Tools to Help Business Owners Understand and Survive the Financial Crisis
Private Equity and the State of Leveraged M&A
Posted by John Slater on July 29, 2009
The market for private companies depends on two primary sources of demand, strategic buyers and private equity. We’ve reported that Focus’s M&A practice has remained strong notwithstanding the recession with six closings year to date. These deals have all been strategic with our firm representing both buyers and sellers. Only one of the transactions could be considered a “distressed” deal. From our vantage point, it appears that in the middle market the strategic buyers neither paid up excessively in the boom, nor have they slashed their valuations unreasonably in the bust. If the acquisition makes strategic sense, these buyers appear willing to pay a fair multiple that relates more to the impact of the deal on their earnings projections than the state of the financial markets.
Financial deals engineered by private equity firms are another matter altogether.
Total Private Equity Deal Flow
Source: PitchBook Data, Inc. (www.pitchbook.com)
According to PitchBook, from the peak in Q4 2007 to Q2 2009, dollar volume of PE deals (including buyouts, growth financings and other) declined almost 96% from $177 billion to $11 billion. The number of deals declined almost 75% from a peak of 702 in Q2 2007 to 174 in Q2 2009. PE buyout deals declined even further than overall PE deals, from $168.8 billion in Q4 2007 to $2.6 billion in Q2 2009, a 98.5% decline. The number of reported PE buyout deals declined almost 80% from 570 in Q2 2007 to 116 in Q2 2009. This confirms our observation that middle market PEGs responsible for smaller transactions have remained more active than their large deal brethren, but that everyone in the industry has been hit hard.
While there are a number of reasons for the sharp decline in PE activity, most observers agree that the primary issue is the lack of available leverage to fund transactions. In the last issue we reported on the almost complete collapse of leveraged lending, the primary source of financing for the megadeals. Reuters reported that middle market loan volume was down 63% from Q1 2008 to Q1 2009. Lending for new M&A deals was clearly down much further. In the UK it was recently reported that middle market M&A deals were at their lowest point since 1995 and that overall M&A was at its lowest point since Q4 1993. Reflecting the decline in leverage, PE firms have reportedly reduced the earnings multiples they are willing to offer. Lower prices have caused many sellers to pull back from the market. As a result a greater portion of the PE deal activity that has occurred involves financially distressed sellers, including additional funding for more than a few PE portfolio companies short of capital.
Lack of equity capital is not the driver of reduced PE buyout activity. PitchBook recently reported that the private equity overhang (I.e. committed, but uninvested PE capital) hit a record $400 billion at the end of April 2009.
Private Equity Overhang
Source: PitchBook Data, Inc. (www.pitchbook.com)
While rumors persist that some PE investors have reneged on capital commitments, this appears to be a minor factor to date and PE firms continue to receive new commitments ($46 billion YTD through April 2009). This tremendous overhang would seem to dictate that, at some point, the floodgates will reopen, leading to a dramatic recovery in the M&A market. Unfortunately that date could be some time off. PE funds typically have expected investment horizons of as many as seven to ten years so many fund managers have the luxury of waiting for better purchase multiples, higher leverage or both. For now we expect to see continued moderate levels of PE activity in the middle market and now quick return of the megadeals. For now the relative strength is with the strategic buyers and there is no reason to think this will change soon.
Categories: M&A
Tags: Tags: Business Acquisition, Business Sale, Mergers
Proposed Changes to Estate and Gift Tax - A Wakup Call for Business Owners
Posted by John Slater on July 29, 2009
Congress and the President appear dead set on creating lasting damage to independent business through ill conceived tax policies. The latest reports show that Congress is planning to solve our health care crisis at the expense of the “rich” with family incomes over $350,000 by imposing a new surtax of as much as 8-9% in addition to other tax increases already in the Obama budget. According to a 2007 Treasury study reported by the Wall St. Journal, fifty percent (50%) of the incomes affected by the new taxes will be generated by the sole proprietorships and Sub-S corporations which are responsible for creating 70+% of the new jobs in the United States.
