Tools to Help Business Owners Understand and Survive the Financial Crisis

Have the Green Shoots Turned to Brown?

Posted 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.

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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 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.

Commercial Lending – Schizophrenia Reigns Supreme

Posted on June 26, 2009

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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.

leveraged-loan-maturities
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.

leveraged-loan-volume
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.