Tools to Help Business Owners Understand and Survive the Financial Crisis

Commercial Lending – Schizophrenia Reigns Supreme

Posted on June 26, 2009

senior-loan-officers-survey

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.

Secondary Loan Markets On a Tear – Is M&A Rebirth Far Behind?

Posted 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.

leveraged-loans

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.

Beware the Ides of March

Posted on March 1, 2009

We won’t be seeing bloody togas on the Senate steps, but there will be great pain and destruction in the American business community.  There’s an annual ritual which starts in March and generally goes through sometime in April, in which tens of thousands of private companies, the heart blood of the American economy, deliver their annual audits and reviewed financial statements to their banks.  For many the results will not be pretty.

In the fourth quarter of 2008, firms throughout the manufacturing, retail and distribution economy, and likely in a number of other sectors as well, were hit by a strong downdraft precipitated by the credit crunch of September and October.   Many of these companies sustained a precipitous drop-off in revenues and resulting operating losses for the quarter.  Others may have seen a dramatic decline in the value of their inventories, particularly if they were in industries dependent on volatile commodities or imported raw materials.  The bottom line is that many companies will report a loss for the fourth quarter and a substantial number for the full year 2008 as well.

Contrary to current opinion, banks don’t like to take losses and will do everything in their power to avoid doing so.  Until now banks have been relatively lenient with their commercial borrowers other than in industries related to residential construction, where the reality of losses is too obvious to be ignored.  Unfortunately for their borrowers, however, banks are subject to strict accounting rules and answer to regulatory supervisors that demand that action be taken to head off potential loan losses.  Delivery of the 2008 annual audits and reviewed financial statements will make the potential for problems all too obvious.

Partially in response to the CRA (Community Reinvestment Act), within the last ten years many banks began to apply credit scoring and other “objective” financial modeling to their credit analysis and management.  As the 2008 audits are plugged into these models, it will become quickly apparent that many, if not most, borrowers have not hit the financial projections on which their loans were based.  We are already seeing this with companies that depend on asset based loans and report on a monthly rather than quarterly or annual basis.  Many such companies are now in “negotiation” with their lenders, which are demanding higher interest, more collateral, loan reductions and more.  In such situations the borrower’s first response is layoffs, salary reductions and plant closings, further exacerbating the economic decline.  For many lenders this will not be enough.  Companies that do not act quickly and aggressively to shore up their balance sheets are in great peril.

Adding to the problem is the tremendous loss of wealth among the owners of small and medium businesses.  Frequently their lenders rely on guarantees backed by personal financial statements composed of stock portfolios, investment real estate and other assets, the value of which has declined precipitously in the market collapse.  We are aware of a small business lender that was forced to shut its doors when the owner’s stock portfolio dropped by 50% and the bank pulled its credit line.  The collateral damage impacted scores of small borrowers.

Perversely TARP has increased the likelihood that the scenario described above will result in more, not fewer, declarations of default and resulting business bankruptcies and shutdowns.  Troubled banks cannot afford losses, lest they fall below minimum capital requirements and become the subject of unwanted regulatory attention or even takeover by the FDIC.  However, once a troubled lender is recapitalized or acquired by a stronger bank, it has the breathing room to take strong actions to clean up its portfolio, particularly if those losses are covered by a guaranty from the Treasury.  Rather than working with borrowers, the recapitalized bank may elect to move quickly to cleanse its balance sheet through rapid write-offs, declarations of default and foreclosures.  In the process jobs, productive capacity and wealth are destroyed.

Much discussion is heard about the “other shoes” left to drop for the banks.  Those that have gotten some exposure include leveraged loans ($3 Trillion to be refinanced over three years), consumer credit and commercial real estate ($560 Billion in the U. S. over three years).  Little if any attention has been given to small and medium business loans.  Yet in an economy that depends on small business for 75% of job creation, this “shoe” will feel more like a pair of hobnail jackboots to the thousands of SMBs (and their employees) about to be crushed under foot.

