President Harry Truman took the mantel of the presidency in a post-WWII world that was filled with threats and uncertainty. To his critics, he was a small-town boy not up to the task. One of his strengths was his ability to harness the lessons of history. When he was tackling the thorny problems of an aggressive USSR, The Marshall Plan and the postwar chaos in Asia, he always would start the briefing sessions by saying “to understand today’s problems, we have to understand the lessons of history.”
In today’s world of superpowers vying for their place on the world stage amidst the rhetoric of the trade war, it is important to look back in history.
Leading up to the 1800s, China was a global trading superpower. However, the demand for Chinese luxury goods — particularly silk, porcelain, and tea — created a massive trade imbalance between China and Britain from 1800 onwards. To counter this imbalance, the British East India Company began to grow opium in present-day Bangladesh and allowed private British merchants to smuggle it into China illegally. The massive influx of narcotics reversed the Chinese trade surplus, drained the Chinese economy of silver and gold, and vastly increased the numbers of opium addicts in China.
In 1839, the Chinese government rejected British proposals to legalize and tax opium, and tried to halt the opium trade completely. The British government responded by dispatching a military force to China and in the ensuing conflict, used its naval and gunnery power to inflict a series of decisive defeats on the Chinese Empire, a tactic later referred to as “gunboat diplomacy”. In 1842, the Qing dynasty was forced to sign the Treaty of Nanking, the first of what the Chinese later called the “Unequal Treaties”, which ceded Hong Kong to the British Empire and Macau to Portugal. In the Second Opium War of 1860, the British looted and burned the massive Summer Palace, which was a national treasure in China. This was the start of China’s “Century of Humiliation.”
By opening the economy to capitalism in the 1980’s, China recognized that it needed to unleash the “animal spirits” of capitalism to regain its place as a global superpower and put an end to The Century of Humiliation. The current trade war is China’s way of saying “we’re back…and no one is going to stand in our way!”
Year of the Trade War
The trade war has been the headline of the year. How has it affected lenders in 2019? For starters, CAPEX has decreased as CFOs tapped the brakes. The freight and manufacturing sectors are facing recession. Several leading banks have exited the equipment financing sector as loan demand softened during the year. The Architectural Billing Index, a bell-weather of commercial construction, has slipped into negative territory. Some New York City banks have stopped issuing commitments for new commercial construction. Added to this — speculation and concern about where we are in the credit cycle.
Robert Grbic, president, White Oak Commercial Finance in New York shares his perspective: “Uncertainty in the global trade markets combined with the hanging possibility of a U.S. recession have created opportunities for non-bank ABL lenders like White Oak. We value a deep understanding of a borrower’s business model which enables us to create flexible structures to allow for market changes. Market volatility allows for lenders to provide working capital to manage through transitions and to capitalize on potential growth.”
Lori Potter, managing director of Originations from Great Rock Capital adds, “We are seeing the impact of the Chinese tariffs on middle market companies in a vast array of industries including agriculture, manufacturing, and consumer products. Companies have either absorbed the price impact as they search for alternative manufacturing sources in other Southeast Asian countries such as Vietnam and Thailand, while others have passed the cost increases on to the customer. In both scenarios, the margins and liquidity profile of a company can change suddenly. As a non-bank lender, we have the ability to help companies execute on their business plans and transition with the changing market by structuring a tailored asset-based solution that will maximize liquidity and provide growth capital.”
At the larger end of the ABL marketplace, “TD saw several new users in the market to leverage the structure and price advantages of the ABL products,” says Jeffery Wacker, head of U.S. Business Development, Asset Based Lending at TD Bank.“ For example, the Metals and Energy sectors continued to be more active users of ABL financing in 2018 and 2019. Middle market and large corporations were able to utilize the product for greater working capital. We also saw several large $1 billion deals and a significant number of $250 million financings as the market continues to bifurcate between larger and smaller facility sizes.”
Loan Market Still Hot
The syndicated leveraged loan market continued to be hot in 2019. Rick Hyman, partner, Duane Morris in New York says, “One sign that deal sponsors continued to keep the upper hand over lenders was the proliferation of ‘Black Lists’ in syndications. A Black List prohibits lenders from assigning their loans to any party of the Black List. Many syndicated loan participants traditionally have sold their loan at the first sign of trouble. Some Black Lists are so extensive that lenders are effectively frozen into the original syndicate and have nowhere to sell their exposure.”
“There was no shortage of bankruptcies and restructurings within the retail sector and few were a surprise, given the record number of store closings by brick-and-mortar retailers,” notes Wacker. “Companies with levered balance sheets, out of favor product offerings or far too many stores found it hard to compete, given the continued shift in consumer buying patterns. Fortunately, it was a proof-point that well-structured and closely monitored borrowing relationships did not lead to credit losses for asset-based lenders.”
