During the past 12 months, some of the largest providers of cash flow lending to the middle market have announced their exit from the business. These institutions maintained entire divisions devoted to middle-market cash flow lending, but have now closed up shop. Spurred by higher than expected reserve requirements from the Office of the Comptroller of the Currency (OCC) and portfolio losses, many cash flow lenders have decided that lending to the middle market isn’t profitable. We agree that, in hindsight, the risk/return profile of middle market cash flow lending has been out of balance for years. However, we are surprised that these lenders aren’t using their current default and recovery portfolio experience to tweak their business model and make it profitable. Especially in light of bank consolidation that may lead the industry toward oligopolistic pricing, we think today is the right time to re-think the cash flow lending business model.
The Old Cash Flow Lending Model
Many cash flow lending groups share a common business model. First, they were established to service private equity groups. The theory was that private equity groups were an attractive opportunity for repeat business because they control portfolios of companies, each with their own financing needs. Thus, banks can leverage one relationship into multiple transactions. Private equity groups also represent a secondary source of capital should a transaction run into trouble. Because private equity groups manage committed funds, they have the wherewithal to inject additional capital into problem situations. Finally, private equity groups typically own a majority of the company’s equity and control the board of directors, giving them the ability to influence strategic direction, capital investments and to initiate management changes, as necessary. This provided greater comfort to lenders, as they believed that sponsors would actively monitor their portfolio companies and make operational changes if the deal faltered.
Banks also sought to cross-sell private equity clients more profitable fee-based services. Several banks hired high-priced investment banking professionals to cross-sell corporate finance products such as high-yield, merger and acquisition advisory services and fund placement services to private equity clients. Credit was viewed as a loss-leader that was necessary to attract more lucrative fee-based business.
Problems with the Model
Where does the model break down? For a number of reasons, cash flow loans weren’t as profitable as expected. One reason is that revenue from cross-selling opportunities hasn’t materialized. Private equity groups don’t typically award corporate finance business based on relationships. They award it based on technical expertise. The sale of a portfolio company is often the most important part of an investment. Private equity groups select investment bankers they believe have the most industry expertise and skill to maximize investment returns. With the lack of cross-selling revenue, lenders must rely on loan pricing alone to determine the profitability of the business.
In addition, not all private equity groups support their portfolio companies with the same level of operational and financial expertise. The amount of value private equity groups bring to board positions varies widely. For example, while the best private equity groups move decisively to augment or replace management teams, others make changes far too late. From a financial standpoint, the backing of a large private equity fund doesn’t necessarily improve the credit quality of a borrower. Savvy private equity groups support portfolio companies for sound business reasons – not to maintain friendly banking relationships. For these reasons, some private equity groups haven’t fit the business model banks thought they would.
Finally, bank pricing models, which are typically based on assumed default and recovery rates, were incorrect. As of September 30, 2001, payment default and bankruptcy rates soared to 9.7% compared with 7% in 1999 and 1% in 1998 and 1997. In a recent Wall Street Journal article, Moody’s Investors Service sited a recovery rate of $0.55 per every $1.00 of defaulted loans last year, compared with a historical average of $0.69 per $1.00. Default rates also have a significant impact on OCC ratings and corresponding reserve requirements, increasing the cost of a leveraged loan portfolio. Many bank pricing models did not anticipate these factors and, as a result, portfolio returns are significantly lower than expected.
The New Model
Clearly, it’s time to re-think, and re-price, the cash flow lending model. Even after seeing the debacle of the last 18 months, we continue to believe that cash flow lending can be a long-term, profitable business. Particularly after watching asset values erode during the last several months, we are convinced that lending, at prudent levels, to stable, well-capitalized middle market companies based upon their enterprise value, can prove rewarding for a financial institution.
However, to do this, lenders need to re-think pricing for these loans. Today, a cash flow loan priced at LIBOR + 350 bps equates to a borrowing rate of about 5.5%. It doesn’t make sense to us that, with bankruptcy rates at an all-time high, banks are lending money to leveraged, middle market companies at 5.5%. Why is this happening? Unlike private equity sponsors and mezzanine investors, banks price their loans, in part, based on their cost of funds. Over the last year, the Federal Reserve Bank has lowered the federal funds rate to 1.75%, the lowest level in 40 years. As a result, short-term borrowing rates for banks have fallen, and banks have passed on this savings to their corporate customers. Even with LIBOR floors of 300 bps, all in, leveraged loan pricing is only 6.5%-7.0%. In light of the increase in reserve requirements and higher than expected portfolio losses, we don’t believe this pricing is properly risk adjusted.
What is a fair market rate of return for middle market cash flow loans? One relevant data point is public high-yield bonds. These companies represent an interesting data point for highly leveraged loans. High yield issuers are typically larger, offer liquidity to investors and are of a higher credit quality than middle market leverage bank loans. For the year-to-date ended Oct. 31, 2001, Merrill Lynch Global Bond Index of BB-rated bonds yielded 9.1%. Assuming a premium of 1%-3% for illiquidity and a size discount, we believe the appropriate yield for middle market, highly leveraged bank loans issued today is 10%-12%.
Another interesting data point is subordinated debt pricing. For years, mezzanine lenders have targeted IRRs of 18%-22.0% on their investments, and these targets remain unchanged today. Is subordinated debt that much riskier that it should earn 11.5%-16.5% more than senior bank debt? We don’t think so. Also interesting, mezzanine lenders, like private equity sponsors, typically don’t vary their return requirements with changes in the cost of funds. At this higher rate of return, changes in the banks’ cost of funds and reserve requirements become less relevant in pricing loans.
How will the banks achieve a 10%-12% rate of return? Banks can do this through a combination of a current coupon, PIK coupon and warrants. A cash coupon of 8% enables the banks to achieve a strong current return while still enabling borrowers to maintain reasonable fixed charge coverage. The remaining 2%-4% can be earned through either a PIK feature or by owning a small portion of the companies’ equity, in the form of a warrant. Mezzanine lenders almost always take warrants when making investments in hope that any losses incurred by a portfolio company can be offset by gains from other portfolio companies. We believe this logic is applicable to senior lending as well.
The cash flow lending market is very competitive and has historically cycled through periods marked by aggressive leverage multiples and thin pricing. Repeatedly, these cycles have ended with participants leaving the market, discouraged by inadequate returns for the level of risk they assumed. Will this cycle be different? We believe it can be. Unlike previous cycles, this cycle corresponds with a period of significant bank consolidation. The economy will eventually rebound, but when it does there won’t be nearly as many cash flow lenders as in the late 1990s. The players that remain face a tremendous opportunity to re-think the cash flow business model and improve upon it with less leverage and more attractive pricing.
Ronald A. Kahn and Susan W. Wilson are managing directors with Chicago investment banking firm Lincoln Partners LLC. Alysia V. Tan is an associate at the firm.