SURVIVOR- Main Street America’s New Reality Show

Posted on November 13, 2008

Shading Denote Recession

Shading Denotes Recession

By now we know the story all too well. Sixteen strangers debark onto a jungle island and are told they must work together to survive. While they pretend they’re on the same team, from the start they scheme to position themselves to outlast the other contestants, because at the end of the day they know there will only be one SURVIVOR.

Every business leader in America (and the World for that matter) is anxious to understand the impact of the financial crisis on their own business and personal prospects. How bad is it going to be? Does the crash present new opportunities? What should I do now? And yes, “What must I do to survive?”

Based on conversations with our clients and with financial and strategic investors, many are choosing to “hunker down” and ride out the storm. For some firms this may be an appropriate course. Yet to make such a decision without a realistic evaluation of your firm’s financial survivability in light of the new circumstances would be shortsighted at best. Unless you have capital reserves sufficient to weather a very protracted (perhaps eighteen months or more) and severe downturn, your business could be at grave risk. And if you depend on leverage, this calculation must also take into account the potential impact of reduced loan availability and dramatically higher loan pricing, which may well come sooner than you expect.

What We Know

The U. S. economy is in the midst of what will likely be the worst recession in the postwar era. It appears that the decline is rapidly spreading around the world and that we may well experience a serious global recession that will dramatically affect even the (until now) rapidly developing economies of Asia and Latin America as well as the developed world. The effects of this recession are expected to impact the economy through much of 2009 and possibly beyond. While all eyes are now on housing, autos and consumer goods, which have rapidly declined in recent months, other industries will be impacted soon.

The financial crisis is far from over. The Treasury has put a Band-Aid on the banking industry with its $250 Billion preferred stock investment and the Fed has already provided over $1.5 Trillion dollars in new liquidity to the financial system worldwide to free up the frozen capital markets since March 2008, with much more to come. (For more information on the explosion of the Federal Reserve balance sheet see the excellent chart maintained by Cumberland Advisors here). To date the worldwide financial industry has experienced $684 Billion in losses from financial asset write downs, primarily from sub-prime and other improvidently granted mortgages and these losses have been replaced with $690 Billion in new capital (see chart here), from private investors, sovereign wealth funds and increasingly from government bailout investments in the U. S. and Europe.

What has not yet been addressed are a number of asset classes that have until now held up reasonably well, but which will almost certainly witness increasing write-offs in the coming months. These include:

  1. The leveraged loans that funded the buyout boom of 2004-2007
  2. Alt-A and even traditional mortgages that are increasingly under water as home prices continue to decline
  3. Credit cards
  4. Auto loans
  5. Land, Development and Construction loans
  6. Commercial real estate loans

Nouriel Roubini , among the most pessimistic, but also among the most accurate observers of the current economic scene, has recently predicted that, before the crisis is over, worldwide writedowns by the financial industry will total $2 Trillion. This almost guarantees a dramatic reduction in credit worldwide over the next 18-24 months.

In Q2 2008 total public and private debt in the United States was almost 3.6 times Gross Domestic Product, well over twice the level just prior to the Great Depression. By comparison this ratio was 2.6 ten years ago at the time of the world’s last major credit crisis.

debt-to-gdp1

(An excellent, but somewhat dated longer term chart of the same data from Ned Davis Research can be found here) Since then the U.S. financial system has created unprecedented levels of leverage, making the economy much more susceptible to economic shocks such as the one we are now experiencing. The current economic pain is not likely to end until this burdensome debt is significantly reduced in a process euphemistically called “deleveraging”.

So What Does this Mean for Me as a Business Owner?

Joseph Schumpeter, the great Austrian economist, popularized the idea of “creative destruction” as one of the great engines of progress inherent in the capitalist system. When you’re on the receiving end there is nothing creative about it. It’s just destruction. Just ask one of the thousand auto dealers expected to go out of business this year.

