Robert McCarrickChief Commercial Lending Officer GE Capital
Robert McCarrick
Chief Commercial Lending Officer
GE Capital
Laurie Muller-Girard, National Director, KeyBank Business Capital
Laurie Muller-Girard,
National Director,
KeyBank Business Capital
Joseph F. Nemia, EVP, Head of Asset Based Lending, TD Bank
Joseph F. Nemia,
EVP, Head of ABL,
TD Bank
Sam Philbrick, President, U.S. Bank Asset Based Finance
Sam Philbrick, President,
U.S. Bank Asset Based Finance
Michael Sharkey, President, Cole Taylor Business Capital
Michael Sharkey,
Cole Taylor Business Capital

It seems we replay the same old recording: high liquidity and low interest rates, increased competition and decreased spreads. Can it get any worse, and will it get any better? Though the industry continues to bring in new business and use asset-based products to expand existing relationships, the challenges continue to mount.

“We remain in an increasingly competitive ABL market,” begins Joseph Nemia, executive vice president and head of Asset Based Lending at TD Bank. “Banks as well as non-banking entities are aggressively pursuing transactions, especially those that have a high percentage of funded commitments. The market depth for ABL deals appears to be at an all-time high and, quite frankly, demand continues to outstrip the supply of new deals.”

“There are a lot of options available to borrowers,” observes Laurie Muller-Girard, national director at KeyBank Business Capital. “They have cash-flow options as well as asset-based options. Borrowers are attracted to ABL pricing, and the structures provide nice financial flexibility.”

Bob McCarrick, chief commercial officer, Lending at GE Capital, Corporate Finance, says more banks and independent asset-based lenders are cropping up, which in many cases forces looser credit structures. “We have also seen smaller banks entering the ABL market over the past couple of years, and many banks are increasing the hold amounts for ABL deals. All of this increases market acceptance for the product and thus overall market liquidity, which helps in syndicating deals at a good price.”

“The individual players tend to ebb and flow, based upon the experience they are having,” comments Michael Sharkey, president at MB Business Capital, formerly Cole Taylor Business Capital. MB Financial, Inc. completed its acquisition of Cole Taylor Bank in August. “Every year it seems to be a slightly different set of competitors driving the craziness. We try to stay the course, be very consistent and not get carried away, one way or the other.”

In recent conversations with several competitors, Sam Philbrick, president at U.S. Bank Asset Based Finance, finds the consensus to be that they are all feeling better about the level of activity but not feeling better about how much revenue they are generating from those opportunities. “We are all growing assets to varying degrees, but it is a huge challenge to get the loan revenue commensurate with that growth. The result is a continued focus to deepen relationships with other products to drive sufficient revenue growth.”

New Money Opportunities

“If you look at the mix of our new business year to date, it is about 50/50 change of control and refinancings,” reports Sharkey. “There are always buyouts that are more asset-driven, however most change-of-control transactions are done as cash-flow deals these days. Refinancings and recaps are still very challenging when competing with the regional banks that do them on a non-ABL commercial basis.”

“There seems to be improved M&A activity with an uptick in sponsor sales of companies, but a lot of the activity is in non-ABL sectors,” underscores Philbrick. “An important factor in terms of the ABL products utilization in M&A activity is the aggressiveness of the leveraged cash-flow market. That market seems very close to their market highs in terms of the leverage they are willing to provide. When the cash-flow market becomes that frothy, it tends to dampen the role that ABL plays in the M&A market.”
“Although refinancing/amend-and-extend facilities continue to dominate reported loan volume, we have seen our share of M&A transactions, particularly within the retail and distribution sectors,” notes Nemia. “ABL industry volume within these sectors will exceed $10 billion in 2014, with M&A accounting for approximately 40% of the total estimated volume.”

“For M&A transactions, buyers have to go through a courtship or auction process,” explains Muller-Girard. “Hand in hand with bidding on a business, buyers will seek financing proposals. Oftentimes the pitch process is very competitive with multiple lenders pitching and negotiating deal terms prior to the buyer selecting a lead lender. So, it takes a long time for M&A deals to work through the pipeline. We expect that many of these opportunities are going to come to fruition, but we are still early in the life cycle of this pickup in M&A activity.”

“While an increase in M&A would likely boost the overall leveraged lending business, it may not have as much of an impact on the ABL market,” counters McCarrick. “For the past few years, lending has been heavily weighted toward refinancing, as issuers pushed out maturities and reduced spreads on existing credits. There have been fewer new loan assets, which was consistent with 2013 and within the broader leveraged loan market. This refinancing bias in the market is expected to extend into next year, at which point we’re looking forward to seeing more new-money deals.”

