The Middle-Market Credit Worm Turns Again
Many lenders and investors are pursuing middle-market opportunities with gusto, but for how long?
If you have followed our credit market ruminations in this space over the past several
years, you know that our view has been that most banks have suffered sufficient
trauma in 2008 and 2009 to impair their risk appetites for years to come. Could
it be otherwise? The rubble left behind by the credit dislocation is only beginning
to be digested. Nevertheless, we have been genuinely surprised by the brio that
many lenders and investors have exhibited over the past three or four months in
pursuit of credit opportunities. It seems that risk aversion is again being pushed
aside as some financing is getting done on what can best be described as pre-crisis
The real eye opener has been the speed at which skepticism and selectivity have
faded among high-yield bond investors, a bellwether of risk appetite. There are
some interesting examples in the past several months of companies in the Northwest
and elsewhere issuing healthy increments of high-yield financing at leverage levels
well north of seven times EBITDA. In the best of times, this is dicey territory
for even bullet-proof middle-market businesses. One is left to wonder whether the
bondholders that are stepping into these deals have a real grasp of the challenges
faced in handling this level of debt. The astounding aspect of many high-yield financings
is that much of the proceeds have been channeled towards shareholders, rather than
into internal investments or accretive acquisitions.
Admittedly, most of our clients are not tapping the high-yield market. But, as enthusiasm
for return at the expense of risk gathers steam, similar sentiments are cropping
up in leverage lending and are now finding their way into middle-market finance.
BALANCE SHEET REALITY The big banks have, in the main, rebuilt
their capital positions through a combination of public equity raises, earnings
aided in part by access to almost costless funding from the Federal Reserve, retention
of TARP capital (e.g. KeyBank), and asset runoff. Asset contraction serves as the
prime impetus for lenders' current desire to make loans.
As illustrated in the nearby charts, banks have seen significant loan reduction since the peak reached during
the fourth quarter of 2008, representing evaporation of a bit more than $410 BN of C&I and CRE assets, a 13.9%
decline. Bank capital and surplus liquidity are seeking better earning assets in a soft market. The choices are rather slim.
Commercial real estate and consumer credit (including credit cards, mortgages and
home equity lines) currently account for about 57% of total bank credit. Consumer
loan demand is weak as the housing market continues to struggle. The recent growth
in consumer credit can be largely attributed to the now-complete surge in mortgage
refinancing and the movement of financial assets from securitization structures
on to bank balance sheets. Banks have scant interest in putting new capital to work
in the painfully over-capitalized commercial real estate sector, where further value
erosion is foreseen.
Business lending remains as the one area where banks are hopeful of expanded activity.
Asset growth goals for bankers have been cranked up in an effort to find higher
returns for under-employed capital. Middle-market lending is back in vogue and the
safety and security of a low-yielding securities portfolio is out. Right behind
general middle-market lending on the bankers' dance cards is leveraged lending for
middle-market buyouts. Resurgent appetites for this credit segment have been bolstered
by the fact that middle-market loans have traditionally performed well relative
to the broadly syndicated financings of larger companies. Over the past 15 years,
the cumulative default rate on deals in excess of $100MM has been nearly double
the default experience on smaller middle-market financings.
If the pricing for the risk is indeed better than for other alternatives, lenders
will be drawn to the opportunity. Unfortunately, in today's market, the missing
link is demand for credit. While rumor has it that the economy is on the mend, out
here in the real world the rebound is tepid at best. A boost in activity was felt
in late 2009 and early 2010 as businesses began to write or receive new orders to
replenish dwindled stocks after one of the deepest inventory cycles in history.
Currently, few companies are rebuilding inventories to pre-crisis levels, or expanding
capacity with new equipment or facilities. There simply is no compelling economic
driver for broad-based middle-market business or loan growth.
The upshot is that bargaining power has again shifted to the benefit of borrowers.
The stronger banks in the Northwest are competing vigorously to protect existing
relationships and to lure healthy clients away from other lenders. In this enviroment,
it is again an opportune time to solidify and improve credit arrangements with the
objective of building additional availability (liquidity), relaxing restrictive
covenant arrangements put in place in just the past 18 months, extending maturities
(well beyond three years), and rolling back pricing (Libor floors are disappearing
and L+100 bps is no longer unusual). A fair and competitive process is likely to
yield significant benefits to borrowers.
Although the credit spigot is open, it is difficult to identify the rationale for
a continued long-term favorable environment for middle- market credit. Conditions
can change quickly. Just in the past month, what had been a red-hot high yield market,
with record new issuance of more than $150 billion year-to-date, cooled rapidly
in response to sovereign debt concerns and weak economic data. Worry is growing
that the economy may again be turning lower. If this comes to pass, bank capital
will be back under pressure and credit strains will reemerge. The evidence suggests
that a wave of credit maturities lies ahead beginning in 2012. All of this portends
the strong possibility of another period of tight credit. Today's respite should
be seen as an opportunity to reset credit on improved terms.
Admittedly, most of our clients
are not tapping the high-yield
market. But, as enthusiasm
for return at the expense of
risk gathers steam, similar
sentiments are cropping up
in leverage lending and are
now finding their way into