If anything like the proposed new taxes comes to pass, it may be time for business owners to shift some wealth back to their tax planners and to dust off C-Corporations and tax shelters as areas of strong interest. When considering their options, business owners should take into account the negative (double taxation) impact of tying up their wealth in taxable C-Corps. In our M&A practice, we find that structuring private businesses as C corporations is one of the major impediments to successful exit transactions. Planned increases in the capital gains taxes are certain to make things even worse. For many business owners the best answer may well be to sell now before these overreaching tax law changes make it infinitely harder to realize fair value from their many years of hard work.
Less well publicized are various tax proposals aimed at “reforming” the estate tax laws. In addition to the planned return of the wealth transfer tax following the expiration of the Bush tax cuts, the administration has several surprises in store which could have a major detrimental impact on the ability of business owners to pass ownership of their companies to subsequent generations. Our friend Denis Brown of Pace Capital Resources, a business ownership transition firm based in Atlanta, has shared with us several goodies, including the elimination of marketability and minority interest discounts in the valuation of privately owned companies. This would have the effect of increasing valuations for estate tax and other purposes by as much as 25-30%. We’ve reprinted Denis’s article on the subject below:
The following is reproduced with permission from Denis Brown of Pace Capital Resources in Atlanta, GA.
As a norm a business owner will spend considerable time planning and working in the business. But unfortunately, will spend little time developing a plan to exit the business and incorporating appropriate estate and gift planning strategies in the process. Given that the biggest asset is the business, the proposed changes to estate and gift tax by the Obama administration may change the urgency on the part of business owners. The proposed changes will have a significant negative impact on the ability to transfer wealth. However, there is a limited window of opportunity to preserve wealth for those who act now.
The administration’s proposed changes would freeze the unified credit exclusion amount at $3.5 million ($7.0 million for couples) and the tax rate at 45%. The proposal also includes a portabililty provision that allows a surviving spouse with an estate that exceeds the applicable estate tax exemption to apply any unused portion of the deceased spouse’s exemption. That is the good news. The bad news is the proposed minimum term for Grantor Retained Annuity Trust (“GRAT’) is 10 years and the elimination of minority and marketability valuation discounts on closely held entities.
A GRAT allows the grantor of a trust to pass on appreciating assets free of gift and estate taxes. The annuity paid back to the grantor over the life of the trust equals the initial value of the asset plus a rate established by the IRS. The annuity is not taxed since it is a flow back to the creator of the trust. If the assets in the GRAT outperform the IRS set rate of return the remainder is out of the estate and transferred to the beneficiaries without incurring a gift tax. A GRAT is an attractive strategy to pass ownership interest in a family business and appreciating assets. There is, however, a mortality risk; if the grantor passes before the term of the trust then the asset reverts back to the estate. Current strategy incorporates a series of short term GRAT’s to minimize mortality risk and downturns in the economy. Under the proposed 10 year term minimum owners must weigh the risk they won’t survive the 10 year period.
A potentially more detrimental impact is the elimination of discounts on closely held entities. Often times the combined minority and marketability discounts are significant typically ranging from 25% to 40%. Thus, greatly reducing both gift and estate taxation for estates that otherwise likely would be over the applicable exclusion amount. For example an owner’s business is worth $20 million and devises 25% to each of his four children. At death each transfer would qualify for a minority and marketability discounts equal to 30% (will vary dependent upon several factors) and each child’s share would be valued at $3.5 million, $14 million in aggregate (the sum of the parts is less than the whole). The difference is $6 million which equates to an estate tax savings of $1.125 million ($6 million less $3.5 million exclusion times a 45% tax rate). This is a simple example of the negative impact of the proposed change and the need for planning by business owners when the estate is much greater than the exclusion. In the real world transferring the business in equal parts to siblings, some of which may or may not be active in the business or capable, is typically a formula for disaster unless the owner intends to exit by selling to a third party.
On a positive note there is a window of opportunity and current conditions are highly advantageous with capital assets at a historic low and interest rates that would be required on a note by the IRS under a transfer is also at a historic low (approximately 2%, changes monthly). In essence, a business owner with an estate exceeding the exclusion amount and subject to the 45% estate taxation rate should consider taking advantage of current conditions and transfer a minority interest in family owned entities under current regulations. Contact your tax advisor and estate planning professional to determine how these changes will affect you and remember every business owner will eventually leave the business, voluntarily or otherwise. Proper Exit Strategy Planning enables an owner to leave under their time frame, maximizing after tax value, ensuring continuity in case of an unexpected event and assuring financial security for the family.