In the short term, one of the primary sources of pain for business owners will be the banks. The chart at the beginning of this article tells the story. From 2005-2007 loan terms and pricing, particularly at the higher end of the market were more liberal than at any other time in the past forty years. The chickens have now come home to roost and we are witnessing a dramatic tightening of loan terms and a sharp increase in pricing. Loan covenants that permitted debt to cash flow ratios of 4-4.5 times will be renegotiated at 2-2.5 times or less; and pricing spreads are currently jumping two to three hundred basis points. This trend will continue, notwithstanding all of the government’s efforts to force easing. Even more conservatively financed businesses will feel the heat as banks, desperate to improve their risk ratios, squeeze those customers most able to adjust to make up for those that cannot. Companies that are unprepared for the onslaught are at extreme risk over the next six to twelve months.

Given the current challenges, many businesses will not survive. We are already witnessing a dramatic increase in business bankruptcy filings and this is just the tip of the iceberg. Additionally many other firms will be forced into shotgun mergers as the only alternative to outright failure. To avoid becoming road kill in the panic, companies must act now.

Action Plan for Survival

Deleveraging is going to occur whether or not you plan for it. At the individual business level, deleveraging can come about in several ways:

The Extreme

  1. Repudiation. In America the primary tool for business debt repudiation is Chapter 11 and it’s not pretty.
  2. Negotiation. Many creditors understand the value destruction inherent in bankruptcy and are willing to make concessions on the theory that something is usually better than nothing. Often such negotiations will encompass conversions of existing debt into equity ownership, the essence of deleveraging.

The Practical

  1. Some firms, particularly those that did not succumb to high levels of leverage during the boom, will weather the storm without radical surgery. For those that remain profitable, ongoing accumulation of retained earnings and repayment of debt will reduce leverage over time.
  2. Even those companies in comparatively good condition must review their current operations and act aggressively to eliminate all unnecessary expenditures.
  3. Non-core or less productive assets and businesses can be sold to further reduce leverage and build up a reserve for opportunities ahead. Once these disposition opportunities are identified, the owners should act quickly. This is not the time to hold out for top dollar. Values are likely to decline further and those who delay may later find themselves selling the family jewels to survive.

The Necessary

  1. If a careful evaluation of your company’s financial position leads to the conclusion that your current financing arrangements are not adequate to weather the storm, you should consider raising additional capital as soon as possible. The market for junior (mezzanine) capital remains strong for good companies with proven cash flow, though more expensive than a year ago. Additionally many banks, particularly community and regional firms that did not get involved in sub-prime lending, are still seeking loans and asset based lenders are available to fill the gap for companies that have strong collateral but an earnings hiccup that makes them unattractive to the banks. Even if you don’t suspect that your bank will pull the plug at renewal time, now is the time to begin looking for alternatives, just in case.
  2. Sometimes, after a realistic evaluation of your situation, you may conclude that your firm’s chances of surviving a deep downturn are slight. If that is the case, sale of the business may well be the best alternative. Consolidation is the watchword in M&A today. Larger, better capitalized, firms will see opportunities to improve their market position through geographical or product line growth. Often these firms can generate profitability, even from acquisition of a money-losing operation at a price in excess of liquidation value, through elimination of duplicative functions and expenditures. Such a sale may not achieve an exit at the price levels seen in 2006-2007, but today’s price will be far better than can be obtained later, after the seller’s operations have felt the full impact of the recession. In any case a sale today trumps a likely bankruptcy somewhere down the road.

The Home Run

  1. Tomorrow’s success stories are often born in tough times like these. If your company has financial strength and superior operational capability, now is the time to jump ahead of the pack. Companies will be available for acquisition that you could never have dreamed of buying in the boom, often at distressed prices. Now is the time to put in place an aggressive program to reach out to the market and see what’s available. And unlike in the boom years, you are less likely to be faced with crazily priced auctions and the need to act before you have a chance to do your due diligence. If you play your cards right, you may even be looked upon as a White Knight, ready and willing to lend a hand to companies in a less fortunate situation (but of course at a great price and on favorable terms).
  2. If you’ve got the skills to grow, but not the bucks, private equity continues to be a good source of the growth capital you will need. Now is the time to establish alliances with potential backers, so that you will be ready to act when the opportunities come along.

At the end of the season there will be only one SURVIVOR, but there will be fifteen losers. You’re now playing in the toughest game of your business life. Which one will you be?

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