Hugh Larratt-Smith, Managing Director, Trimingham

Thanks to a glut of dry powder in the market over the last two years, competition in the asset-based lending industry has been fierce, leading to aggressive action by many lenders. But with challenges piling up thanks to supply chain disruption, labor shortages, increasing interest rates and rising inflation, some lenders may be in for a rude awakening in 2022. Let’s dive into the trends of the last 12 months and look ahead to next year.

The SPAC Bubble

One harbinger of the liquidity and hunt for yield in today’s financial marketplace are blank-check firms known as special purpose acquisition companies (SPACs), which have surged in popularity lately.

SPAC deals have emerged as alternatives to traditional initial public offerings for startups in part because companies merging with SPACs can make business projections that wouldn’t be allowed in IPOs. SPACs have raised a record of approximately $140 billion this year, according to Dealogic. Issuance slowed this summer but rose to about $10 billion in October, the highest level since March’s record total of roughly $36 billion. As of writing, there were 329 new SPACs so far this year, up from 248 in 2020 and 59 in 2019.

Gary Gensler, chairman of the SEC, has questioned whether the SPAC structure appropriately protects small investors who have piled into the recent trading frenzy around blank-check firms. In recent testimony to U.S. Congress, Gensler opined neophyte investors might not understand the risks of trading SPAC shares, including the potential for dilution.

Adding fuel to the fire, there are an estimated 7,000 private equity firms in the United States, according to data from Prequin, many of which are using SPACs to create liquidity events for their portfolio companies.

How has this abundant liquidity affected the asset-based lending marketplace?

“2021 was a challenging year for our industry. Because of the overall slowing down of the economy, we saw banks hold onto loans that limited deal flow. Like a domino effect, lenders dropped prices to secure business and became creative to gain partners,” Jennifer Palmer, CEO of Gerber Finance, says. “We know as an industry we are very resilient and resourceful when it comes to finding new ways to achieve growth. At Gerber, in addition to supporting all our partners at this challenging time, we leaned into our natural products and food business, which is growing exponentially. As a woman-run company, we attract numerous women-owned companies seeking a partner who understands these owners’ obstacles and opportunities.

“Given that 2021 was such a challenging year, many in our industry took deals that they might not typically take, and I am concerned that some ABL firms will regret the agreements they made. Another ongoing topic of concern is the relentless supply chain issues. At the beginning of the pandemic, lenders were able to support companies trying to secure materials and supply needed products. However, many companies are struggling, as the supply chain issues have lingered and gotten worse and the cost of goods has increased, substantially reducing margins. As the online purchasing and [direct-to-consumer] landscape grew sharply during the pandemic, we saw more finance companies offering e-commerce lending. This trend is here to stay and represents a significant opportunity for our industry.”

Inventory Lending

Prior to the 1980s, most lower middle-market companies had no meaningful computing power, therefore poor inventory management was a leading cause of corporate deterioration and loan workouts. With computerization, companies became more proficient with working capital management and inventory problems became less frequent. The current supply chain problems have triggered inventory mis-balancing for many companies, possibly leading to an “inventory recession” in some sectors of the economy. Many companies will have a surfeit of goods for sale, while others, like consumer products companies, may miss the crucial holiday season.

“Everyone thought after 2020 we would have a recovery in 2021,” Michael Haddad, president of capital finance at Sterling National Bank, says. “We didn’t — 2021 was a “delta” — variant that is. We came to a big bump. Lenders responded by doing deals they wouldn’t do in normal times.”

Yes, many asset-based lenders are aggressively lending against inventory, with some loans collateralized solely by inventory. This is a major departure from legacy ABL practices. Many middle-market U.S. companies cannot obtain financing for inventory until it lands in the United States. Financing goods in transit has always been tricky, particularly since retailers and consumer products companies typically agree on prices anywhere from six months to a year in advance. Many companies are now scrambling to renegotiate prices with retailers. In some instances, the manufacturers will guarantee the gross margins to the retailer. How do you lend against inventory that is on the water and may be subject to significant pricing disputes? A crucial financial issue for companies in 2022 will continue to be optimizing inventory management to avoid over-advances triggered by creeping ineligibles.