Categories: Taxes
Tags: Tags: Add new tag, Business Owners, Business Ownership Transition, Business Sale, Entrepreneurs, Estate Tax, Health Care Reform, Small business, Taxes, Transition Planning
Have the Green Shoots Turned to Brown?
Posted by John Slater on June 26, 2009
As I write this, summer has officially begun with 100° plus days to prove it. The past two summers have not been kind to the financial markets. The collapse of the leveraged loan market in August 2007 marked the beginning of the current financial crisis and July of last year witnessed the initial low for collapsing bank stocks, setting the stage for much more dramatic pain in the fall. I’m not predicting any surprises for this summer, just suggesting that we’re in the witching hour and should all be on the lookout for things that go bump in the night.
The jury’s still out on the shape of the recovery. I have been expecting a W shaped recession, with economic strength appearing later in the summer to be followed by another step backwards toward the end of 2009 or sometime in 2010, as the impact of the financial stimulus wears off. Recent events have increased my concern that the economic trajectory in coming months could look more like a landing between two flights of stairs on the way down. There’s lots of reason to think that the decline is leveling out, but much less reason to expect a strong upturn. Consumer credit is just too weak and, with many consumer balance sheets irreparably broken and consumer credit standards showing no signs of easing, it’s hard to see what will serve as the engine for growth. At this point I’d be pretty happy with an L-shaped recovery in which we maintain something like current activity levels (perhaps after a short bounce off the bottom) while balance sheets are given time to recover.
For a good overview of the current condition of the real economy I suggest this article by Steven Hansen in Seeking Alpha. Bottom line is that the economy is still in decline, though at a slowing pace, and will likely be on that path until the fall.
ECRI Weekly Leading Indicators
On the brighter side, the Weekly Leading Indicators series published by the Economic Cycle Research Institute has been trending up since the first of the year, predicting at minimum an end to the decline before the end of the year and perhaps some real improvement, not just a slowing of the decline, going into the fall. For now that feels more like a best case scenario with the risks on the downside.
The Worst of Times – the Not So Worst of Times
Posted by John Slater on June 26, 2009
The recently released Brookings Institution Metro Monitor confirms something I have thought for some time; the recession’s impact has been very different in the Central U. S., including Memphis, where I live. Certainly unemployment is up, but there is no feeling of impending doom or of pervasive despair.
Fourteen of the strongest twenty metros in the report are in Texas, New Mexico, Oklahoma, Arkansas, Iowa or Kansas. Memphis and its neighbor to the south, Jackson, MS, are in the second quintile. Housing prices in Memphis were flat from Q1 2008 to Q1 2009 and they were actually up in many of the Texas markets. “What’s going on here?” you might ask. Certainly the regional focus on agriculture and energy, which remain relatively strong, doesn’t hurt, but I don’t think that’s the primary issue. The mid-continent never enjoyed the full force of the Bubble to the extent experienced on the coasts, so we just didn’t have as far to fall.
This recession is proving to be a great leveler. My guess it that this applies not just to states and regions, but to economic strata as well. All that data which Robert Reich and others use to deplore a growing concentration of wealth at the top, has likely turned dramatically down over the past year as portfolio values have collapsed and outsized bonuses have become the bête noir of the American economy. For the first time in my thirty-six year career, fear stalks the halls of the major law firms as hundreds, perhaps thousands of six figure associates and more than a few seven figure partners have been laid off by some of the largest and most prestigious law firms in America and similar impacts are being felt throughout the higher end of the economy.
Categories: Business Survival, Economics, Uncategorized
Tags: Tags: Add new tag, Economics
Commercial Lending – Schizophrenia Reigns Supreme
Posted by John Slater on June 26, 2009
Many companies remain under pressure from their lenders, but we have seen recent signs that selected lenders are becoming more aggressive in offering new loans to credit-worthy borrowers. We are quite active in helping companies find senior debt to replace existing lenders and are getting good response from selected lenders, primarily banks that were less impacted by the financial crisis and independent asset based lenders. In prior years there was little or no need for an investment banker’s assistance in arranging senior facilities, as multiple lenders (both banks and non-banks) aggressively chased all but the worst of credits. That is no longer the case; today senior deals take a lot of work and persistence, but they can be done.