“Today when we see an opportunity to refinance a transaction, it usually comes with another event-driven client need,” says Muller-Girard. “This might include expanding geographically, opening new warehouses, doing a tuck-in acquisition or returning capital to shareholders. With our existing clients, these events provide opportunities to grow with them as their needs change. When a company engages in event-driven financing, it often seeks proposals from a number of different lenders, so this creates potential for us to add new clients.”

Stretch or Hold the Line?

“Winning goes beyond a competitive structure,” declares Nemia. “Although the ABL market is extremely competitive, there still remains a discipline to asset valuation, advance rates based on historical trends and risk-based pricing which is determined by the market. Today’s borrowers are more sophisticated. They understand pricing dynamics, but they also have been witness to the unprecedented financial meltdown that occurred less than five years ago. They are looking for banking partners with a strong balance sheet. Borrowers take great comfort in a bank with a solid reputation that will remain ‘open for business’ throughout the economic cycle.”

“It is rare to see a deal that doesn’t include some sort of structural accommodation to give a strong company an additional reason to change banks,” adds Philbrick. “That may mean liberal advance rates on current asset collateral or increased reliance on fixed assets as part of the overall deal. We try to put structures in place that service the needs of the client over the long term, no matter what economic conditions lay ahead.”

Gone are the days when ABL lenders look exclusively at accounts receivable and inventory as the asset classes they lend against. “Depending on the client need, we also look at equipment, machinery and real estate,” states Muller-Girard. “These assets might be included in the borrowing base or in a term loan component. We look at tailoring solutions to the unique needs of each individual client, which may include stretch components to an ABL structure or providing a combination of financing tools, which might include ABL, leasing, term loans or other solutions.”

“The presence of new market entrants, large investment banks and more traditional ABL bank arrangers will continue to put pressure on price and structure,” stresses McCarrick. “However, even in this intensely competitive lending environment, not all transactions are candidates for a stretch structure. Stretch structures are typically provided to stable, well-established businesses that have a specific need for more availability and also have good overall collateral support.”

“We are willing to stretch outside of our standard working capital-based ABL structure for a client who requires additional support for a specific need such as an acquisition,” relates Philbrick. “A significant long-term stretch component is made based on the customer’s future earnings potential, and really crosses from a traditional working capital liquidity-based ABL to a cash-flow underwritten financing.”

“Another aspect of stretching depends on what size client you are looking at,” suggests Muller-Girard. “The larger ABL borrowers and financial sponsor ABL deals have the advantage of springing financial covenants. It is typically a fixed charge coverage ratio, and instead of measuring it at all times or on a quarterly basis, the covenant is measured only if the borrower’s availability falls under a certain threshold. It gives borrowers a tremendous amount of financial flexibility. They don’t have a debt-to-EBIDTA covenant — which can be difficult for borrowers to manage in a downturn or if they are highly cyclical — and they can avoid having to manage a fixed-charge coverage covenant.”

“There are no cookie cutter deals,” finishes Sharkey. “We try to listen very carefully to what a prospect is looking for and try to find a way to be as creative as possible in providing for those needs. Pricing is always a guess, but it is coming down to how creative you can get on the structure, because pricing is about as thin as it can get. This is where the talent of our people comes into play. We have built a very high-quality lending staff so that we can be creative and walk as fine a line as possible on the credit side. We need to use them and trust that we have the ability to manage the risk.”

Regulation Isn’t for Everyone

Most agree that the advent of increased regulation has leveled the playing field, but does it give a competitive edge to non-bank and alternative lenders? “Large banks continue to dominate the ABL market that we compete in, so we really don’t see the non-banks as a major threat — as it relates to lending — at the present time,” proclaims Nemia. “Given the difference in the cost of capital between banks and non-banks, large well-rated ABL revolving lines of credit do not provide attractive yields for the non-bank lenders.”

“We’ve always been a regulated industry, and we continue to stay focused on 100% compliance,” remarks Philbrick. “Non-banks and alternative lenders don’t have those same requirements.”

“In the ABL space, there haven’t been many unregulated participants coming into the middle market, so operating in a more regulated arena is not a competitive restraint for us,” mentions McCarrick. “Unregulated lenders tend to focus on smaller deals, where we are much less active.”

“The OCC recently came out with new guidelines, and they need to be fully understood,” cautions Sharkey. “The Commercial Finance Association (CFA) is trying to interpret those guidelines and will go back to lobby some of the points, but time is going to put some of the issues into context. Overall from a regulatory perspective, I think it boils down to how much shelf space the banks have for doing classified loans and to what extent the banks are pressured not to do riskier credits. This presents opportunities to the non-bank alternative lenders and the finance companies.”