Supply (Chain) Disruption

“This past year was challenging for non-bank asset-based lenders in terms of new loan growth,” Scott Winicour, CEO of Gibraltar Business Capital, says. “Many, Gibraltar included, had a strong 2020 with high expectations for 2021’s growth potential. Pre-pandemic, the supply of capital was abundant. The massive economic stimulus packages provided to lower middle-market borrowers, coupled with pullback in government regulations, allowed banks to be more aggressive with new business and loan retention. Now, more than 18 months into the pandemic, the supply of capital remains at all-time highs. These circumstances have created unique challenges for non-bank asset-based lenders.”

“2021 was a year of pandemic recovery, with companies recalibrating to the rebounding new world,” Lori Potter, managing director of originations at Great Rock Capital, says. “Some negative impact to the economy was reduced due to the abundance of government programs that masked quite a bit of ‘core’ corporate stress, as well as commercial banks continuing to be flexible and patient with their borrowers. As these programs expire and banks tighten up from a risk management perspective, liquidity from alternative lenders will likely be in high demand throughout 2022. Companies with less leverage, supportive owners, contingency plans, solid market share, a reason to exist and risk awareness will be successful; 2022 will be about survival of the fittest.”

“The residual effects of supply chain and labor shortages continued to be underestimated throughout 2021,” Kathy Auda, chief risk officer at Great Rock Capital, says. “The shifts in consumer behavior as well as macro supply factors have resulted in higher costs, labor challenges and significant delays in receipt of key manufacturing components. This was a real wake-up call to understanding operational risks. Companies across a multitude of industries were caught flat-footed given labor and supply shortages, with no tangible contingency plans in place. As we enter 2022, the pendulum may swing too far the other direction, as demand-surge hiring and stockpiling of core resources may result in excess capacity and costs, especially if inflationary pressures dampen some consumer and business demand.”

“There is currently a major labor shortage at every level in the economy. This prevents things from returning to ‘normal,’ challenges how leanly businesses can operate without compromising service or quality and makes the prospect of a more robust supply chain look increasingly grim,” Meredith Carter, president and CEO of Context Business Lending, says. “I think the biggest challenges facing businesses in 2022 will be attracting and retaining a skilled workforce.”

Pressure of Inflation

“The elephant in the room is inflation,” George Psomas, managing director of BHC Funds, says. “Most investors, lenders, bankers and advisors have not operated in an inflationary environment that hasn’t been seen [since] the 1970s. For most, up until recently, it was just a history lesson discussed at business school; now it’s real.”

A pressing question for underwriters is how to bridge EBITDA from pre-COVID-19 2019 financials to 2022 and 2023 in the face of inflation. How do you determine “core EBITDA” and what factors do you use to sensitize projections?

“We have seen a bounce-back of ABL opportunities which began in late 2020,” Jeremy Harrison, who is based in London and Amsterdam and is head of sales and origination at ABN AMRO Commercial Finance, says. “We are seeing growth in all areas we cover, from mid-market to corporate, including a mixture of M&A and refinancings. M&A remains buoyant, and I believe this is a growing area asset-based lenders now feature more as an option to companies and their advisors. This is, in part, due to advisors obtaining collateral due diligence at an early stage, meaning the challenges of the due diligence required is becoming less of a contention. We have also seen leverage or cash flow structures convert to ABL, thus being more flexible and covenant lite. This is something we have been predicting for a number of years. ESG and sustainability are also a core requirement from both clients and advisors, and this has been a trend that has gained momentum over the last couple of years.”

Shipping Concerns

The COVID-19 pandemic has brought the biggest disruption to the container shipping industry since its inception some 65 years ago. Under normal circumstances, a container will go from a factory in Shanghai to Chicago in 35 days. Now it takes up to 78 days and then the same container often returns empty.