To summarize the current situation:
• At the higher end, the loan syndication market remains catatonic with no signs of near term recovery. This both reflects and creates the almost complete collapse of the Private Equity acquisition market for the larger deals north of $100 million. Most syndication activity that does occur relates to restructuring of existing credits.
Source: Churchill Financial and Standard and Poors
As the chart above demonstrates, we’ve only seen the tip of the iceberg in leveraged loan maturities. The peak years for refinancing/renegotiation of the loans created in the buyout boom are 2013-2014, but we are already seeing a strong increase in the number of buyout bankruptcies. This five year overhang in potentially troubled leveraged loans, means that we are a long way from cleanup of the problems created by excessively liberal lending practices during the buyout bubble. This indicates that we are unlikely to see another debt fueled boom in the buyout industry before we are well into the 2010’s. The chart below provides a dramatic demonstration of the extent of the decline in syndicated loan volume, with very little indication of a pickup in this market, green shoots notwithstanding.
Source: Deutsche Bank Principal Finance
At $5 billion per month, the leveraged loan market is off more than 90% from its peak in the first six months of 2007.
• Healthy banks, particularly the community banks, are trying harder to make loans, but credit standards remain high and many banks complain that they are having trouble finding good loans to make. Many remain constrained by workouts of construction loans and concerned about the quality of their commercial real estate portfolios. Deterioration in CRE could have a significant impact on bank earnings over the next several years, as recent bubbles in the construction of shopping centers, hotels and office buildings are worked off in many markets. There’s good news for operating companies in all of this as lenders are increasingly reaching out to the commercial & industrial market to offset deterioration in consumer and real estate portfolios.
• Asset based loans are beginning to see a resurgence as selected lenders perceive these loans as a way to put funds to work while keeping a lid on risks. We particularly see this in the asset based lending operations of some the healthier regional banks and a few of the stronger national institutions. Even the strongest lenders have some weak performers in their existing portfolios, however, and this has clearly had an impact on underwriting standards. Trends of note in this market:
o Appraisals are far more conservative than in the past, which restricts loan availability. Many lenders now require third party inventory appraisals.
o Lenders which pushed highly leveraged recaps on the market two years ago, now require that their borrowers demonstrate positive tangible net worth. Debt to EBITDA ratios are far lower than in the past, with senior debt offerings of 2-2 ½ X EBITDA from lenders that might have offered 3 ½ - 4 X or even more in 2006. That poses quite a problem for thousands of companies which used the heady markets of mid-decade to pay large one time dividends or structure acquisitions at a multiple of GAAP book value.
o Companies hit by the recession with what we call “black canyon” income statements (i.e. a precipitous drop in earnings for six to nine months as they adjusted to the “new normal” of reduced sales and production), find that they must present clear evidence of EBITDA recovery to entice new lenders.
o Interest rates are up across the board. Loans that might have been structured at 175-200 over Libor at the peak of the boom now carry rates of 300-400 over. Many, if not most, proposals include interest floors or use formulas based on the greater of Libor or the bank’s prime or base rate, which means that effective rates are above formula rates in the current low rate environment. And rest assured that “covenant light” is not the order of the day; expect even asset based loans to have meaningful performance triggers to prevent a repeat of the zombie deal overhang from the 2005-2007 leveraged loan bubble.
o Refinancing existing deals often requires something more than a new lender. Shareholders are frequently required to inject additional equity to show a level of commitment to the borrower. For the stronger credits, mezzanine debt or minority equity may fill the gaps left by tightening lending standards. Increasingly the existing lenders are being asked to contribute as well, by forgiving some portion of the existing line to close the deal. This is much easier for those lenders which have reserved meaningfully against their troubled credits than for those still hiding their problems under the rug.
Categories: Asset Based Lending, Banks, Business Financing, Senior Debt, Uncategorized
Tags: Tags: Asset Based Lenders, Asset Based Loans, Bank Lending, Bank Loans, Banks, Business Survival
Secondary Loan Markets On a Tear – Is M&A Rebirth Far Behind?
Posted by John Slater on April 23, 2009
Since the collapse of the syndicated loan markets in August 2007, the private equity M&A market has gone from red hot to stone cold at the high end and luke warm in the middle market. The primary cause of this collapse is not lack of equity; at the beginning of the year PE firms had close to $200 Billion of dry powder. The issue holding back the M&A market worldwide has been the lack of leverage for new deals.
