The irrational exuberance of the 1990s was followed by a period of falling profits and corporate belt tightening. With sales for many firms flat or declining, companies were forced to keep a close eye on expenses and the bottom line. The environment started to change in 2003, as the economy and corporate financial performance improved. Businesses and consumers began spending, profits climbed and cash flow increased.
As a result, borrower credit quality is hitting record highs and bank loans are the cleanest they’ve been in years. Business bankruptcies dropped to 34,300 in 2004, the lowest level since 1980, according to the American Bankruptcy Institute (Exhibit #1-Business Bankruptcies, 80-’04). The aggregate charge-off rates for commercial and industrial loans dropped to .34% in the fourth quarter of 2004, the lowest level since 1998, according to the Federal Reserve.
Fed policy continues to be accommodating, and many businesses are refinancing existing loans to take advantage of lower interest rates and extend loan maturities. Nearly three-quarters of all asset-based loans completed in 2004 involved some refinancing, according to Loan Pricing Corporation.
With cash flow at many businesses exceeding capital expenditures, management is in the position of deciding how to spend the excess funds. However, many businesses are unsure how best to deploy their cash. Memories of how the business environment deteriorated after the dot-com bubble burst haven’t completely faded. As a result, mid-to-large size companies are being careful about putting money into investments that may be perceived as risky, such as mergers and acquisitions.
Liquidity Expands, Demand Contracts
The economic upturn has done more than fill corporate coffers. It has created a liquidity supply and demand imbalance. On the demand side, fewer companies are looking for external sources of financing since they’re generating more than enough cash from their operations.
On the supply side, institutional investors, hedge funds and buyout firms are fueling the market. One indication of this can be seen in today’s private equity funds. Looking to deploy capital, billion-dollar mega-funds are competing for a smaller pool of companies. The competition for quality acquisitions is fierce and in some cases drives up the price of target companies, making return on investment a challenge.
Asset-hungry lenders are looking to put their money to work too, but fewer asset-rich borrowers can be found. Many manufacturers have moved operations overseas where, in a number of countries, the legal infrastructure necessary to support secured loan agreements has yet to be established.
At the same time, there is significant increase in loan market liquidity and aggressive competition from cash flow lenders that has forced asset-based lenders to take more risk to win deals. As a result, debt to EBITDA multiples for leveraged buyouts (LBOs), for example, have climbed to 5x EBITDA in 2005. That compares to 3.7x EBITDA in 2001 (Exhibit #2-Average Debt To EBITDA Multiples For LBOs, ’97-’05).
Loan Structures Du Jour
Asset-based loans are finding a new niche in this dynamic economy. They are now being priced competitive with-or even less than-cash flow loans. This is even the case with BB rated loans, which have traditionally been too strong a credit for asset-based lenders. Between January 2004 and February 2005, the premium over LIBOR on BB rated loans declined from 225 to 175 basis points, according to Loan Pricing Corp.
Borrowers also are seeing an increase in second-lien loans, which are being used instead of mezzanine or high yield debt to increase senior leverage. Also known as junior secured or Tranche B loans, second-lien loans stand behind senior bank debt, but ahead of subordinated debt within a company’s capital structure.
Before 2003, use of second-lien loans was infrequent because many senior lenders did not want to share collateral with second-lien lenders. Increased competition is prompting many lenders to re-evaluate their position and use second-lien loans as a way to provide borrowers with a total capital structure. According to Standard & Poor’s Leverage Commentary & Data, the volume of second-lien loans jumped from $3.2 billion in 2003 to $12.2 billion in 2004 (Exhibit #3-Second Lien Loan Volume, ’02-05).
Terms on asset-based loans also are relaxing. It’s not uncommon to see loans with no covenants or springing covenants, i.e. covenants that apply when liquidity, as measured by excess availability under the revolver, drops below a certain level. This flexible covenant package is attractive to borrowers who are undergoing a restructuring or operate in a volatile industry where it can be difficult to maintain financial ratios for covenant purposes. Additionally, asset-based lenders today are offering stretch financing through the use of “airballs,” loans whose value exceeds the underlying assets.
Asset-based lenders are developing ways to work with companies whose assets differ from traditional collateral, such as inventory, equipment and raw materials. For instance, more asset-based loans are being structured for companies in the rental equipment industry. Rental equipment can be challenging to value because assets are transient, difficult to monitor and quickly depreciate. Lenders also are structuring a greater number of deals using intangible assets, such as trade names, client lists and patents as collateral.
The lines between traditional and nontraditional asset-based lenders continue to blur. Some investment banks are starting to dabble in asset-based lending, and traditional asset-based lenders are now offering second-lien loans. Meanwhile, borrowers are increasingly looking for a “Universal Bank” that can provide complete financing. Many borrowers now expect lenders to move between the corporate debt and equity markets, offering products from both. Consolidation has created larger banks with the resources to provide borrowers with a total capital structure.
Convergence also is taking place in the investor community. The shortage of opportunities is spurring some investors to expand beyond their traditional comfort zones. The LBO market, for example, has always been dominated by private equity firms. These investors are beginning to see competition from hedge funds, which tend to be much larger and have more money to work with. According to Investment Dealers’ Digest, there are currently approximately 9,000 hedge funds with nearly $1 trillion in assets, versus 3,000 private equity funds with $150 billion to invest. In 2004, 23 companies were bought by hedge funds in deals totaling almost $30 billion. In response, some buyout firms are starting their own hedge funds.
The Credit Cycle
Competition for deals is likely to continue for the remainder of 2005, keeping pressure on margins and driving lenders to compete aggressively on price and structure. That’s good news for borrowers in the short term, but may precipitate an imbalance of lender risk and reward that could set the stage for the next downturn in the credit cycle.
It’s impossible to say when the market will change, but at some point, overconfident companies accustomed to hefty cash balances may start to overspend, resulting in tighter credit and a rise in default rates. We might see fallen angels and monster asset-based deals that rival those of 2003. A slump could also be bad news for second-lien lenders, whose recovery rate has never been tested during a downturn.
Innovation in the lending market, as well as convergence between the debt and capital markets, is likely to continue. More bank consolidation may affect the supply of capital particularly for bigger deals by shrinking the pool of syndicated loan participants.
As the economy fluctuates, asset-based loans will evolve to meet borrowers’ changing needs and increased expectations. Asset-based lenders have demonstrated their commitment to corporate borrowers, and will remain a strong, viable financing solution that offers flexibility, liquidity and patient capital.
Harold Blatt is responsible for overseeing a team of business development professionals experienced in providing asset-based lending solutions and an array of banking products to large and middle-market companies within a 16-state area. Bank of America Business Capital is an asset-based lender, with 19 offices serving the United States, Canada and Europe.