“There can be real benefits for a borrower who works with a bank ABL shop, such as our ability to provide the commercial payment solution to help with their collections and disbursements or other services that intertwine closely with the ABL product,” says Muller-Girard. “As deposit-gathering institutions, bank ABL shops are frequently able to provide borrowers with more attractive pricing than non-bank ABL shops. But there is definitely a place in the market for non-bank ABL shops. Borrowers need to look at the pros and cons of each to determine what best meets their needs.”

The Advent of Rising Rates

“Given the Fed’s continued monetary policy and improvement in activity in the economy, I would expect some upward pressure on rates in 2015,” ventures Philbrick. “How much and the timing of it is obviously unknown. Even with a moderate increase in interest rates, overall rates will still be pretty low by historical standards. So I don’t think there will be a significant impact on a company’s willingness to borrow. In fact, if rates start to tick up, and people view that as the beginning of a trend, they might consider increasing their investment in their business before rates go higher.”

“It’s hard to tell when we will be in a rising interest environment,” admits McCarrick. “Rising rates can have an impact on a borrower’s ability to service their debt. However, if inflation is driving rising interest rates, then some of that impact will be offset by higher prices and therefore borrower revenues. With respect to the impact on our lending business, GE Capital is positioned to compete effectively and support the market in all different types of interest rate environments. If rising rates are driven by higher GDP growth, then we can expect to see a more robust transaction environment with more demand for growth capital.”

“Given that interest rates are a combination of LIBOR or prime plus the spread, I think borrowers will continue to see attractive overall pricing, even if rates rise in 2015,” assures Muller-Girard. “As long as we have the supply and demand imbalance, we will have spreads that are relatively low. The result is an overall rate for borrowers that is manageable and comfortable. How it affects us as a lender depends on how much rates go up.”

“Given that the big banks — and this now includes us — run their loan portfolios largely through free deposits, a rise in interest rates will fall to our bottom line,” emphasizes Sharkey. “As rates go up, we will be more profitable, and it will make our customers less profitable. To the extent that we have highly leveraged deals with floating rate debt, higher rates will have an impact on the number of turnarounds and troubled situations we see. I think that will stress our portfolios, but it will create a better ABL environment as rates go up.”

Net Interest Margin

For Q2/14, the FDIC noted the average net interest margin of 3.15% was the lowest since Q3/89 as declining asset yields outpace the decline in cost of funds. Does this bode well for ABL business volume?

“Unless there is a market disruption or dislocation, given the amount of supply among lenders looking to deploy capital and the competition that surrounds that, I think spreads will remain relatively low for ABL clients,” projects Muller-Girard. “There is a limit to how low you can go, and lenders will need to differentiate themselves in different ways. Individual banks will have to decide how much they are prepared to stretch, or not stretch, given the competitive environment, the strength of the economy and the strength of their clients and prospects.”

“In the years right after the financial crisis, many companies had to replace cash-flow facilities with ABLs, as ABLs provide lenders with a solid return at a good risk,” recalls McCarrick. “Interestingly, even though many of those companies regained their financial footing and now qualify for cash-flow loans, they are choosing to keep their ABLs in place due to lower costs and because ABLs don’t include covenants usually associated with cash-flow loans. All in all, ABLs have become an increasingly desirable alternative and more players have been getting into the ABL market over the past couple of years.”

“To the extent that we have costs of funds that allow it, we all try to meet the market,” notes Sharkey. “As rates compress, you still have as much liquidity in the market, because the non-bank lenders will have to seek higher yields and therefore take more risk. There is ample liquidity in the market, so as the competition heats up and the spreads fall, it forces certain types of players into certain areas of the market as they seek yield to satisfy their return requirement. It pushes the alternative lenders to take more risk, and it depresses our margin. But we are seeing it level off, and it doesn’t affect us anymore than it has in the past.”

“As long as the economy continues to improve and there remains ample liquidity, margin compression will be a challenge for all of us,” states Nemia. “This new reality will require lenders to become more efficient to drive productivity. Lenders will need to leverage technology to improve speed to market and look closely at their processes to ensure continuous improvements in the way they do business.”

“As our portfolio is re-priced to the current market and we book new opportunities, there is no question that it puts real pressure on the profitability of our business,” laments Philbrick. “We therefore continue to be very diligent in managing the expenses of our business and focus on increasing our bank’s share of wallet with clients through our relationship-based approach. Within the context of the revenue from our product, one of the key levers that all of our competitors have used is to increase hold sizes. By increasing the average commitment size per relationship, we have all offset, to a significant degree, the revenue-per-relationship pressure caused by the decline in spread.”