With the surge in leveraged financings with minimal or no meaningful covenants, Hyman at Duane Morris in New York sounds a cautionary note, “Some companies will go over the edge of the cliff and leave no skid marks. The first default will be a payment default. That is not a pretty picture.” Indeed, there are borrowers with sales of $100 million and more who are running on daily availability of less than $1 million. There are other borrowers who have loan agreements so loose that sponsors can transfer assets through a back door, away from the secured lenders. Or worse, sell the company. The fights which will occur over who controls the fulcrum securities in the capital structures in the next recession will fascinate MBA finance students for decades to come.
Lending on Brands
For ABL players looking to differentiate themselves in highly competitive markets, lending on brands has become a key tool in the tool chest. No longer in its infancy, brands and trade names have allowed lenders to stretch on deals in order to be first past the post. The critical issue is to accurately underwrite and monitor brands that have staying power in a rapidly changing consumer products environment.
Richelle Kalnit, senior vice president, Hilco Streambank in New York notes, “As the economy slows, we find that brands become a more important component of value because they serve as the key differentiator for consumers. This was the case a decade ago, and we anticipate it will continue to be the case again. On top of that, over the last decade, companies have invested in assets that support and complement their brands, including more robust ecommerce capabilities and customer data. And during that time, buyers — including some of the world’s largest retailers and brand investors — have become more sophisticated when it comes to how they evaluate and then use those assets.”
Brands and trademarks are sometimes “boot collateral” — nice to have, but not a deal breaker. In other situations, a loan against these assets is seen as the fulcrum security on a tough balance sheet. A good brand appraisal will install guardrails on the important functions and expenditures that support brand value. Typically brand appraisers are asked to provide FMV, NOLV (net orderly liquidation value) and NFLV (net forced liquidation value). The NFLV standard most resembles a compelled sale in Chapter 11. Understanding the risks associated with different distribution channels like brick and mortar is a critical component of a good brand valuation.
When it comes to fixed assets as collateral, David Fiegel, managing director of Blackbird Asset Services in Buffalo adds, “Our window into the industrial/manufacturing sector shows accelerating weakness. Our appraisal due diligence into industries such as machine tools, manufacturing, and plastics remains positive in forecasts by the various trade groups that serve the particular sector. However, our conversations with the owners of companies in these sectors show a more real-time slowdown in orders coupled with a fear of a sector recession. Some owners blame trickle down from the trade situation with China for their declines. These are mostly smaller niche manufacturers that serve larger manufacturers, but we feel it is a good barometer for the larger manufacturing sector as a whole.”
Banks Using Workout Staff In Place of ABL
Another interesting development in the ABL market is some bank-owned ABL players are involving their bank workout staff in underperforming loans alongside or in place of ABL portfolio managers. The legacy model of asset-based lending is that the ABL portfolio managers would manage loans from cradle to grave. With several leading New York banks, underperforming asset-based loans now are actually transferred into the bank workout group.
From London, Jeremy Harrison, head of Sales UK, ABN AMRO Asset Based Finance (UK Branch) notes,“This year will be remembered for Brexit, and the uncertainty around that undoubtedly stifled loan demand in Q1/Q2 19. The turbulent economic landscape also resulted in increased insolvencies across a number of sectors. Despite this, in addition to our standard receivables funding solutions, we have completed a number of receivable purchase facilities which are attractive solutions for clients due to its ease of use to support working capital.
“Additionally, this structure can increase debt capacity through a risk transfer with off-balance sheet characteristics. We have also recently completed ABL facilities in two cross border single facilities originated from Germany and Belgium which covered multiple European geographies. These cross-border funding solutions offered multi-local and SPV facilities to businesses headquartered in UK, Germany, France and the Netherlands, thus covering the biggest ABL geographies in Europe. We also included receivables from other European countries into the structure. A recent trend is where UK Clearing Bank clients have approached us for funding for newly formed subsidiaries in the Netherlands, Germany and France registered to cope with Brexit, which provides solutions to those companies without jeopardizing their UK facilities. Going forward in 2020, I believe that ABL will become ever more important as regulation tightens around traditional bank lending.”
In London, “This year Wells Fargo Capital Finance UK supported a myriad of customers from a range of sectors — such as retail, technology and distribution to name a few,” comments Steven Chait, Managing Director, EMEA Regional Head. “Many of our customers have international aspirations, and as a customer centric bank, we acknowledge the funding needs and geopolitical complications facing them. As an international provider of ABL services, in 2020, we aim to deliver a framework of certainty during uncertain times through our reliable banking platform, which is underpinned by Wells Fargo Bank’s strong capital base.”
As the trade war with China changes course daily, one thing is clear – both leaders are determined not to back down as the U.S. and China vie for global economic leadership. U.S. companies are preparing for tensions with China to extend far beyond the current trade negotiations. A survey of 220 U.S.-China Business Council members in August 2019 showed that optimism about China is at a historic low. The survey stated that more businesses are halting their investment in the country and only a slight majority of companies expect their revenue in China to rise next year. There seems to be a realization that no matter what happens with this trade deal, America is following a trajectory of a much more confrontational relationship with China — and it’s very unlikely to shift in the opposite direction in the foreseeable future. The impact of this uncertainty on the U.S. economy is spreading, and with interest rates at historic lows, the Fed has little dry powder left in its barrel. •