALLENGES FOR LENDERS
The asset-based lending marketplace has seen a plethora of new entrants in the past five years with a wide range of “wheelhouses.” Despite this backdrop, according to George Psomas, senior managing director, head of originations and investment committee member at BHC Capital Partners, “we’ve seen a pullback in credit appetite across all industries. There are simply fewer lenders at the table bidding on deals. And the difference between aggressive and cautious lenders is much more pronounced this year vs. one year ago. We detect an undercurrent of anxiety in the credit committees of both banks and credit funds.”
“During the pandemic, we have seen ABL remain open for business, supporting companies when other financial option are off the table,” Jeremy Harrison, head of sales UK at ABN AMRO Commercial Finance UK, says. “However, we have not only had to contend with a pandemic and ensuing supply chain issues. Remember, much of the world was shut down for two months at least, but now we have a war raging in Eastern Europe, resulting in further disruption, notably around energy prices and continued supply chain volatility.”
“Rising interest rates have driven cash flow lenders deeper into the capital structure of highly leveraged companies, much more so than the lenders originally underwrote,” Psomas says. “Enterprise values — which are dictated by the net present value of cash flows — are under pressure, reflecting the rising discount rates triggered by the Fed’s actions. We hear many stories about declining EBITDA and enterprise values arising from margin compression. It will be interesting to see how this affects intangible lending on intellectual property such as tradenames. Who remembers the Chapter 22 — or was it the Chapter 33 — odyssey of FAO Schwartz and Fredericks of Hollywood, where lenders and investors were bullish about the durability of the tradenames? Oh, and how about loans based on pro-forma EBITDAA? (the extra ‘A’ refers to addbacks).”
One challenge facing rescue capital lenders and investors is determining, in the aftermath of the height of the COVID-19 pandemic, whether a company is a “broken wing, fallen angel” or “dying from 1,000 cuts.” Bridging pre-pandemic EBITDA and post-pandemic EBITDA was difficult enough without the recession fears that now cloud the visibility on the cash flow generating capacity of borrowers. Added to these concerns are the “CAPEX pauses” that many large companies like Amazon have implemented, throwing a curveball at numerous middle-market manufacturers.
More than 60% of CEOs expect a recession in their geographic region in the next 12 to 18 months, according to a survey by The Conference Board. An additional 15% think the region of the world where their company operates is already in a recession. Bell-weather companies such as FedEx and Nike have experienced double-digit declines in their stock prices in a single day, reflecting this concern. Many SPACs have folded their tents, unable to get deals done. This recessionary outlook will create opportunities for asset-based lenders, but it may be time to proceed with caution.
THE BUBBLE BURSTS
Mark Twain has been credited with saying, “History may not repeat itself, but it often rhymes.”
When the price of the South Sea Company finally reached its peak at £1,050 in early August of 1720 in an orgy of trading, the subsequent rapid crash was catastrophic. Throughout the autumn, the slide continued until December, when the stock reached its par value of £100, where it had started at the beginning of the year. The company’s directors tried to reverse the slide by promising a £50 annual dividend, which was 50% of the par value but was also a mere 5% annual return for investors who bought in at £1,000. The collapse in the share price triggered bankruptcies amongst the thousands of investors who had bought the shares on margin. In a 1764 survey of the financial wreckage, just four of the bubble companies launched in the go-go days of 1720 survived as going concerns.
When Sir Isaac Newton was asked about the bubble and the South Sea Company stock, he answered that, “I can calculate the movement of the stars but not the madness of men.” •