The M&A bubble of 2005-2007 was driven in great part by an explosion of new funding sources that entered the leveraged lending market, leading to an unprecedented narrowing of lending spreads. At the peak, leveraged loans were being written at spreads as much as 300 basis points narrower than historical norms. Funding sources included hedge funds, special purpose entities created by the banks, collateralized loan obligations (CLOs), institutional investors and various international purchasers.
From the market crack in August 2007 through August 2008, this market traded at a discount of up to 10% of principal, reflecting a partial return to normality in terms of risk based loan spreads. During this period it became increasingly difficult for lenders to syndicate new deals. In September 2008, coinciding with the collapse of Lehman Brothers, this market went into freefall with a basket of the largest leveraged loans trading below 65% of principal by late 2008. The market for new syndications, particularly the multibillion dollar deals that had been so prevalent, ground to a virtual halt.
Source Churchill Financial - On the Left; S&P LCD Index
At the beginning of this year, the leveraged loan market priced in not only a correction of the previous mispricing of risk, but the assumption that battle horns were blowing in the Valley of Armageddon. After rising from 63.5 to 80.6 in the last four months, the LCD Index now reflects normalization of spreads plus a fifty year flood, a substantial improvement, but far from Nirvana. The market collapse in fall 2008 had far more to do with the deleveraging of the hedge funds and special purpose entities than it did with a considered pricing of risk. A cry of “give me a bid, any bid” could be heard across the land. As the deleveraging has run its course, inventories have declined and prices have recovered.
In a thoughtful piece in Tuesday’s Wall Street Journal, Michael Milken described past manic swings in the leverage levels of America’s corporate balance sheets. He pointed out that every cycle of overleveraging has been followed by a period of recapitalization, through debt for equity exchanges, repurchases of discounted debt and new equity offerings, which restores corporate balance sheets and provides the foundation for a renewal of new investment and growth. The current rebound in leveraged loan pricing may indicate that this process is now underway in the current cycle.
So long as existing senior debt was trading to yield potential returns approaching 20% per annum, those lenders with capital remaining had little incentive to provide new debt at acceptable spreads. With that competition for investment dollars winding down, new loans will become increasingly available, though still at spreads far in excess of those available at the peak of the boom. While we are a long way from a return to the frothy M&A market of mid-decade, it’s reasonable to expect a return of the financial buyers to the marketplace and a far more active M&A market for the balance of the year than we have seen over the past six months.
Categories: Banks, Business Financing, M&A, Senior Debt
Tags: Tags: Add new tag, Asset Based Lenders, Bank Lending, Bank Loans, Banks, Business Acquisition, Business Financing, Business Sale, Money Supply, Shadow Banking System
Allen Stanford Proclaims His Innocence
Posted by John Slater on April 21, 2009
Recently we have been presented with the spectacle of a high flying banker in deep financial trouble proclaiming that he and his organization have been wrongly singled out for reprisal by the Federal government. The charges are clear. His bank aggressively sought deposits from around the world to fund a portfolio of outrageously bad investments, leading to the bank’s insolvency. The bank funded high paid executives’ lavish lifestyles, including Caribbean junkets, sports sponsorships, a fleet of private jets and outsized bonuses unrelated to actual performance. Insider loans were made to bail out the personal financial problems of those in control. Yet that banker has the gall to blame overzealous government actions for his problems.
We are speaking, of course, not of Allen Stanford of Stanford Financial, but of the CEO’s of America’s largest banks. While there is certainly a difference in degree and Mr. Stanford’s personal style is less than savory, the biggest difference between Stanford Financial and several of our nation’s largest banks, is that the U. S. government chose to bail these institutions out of their mistakes rather than prosecute them as has been done with Stanford Financial. And these bankers are whining daily about their inability to pay “adequate” compensation due to the restraints placed upon them under the TARP legislation.
Don’t get me wrong, Stanford abused the trust of thousands of investors, many of whom are presumably innocent, and he will likely be punished severely for his apparent wrongdoing. But so did the big banks. Had the big banks been allowed to fail in September, as they surely would have absent the federal bailouts, the damage to investors would have been far more dramatic and the retribution on their executives would likely have been far bloodier. The difference is that they hail from the financial and political centers of the U. S. and are far better at gaining support in Washington. Instead of indictments and fraud charges, they are given audiences with the President and free rein on CNBC and Bloomberg to make their cases for support. And yes, even after they’ve sold some of their jets, I’m not likely to see any of them on row 21 the next time I fly Airtran.
