The ABL Landscape: Hyper Markets and the Manufacturing Economy
November 13, 2013
By: Marc Adelson
These days, you can’t read an industry publication without coming across an article that comments on how competitive the markets are and laments the increasing number of bank and nonbank entrants into the commercial finance space.
Without giving away my age, it was less than 15 years ago when the mid- to large-cap asset-based lending was dominated by only a handful of bank and nonbank finance companies. Nonbank financial institutions, such as my former employers Heller Financial and CIT Group, had little difficulty raising capital through the commercial paper markets with funding costs rivaling deposit taking banks. GE Capital had some of the lowest cost of funds in our industry and a balance sheet that allowed it to take enormous hold positions — sometimes well over $500 million in a single credit. Banks were just beginning to ramp up their syndication desks and weren’t burdened by the capital adequacy pressures of soon-to-be fully implemented Basel III or any limitations that would arise out of Dodd-Frank.
Most banks ceded the small-cap ABL markets (deal size of $15 million and below) to privately held finance companies. These companies were staffed with ABL veterans who understood collateral, knew how to liquidate companies and weren’t afraid to do so. These companies also maintained strict account management techniques that relied on a daily detailed understanding of a company’s collateral position, value and liquidity. The large institutions weren’t equipped (nor were they inclined) to pursue this space. They understood the risks involved and the investment in time required simply didn’t justify income earned. There were also well aware of their serious organizational and structural limitations.
Two Worlds in Asset-Based Lending
Then, as now, there were two worlds in asset-based lending. Mid- to large-cap ABL deals were structured and underwritten with a focus on a company’s distressed enterprise value and whether or not it could survive a bankruptcy filing. The small-cap ABL loans were underwritten and managed on purely a collateral focus with detailed account management.
During the last 15 years, the mid to large-cap space experienced very little activity in liquidating companies/assets. At the same time, many of the industry veterans who worked for larger financial institutions and possessed this collateral valuation/liquidation skill set, either retired or moved to privately held, entrepreneurial finance companies, which to this day continue to chase higher yields at the expense of taking on more liquidation risk.
These changing market dynamics and the newly emerged asset-based lending landscape have led to two trends:
The current hyper markets in the small- to mid-cap space are being driven largely by community and regional financial institutions that have an insatiable desire to get their deposits working for spread income. With the real estate refinancing markets cooling down, there’s no other place for these institutions to invest their funds so the diverse industry segments that ABL supports is ground zero to go after.
While the transformation may be a trickle today, seeds are being sown to reintroduce manufacturing back into the U.S. Not only will this be great for the economy and for employment, but it will increase the lending risk to small- and mid-cap space. This is a market that requires “old school” asset-based lending expertise and is a significant opportunity for those who still possess it. For traditional banks that now offer ABL facilities, lending risks will increase measurably without having the proper controls or oversight that a leveraged transaction in the manufacturing space requires. Therefore, the rebirth of U.S. manufacturing will separate the experienced professionals from the opportunists.
Let’s break down the two issues further: the small- to mid-cap space utilizing ABL products is being presented with an unprecedented amount of liquidity. Rates and structures are being aggressively pitched. While Basel III will eventually have a dampening effect on how these financial institutions deploy their assets, my fear is that borrowers can’t ignore the lower pricing and aggressive structures being offered and will be adversely impacted quickly when financial institutions are given the order to cease and desist. Such good companies that have operational issues or are being impacted by a weak economy may not have time to refinance quickly and may be left high and dry when (not if) these lenders exit.
Given that many of these deals are being structured with more of an emphasis on financial performance (hence financial covenants) rather than liquidity and collateral values, traditional banks will certainly over react. Without having the deep experience necessary to work through rough patches, knowing that you’re comforted by the ability to recover most if not all of your loans through collateral liquidations, most of these financial institutions will likely end up acting hastily. Additionally, regardless of the experience level at these smaller financial institutions, regulatory pressures that will come with diluted risk ratings to increase capital adequacy ratios that will hasten the decision to exit. This will obviously benefit those with the capital and ability to enter the markets at that time to take advantage of these opportunities. However, much time and capital will be lost as a result. More importantly, borrowers could be irreparably damaged by not having a patient and experienced lender who is willing to work through their own issues and economic bumps in the road.
Resurgence in U.S. Manufacturing
U.S. manufacturing is increasing. Recently Wal-Mart committed to purchasing $50 billion more in U.S. produced goods over the next ten years. Companies are moving some of their manufacturing back to the U.S. not only to take advantage of Wal-Mart’s commitment but to gain more control over the quality of manufacturing process, reduce logistic costs and ship times. For example, General Motors recently announced a $200 million metal-stamping plant in Arlington, TX, which will save the company $40 million a year in shipping costs.
Rich in physical assets, asset-based loans become an ideal financing solution for U.S.-based manufacturers. However, asset-based lending to manufacturers presents unique challenges depending on how deep into the assets one is willing to lend. While I believe that many of these companies will be backed by private equity, giving new manufacturers’ capital to get started, asset-based lenders will be asked to lend on assets and platforms in industries that have not been financed in the U.S. for decades. Having an experienced lender on staff who understands many different industries, who quickly recognizes underperformance and who knows how to work with an asset valuation firm will be vital to keeping financial institutions out of harm’s way and will increase the likelihood of making well-structured loans to well deserving companies that produce desirable yields.
As our economy moves in the direction of being a producer not merely a consumer of goods, asset-based loans will be vital in assisting in this process. These loans will need to be structured with creative covenants that benchmark performance differently than today’s typical suite of financial covenants. Additionally, lending risks will increase exponentially from the typical working capital revolvers we see today. As an industry, we must start to train our staffs on “old school” lending in order to take advantage and thrive in this potentially new-producing economy.
For collateral-focused asset-based lenders, my message is to be patient and to continue to educate prospects on the value that a true ABL brings to the table … a lender that will ultimately be their partner for years to come and will understand of the peaks and valleys of their business. Traditional ABL lenders must also keep an eye on the emerging U.S. manufacturing market and understand the opportunity it presents.
Companies in need of funding should understand that rate is not everything and they lose enterprise value by getting in bed with a lender who ultimately may not be in control over credit policy as dictated by the Fed. Traditional banks are neither trained nor equipped to be collateral asset-based lending experts and the minimal cost savings that borrowers may achieve by signing on at a lower rate will be washed away when the bank dissolves the relationship when the going gets tough. In the end, experience matters when it comes to ABL lenders.