Improved Utilization

The CFA recently noted that small- and mid-size businesses in the U.S. used more of their available credit in Q2/14 than during any other time in five years. “When times were booming, companies had very large lines of credit, and when the downturn hit, a lot of those lines didn’t get reduced,” proposes Sharkey. “That caused utilization rates to drop substantially, because the lines were not right-sized for the market. As we continued to turn the ABL portfolio globally, those deals have been redone at proper line limits, so you naturally see a higher percentage of lines being used. As far as I can figure it out, the only reason utilization rates are going up is because lines are going down — not because borrowings are going up.”

“In the last 60 days, I sense that there is some improvement in the overall economic activity and that it translates into improved utilization,” says Philbrick. “We usually get a seasonal uptick in utilization at this time of year anyway, as people build inventory to go into the prime selling season at the end of the year, especially in retail. But it seems, over and above that, that there is some improvement in utilization.”

“I see varying levels of utilization depending on the size of the client, their asset mix and their access to the capital market,” informs Muller-Girard. “The smaller borrowers, who are utilizing only an ABL revolver, are often utilizing that facility heavily. For many of the smaller borrowers, that is their primary source of capital. The larger borrowers and the financial sponsor borrowers have more financing options, so they may be using leases, different capital market solutions or institutional term loans. Many of those borrowers will use those sources of capital and reserve their ABL facility for excess liquidity if they have a significant swing in their working capital needs.”

McCarrick reports that overall revolver borrowings have not increased significantly in the second quarter across GE Capital’s portfolio. “Increased borrowings tend to be company-specific and driven by factors like growth, M&A and performance-driven issues.”

Outlook for 2015

Even with 2014 conditions holding fairly steady, our panelists feel optimistic about the year ahead. “We are certainly growing assets, and we are on plan as to our expectations for loan growth,” confirms Philbrick. “It is growing the loan-based revenues that continues to be a challenge with the continued pressure on pricing. Our bank continues to invest in products that complement our ABL product, and that bodes well for our long-term revenue growth opportunity.”

“We’re finding clients and prospective clients are very receptive to learning more about our ABL capabilities,” encourages Muller-Girard. “We also find that clients and prospective clients value our emphasis on learning about their business needs and suggesting solutions tailored to those needs, as well as our ability to bring all of the banks’ services to them.”

“Earning assets are up, however overall transactional activity is down,” describes McCarrick. “Credit quality continues to be very strong, so our business is doing quite well, despite the less-than-robust new business environment.”

“We are ahead of budget on profit, and we are on budget from a growth perspective,” declares Sharkey. “As a merged company, our volume of new business activity has been consistent with past years, which is surprising, given that we were a lame duck when Cole Taylor was for sale. To me, that is an indication that the market sees the value in the merger and isn’t scared away by it.”

“The economy should pick up in terms of its overall growth rates; I think most of us feel that way,” predicts Philbrick. “We also believe that interest rates will finally begin to rise in 2015 and that there will continue to be strong competition in the market. I think 2015 is going to be another good year of asset quality, which is something our industry has enjoyed for the last couple of years. So overall, I feel that next year will be better in terms of solid activity, continued strong credit quality, with some stabilization in market pricing.”

When asked what keeps him awake at night, Nemia replied, “I don’t get much sleep.” He cites the challenges of an increasingly competitive market, competition for good talent coming from both banks and non-banks, M&A activity, a low interest rate environment and adapting to increased regulations and compliance.

Muller-Girard has similar concerns. “There is a fine line that ABL lenders need to manage to, in terms of how competitive they are prepared to be in this environment. There is a point when an ABL structure crosses a line and really becomes a cash-flow structure. Given the amount of competition, I worry that some clients and prospects will be steered into cash-flow loans when they would be better served by an ABL loan.”

“Strong growth and revenue performance among middle market corporations has made executives running these companies feel more confident,” asserts McCarrick. “We expect this confidence will lead to additional growth-related investing with correspondingly more financing requirements. We expect this to continue well into 2015.”

“We have a lot of plans,” announces Sharkey. “The merger is done, and we are focused on the business. We are going through the strategic planning process to win support for new initiatives. We are focused on further expansion and some new products. We are going to do our own thing to take steps that will make us better, stronger and larger on our own. We are positive and excited about the future.”

“We feel good about the future,” concurs Muller-Girard. “We continue to invest in new employees and are looking to bring on additional business origination people. We wouldn’t make that investment, if we didn’t think there was a lot of opportunity for growth.

Lisa A. Miller is a regular ABF Journal contributor who has worked in the commercial finance industry for more than 15 years.