Time for Transparency on Bailing Out the Banks’ Bondholders
Posted by John Slater on April 20, 2009
This morning the New York Times reported that the Treasury is planning to convert TARP holdings of preferred stock into common equity at a number of banks. As we previously raised, the real issue is whether and why the Treasury is committed to protect the bondholders of the big banks. There is a great deal of capital in the banking system in the form of unsecured debt. In a normal world, when a company goes broke, some or all of the debtholders’ interests will ultimately be converted to equity capital either in bankruptcy or in an out of court restructure. The current issue of The Institutional Risk Analyst makes a very interesting proposal for conversion of Citibank debt into equity, which would address the capitalization issue once and for all. It’s time the Treasury explains in clear English why they are electing to further commit taxpayer funds to bailing out the big banks’ bondholders.
Categories: Bailouts, Bankruptcy, Banks, Business Survival, Distress, Economics, Junior Capital
Tags:
We’re Seven Months into the Great Mess. What’s Going to Happen Next?
Posted by John Slater on April 14, 2009
Seven months ago (Monday September 15, 2008) we learned of the failure of Lehman Brothers and soon thereafter the sale of Merrill Lynch and the bailout of AIG. These events were the culmination of a series of market shocks that had started with the demise of the sub-prime loan market, had accelerated with the collapse of the leveraged loan market starting in August 2007 and had included the takeover of Bear Stearns in March 2008. But September 15, 2008 is the current era’s equivalent of 1929’s Black Monday.
Since September we have witnessed dramatic governmental actions designed to prevent the current crisis from descending into a downward spiral reminiscent of the 1930s. For the moment, the stock market seems to be giving these actions (as well as our charismatic new President) a vote of confidence. We’re also hearing from some of our clients that their operations improved in March and that they are more optimistic about their businesses looking toward the summer. Another “green shoot” is the middle market M&A market, where I spend much of my time. The M&A market has definitely improved since the first of the year and indications are that it will remain reasonably strong for a while, at least for profitable companies in favored industries such as government contracting, IT services and health care.
So what is the economic scorecard to date and what can we expect to see going forward?
1) The World economy is in the midst of the first major global recession of the postwar era. Global trade has been collapsed for many of the major exporters, particularly China, Japan and Germany.
While there have been some recent hints that the rate of decline is slowing (the second derivative of negative growth) or even bouncing a little, world trade is still an area of significant concern. Additionally, there remain a number of weaker economies (the Baltics, Spain, Ireland and Hungary among others) which could precipitate a currency and/or banking crisis at any moment.
2) U. S. government commitments to the financial system bailout now total around $10 Trillion and perhaps more. At this point we appear to have a two tiered banking industry, with most smaller banks reasonably well capitalized, though closures of the worst continue on a weekly basis, and a number of larger banks in the intensive care ward. Both Chairman Bernanke and Secretary Geithner have said that these larger banks will not be allowed to fail, though additional capital may be required at some point. The Treasury has committed to bet $1 Trillion of the FDIC’s credit on a public private investment plan (PPIP) designed to fix the balance sheets of the large wholesale banks. Secretary Geithner has indicated that a primary focus of this plan is to restore the function of the securitization markets. As we indicated last fall, the loss of these markets has had a far greater impact on credit contraction in the U. S. than credit tightening by the banks. In fact, politics aside, indications are that the banks have been lending more to consumers, not less, since the crisis began.
The primary unresolved issue with the big banks is whether there has been an impairment of their capital large enough to wipe out shareholders and potentially some of their unsecured creditors as well. The PPIP is predicated on the belief that mark to market accounting has forced the banks to write down mortgage assets to levels below their ultimate realizable values and that, by stabilizing these values through injection of federal guarantees; the major banks will be able to fix their balance sheets and return to their normal businesses (primarily wholesale lending, trade finance, securitization of consumer loans, mortgages and other assets, and trading of derivative contracts).