“We are currently in a unique circumstance wherein we are experiencing broad-based declines in availability across several sectors in the logistics industry,” Vincent Belcastro, group head of syndications at Element Fleet Management, says. “In addition to the shortage of container vessels, the industry is equally plagued with a shortage of the actual containers themselves that hold the cargo. This is largely due to a slowdown of manufacturing in China as a result of the pandemic and a decreased labor supply, both in the manufacture of these assets as well as steel mills that make the raw materials. This country – China – which is driven primarily by demand in the [United Staes] is experiencing historic shortages in goods that aid transportation of goods such as Class 8 trucks, over-the-road trailers and, certainly, light-duty commercial and passenger vehicles driven by the chip shortage. The trucking industry has experienced labor shortages for the last several years, and now demand for logistics is at an all-time high with not enough equipment or drivers to address the issue. While no one can be sure when this constraint problem will ease, it is clear that supply chain and procurement managers must think about alternative on-shore solutions to hedge against the risk of operating in an import-driven economy.”

The pandemic has highlighted how U.S. ports are in desperate need of investment. Now another shortage is occupying the industry’s attention: that of the ships themselves. Many companies have hesitated until this year to order new capacity, while many old ships are overdue for scrapping, meaning there is a potential risk of pressure on supply in terms of vessels three, four and five years out.

Restructuring Review

“For many restructuring professionals, 2021 has been slower than they anticipated,” Frederick Hyman of Crowell & Moring, says. “Continued monetary and other support from the federal government, together with seemingly unending liquidity from private lenders and a further decline in interest rates, have hidden many problem areas in the leveraged markets. Additionally, many lenders have been hesitant to exercise remedies or otherwise take actions that might lead to a borrower’s bankruptcy during a period when their collateral may be valued at its low point. The general economic recovery in 2022 may ironically correspond with an uptick in restructuring work as governmental support programs cease, inflation and supply chain problems continue and lenders begin to explore their options with respect to those borrowers whose business[es] will not recover.”

Prepping for 2022

“While 2021 was extremely difficult, I remain optimistic about our industry’s future,” Palmer says. “We are a resilient and resourceful industry and need to continue to shift how we do business, not just to adapt, but [to] thrive in 2022.”

“With rising interest rates, I am hopeful we will once again see increases in borrowing requests for non-bank asset-based lenders,” Winicour says. “And we’ve experienced a recent uptick in new borrowing request activity, which is a great sign. Still, I remain concerned about the credit quality of the prospective borrowers given these macroeconomic pressures and the uncertainty of their duration. I also expect 2022 will continue to be a borrower’s market, making it challenging and hyper-competitive as well-capitalized, non-bank ABL players, such as Gibraltar, compete for growth.”

“U.S. retail consumers are said to [be] in the best financial shape of the last 40 to 50 years in terms of their fixed obligation ratios,” Carter says. “As a result, Context expects that e-commerce will continue to skyrocket in 2022. This will create a great opportunity for lenders to provide working capital to e-commerce companies to meet consumer demand and, in some cases, provide growth capital needed [to] repatriate manufacturing to overcome overseas supply chain issues.”

“Supply chain issues will continue to pressure borrowers into 2022, driving the need for additional and more complex inventory financing,” Robert Grbic, president of White Oak Commercial Finance, says. “Rising inflation rates, fueled by supply issues, rising energy and increasing labor costs, will be one of the dominant factors in 2022 which will present challenges and opportunities for ABL lenders. As we move into the new year, we are all hopeful that the pandemic will be greatly mitigated, allowing a return to a level of predictability and normalcy we have not seen since January 2020.”

On a final sobering note, some lenders see some clouds on the horizon, including:

  • Heightened fraud risk as Paycheck Protection Program loans face the inflection point of maturing or converting into equity
  • Intensification of economic and political friction between the United States and China
  • Uncertainty about when the banking regulatory environment will “return to normal”
  • Weakened “loan workout bench strength” as the baby boomer generation of workout lenders and professionals retire

“As Johnny Cash sang, ‘the train is coming.’ In this case, the train is loaded with a ton of bad loans that will default in 2022 and 2023,” Haddad says. “The sunny side of this street while this train is passing by will be growth for non-regulated lenders as banks have to ‘take their medicine’ for being aggressive.”

Hugh Larratt-Smith is a managing director of Trimingham and a regular contributor to ABF Journal.