A lively debate has developed over this point, with many observers convinced that the PPIP plan (combined with the earlier AIG bailout) is an outright subsidy to the banks, without compensation to the taxpayers. As a result, a real question exists as to whether Congress will be willing to commit additional budget dollars when the fast dwindling TARP funds run out. To prepare for this eventuality, Treasury and the Fed have asked for new authority to place major financial holding companies into receivership in the event of insolvency. Additionally, trial balloons are being floated to test the possibility of a forced debt for equity conversion at some of the big banks similar to that now being push for GM’s bondholders.
Our view is that the wheel is still in spin with regard to the financial solvency of some of the larger banks. With residential mortgage defaults still working their way through the system, there are at least three major categories of bank loans at risk:
a. Credit card receivables. Delinquency rates are at historic highs and expectations are for further deterioration through 2009.
b. Commercial mortgages. Leon Black, one of the most successful distressed asset investors, recently projected it will cost the banking industry $2 Trillion to clean up losses from commercial real estate problems.
c. Leveraged loans. Leveraged lending peaked in 2006-2007 at the zenith of the buyout boom. Many of these loans were made on relatively short terms and will be coming due or moving into a period of rapid amortization over the next two years. While some of the larger loans have most likely already been haircut under mark to market rules, many others are being treated as level three assets held to maturity and have likely not yet sustained any impairment. Many of these will eventually default, particularly if the recession drags on into 2010 or worsens further.
Countering these negatives is the strongly positive yield curve being maintained by the Fed. This is the perfect environment for bank profitability, leading some bankers such as Jamie Dimon of J. P. Morgan Chase to argue that they will be able to earn their way out of these issues, given a reasonable amount of time.
3) The U.S. economy is far from healed. Consumer confidence may have bounced at the bottom, but remains at historical lows
U. S. consumer spending was in free fall at the end of January and, based on today’s surprise report to the downside, has likely not improved much since.
The decline in U. S. manufacturing at the end of February was even more dramatic:
We previously predicted that yearend financial statements would cause significant stress in companies’ relationships with their banks. This chart below, produced by Randy Schwimmer of Churchill Financial in their On the Left newsletter, shows Q4 results for selected firms financed with leveraged loans, as well as the dramatic impact in terms or renegotiated covenants and likely interest rate increases as well.
There is nothing in this picture that supports the cheer seen in the stock market in recent weeks. As we have written previously, the real issue that must be addressed if the economy is to recover and resume its growth is the dramatic overleveraging that has occurred since the 1990’s. Far from addressing this issue, the Administration’s bailout plans are calculated to maintain this high level of borrowing, which hit a new record of 3.7 times GDP in Q4 of 2008.
Notwithstanding all these negatives, an enormous amount of financial stimulus have been injected into the U. S. economy over the past four to five months. Additionally the Obama administration’s fiscal stimulus package is just now beginning to flow into the economy. With normal lags, this is likely to begin to have an impact on the economy in the next few months. We expect to see some near term improvement in economic activity in some sectors. This should not be confused with the end of the economic malaise; that will only come with the deleveraging of overstressed consumer balance sheets, which will likely take several years. In the meantime, a better tone in the financial markets may present a short window of opportunity for companies to clean up their balance sheets through refinancing, loan restructures and asset sales.
Categories: Bailouts, Bankruptcy, Banks, Business Financing, Business Survival, Distress, Economics, Junior Capital
Tags: Tags: Add new tag, Bailout, Bank Lending, Bank Loans, Bankruptcy, Banks, Business Financing, Business Sale, Business Turnarounds, Economic Crash, Economics, Federal Reserve, Junior Capital, Mergers, Mezzanine Debt, Money Supply, Shadow Banking System, TARP, Treasury
It’s Raining; Has Your Banker Asked for the Umbrella Back?
Posted by John Slater on April 13, 2009
The old saw goes “a banker is someone who lends you an umbrella when the sun is shining and asks for it back when it begins to rain.” It’s certainly raining now and we are working with a number of clients who are in danger of losing their umbrellas. My partners Stan Cutter and Mike Zook have recently published a very insightful article which addresses some of the issues companies are facing with their banks. One of their key points: you may be in trouble even if your company is performing well, if your lender is in trouble or has recently been sold. We’ve reproduced the article in its entirety below:
Is Your Company Ready to Face Financial Institutions in a TARP World?
By Stan Cutter and Mike Zook
What is your strategy if your bank calls and invites you to find a new lender? One of our customers recently met with their banker to find that their loan renewal would have substantially different provisions. The Bank requested:
* Higher collateral levels,
* Lower availability,
* An interest rate floor provision,
* Increased fees for changing the agreement.
Another customer was told to raise more equity before the bank would renew the loan!
Risks and Opportunities of Credit Restructuring Issues
Today’s credit environment is characterized by market turbulence, bank consolidation, markets in disarray and increased regulatory scrutiny. Many companies find themselves weathering the storm although business is not as good as they would like. But, even if every interest and principal payment has been made on time and there is no apparent reason for concern, the onset of credit restructuring issues can be sudden.
Companies and managers need to understand the risks and opportunities surrounding the financial markets’ impact on capital availability. While most often the impact is felt through banking relationships, the impact extends to other financing sources and can affect the company’s liquidity.
As the new year begins, your annual financial statements are with your accountant and they will be sent to the bank as usual. You expect no reaction, but perhaps your bank has gone through some changes:
* Have they applied for TARP funds?
* Have they merged or consolidated with another bank?
* Has their credit quality declined?
* Has your banking officer changed?
If any of these are true, you may want to prepare for potential changes in your banking relations.
Credit agreements are legal contracts that have a number of provisions which may affect your business during this turbulence:
* Is your company within stated covenants?
* Are your company’s minimum equity requirements met, or is the value of your collateral still sufficient?
If you do not understand the consequences of not meeting any of these provisions, you may be surprised by your bank’s reaction.
The Era of “Easy” Corporate Banking is Over
Needless to say, the credit environment has changed and it is likely that your bank will ask for substantial changes to the agreement if anything is out of compliance. The era of “easy” corporate banking has come to an end and banks have tightened their credit standards. In addition, the bank may not have full control over the decision as regulators may have caused the bank to re-examine its portfolio and lending practices.
Recent discussions with bankers have revealed several concerns which play in their credit decisions:
* Is the client or prospect strong enough to survive a prolonged downturn?
* Is the company proactively managing the critical factors in its business?
* Is the company’s Balance Sheet reflective of a financially well managed firm?
* Are there multiple ways to repay a loan beyond cash flow from the business?
* Will making a loan be profitable to the bank?
The banker translates these thoughts into a financial analysis, often historical, to seek answers, and to lead discussions with the company. A ratio analysis of the company’s historical income statement and balance sheets will be compared to others in the industry.
This financial analysis will eliminate or greatly reduce any inaccurate perceptions about the company’s performance. It will direct the banker into specific areas for questioning management and will look to formal plans and benchmarks for the company to overcome prior to a loan being made.
If the banker decides to move forward, the covenant, collateral structure, and the loan amount will be driven by the same analysis and designed to prevent the company from going too far astray. Loan pricing also will reflect the economic times and allow the bank a profit, even if prime rates fall to new lows. The banker may use an interest rate floor to protect himself as rates drop.
Proactive Companies Must Move to Understand Their Liquidity Position
This is not good news. Proactive companies move to understand their liquidity position, though liquidity planning is not usually part of the budget process. Budgets predict revenues and related costs to make sure they are in alignment, but liquidity planning centers on the operating cash needs of the company in comparison with its capital plans and budgets. If there is not enough cash, then budgets must be changed. If a faulty assumption is made about a banking relationship, the results may be devastating.
In-Depth Financial Analysis Can Better Position a Firm’s Capital Structure for the Future
A financial review is a proactive, analysis based plan for the company’s liquidity whose foundation is an interactive review of the company’s budgets, plans, operations and sales expectations. In addition to reviewing the company’s liquidity position, it also reviews the financing alternatives available to the company. The in depth analysis can review covenants to insure compliance over the budget period.
The results of the review may suggest that the company prepare for tough banking discussions, or to seek an additional banking relationship. The review also may suggest other financing sources that might bring capital to the company. There are active mezzanine lenders and minority equity investors who might support the company if the plans and opportunities are of sufficient size or materially change the company’s position.
Categories: Banks, Business Financing, Business Survival, Distress
Tags: Tags: Bank Lending, Bank Loans, Banks, Business Financing, Business Survival, Business Turnarounds
