It’s 1988, at an ABL shop near you…“Hey boss,” the Account Manager chimes in, “I just heard from the field examiner that Supermega Steel Corp. lost its biggest customer two months ago and has been generating bogus invoices just to meet payroll.”
The ABL Division Manager isn’t pleased. “You idiot!" He screams. "You should have known all of this three months ago!”
The operations group two floors below heard the screaming and felt the floor shake from projectiles hitting the walls. They knew that the Account Executive would run down to demand the dot matrix accounts receivable aging printout and faxed assignment and collection reports.
“We could all go down for this one,” says the Account Manager.
The verifications analyst was already scrambling to fill out the verifications forms when the Operations Manager yelled: “Everyone stop what you are doing and get started on the verifications forms! No one goes home until they are in the mail!”
Emergency meetings in the mahogany boardroom lasted well into the night with the attorneys that had run over in their tassel loafers, suspenders, and pinstriped suits.
A nearly identical situation took place at the same ABL shop last week (now a division of a commercial bank); however, the events unfolded a little differently:
”How’s it going this afternoon, Bob? Hey, nice jeans. By the way, the CFO of Boutique Import Steel called to say that he had to do some pre-billing in order to meet payroll – he hoped the orders would eventually come in but, if they don’t, dilution should not rise too much.”
“Oh, well, that’s good, Joe. If they can get over the hump then that’s great since we can’t afford to lose another deal. We’re getting L+275 on this so I’d really hate to lose it. Do they need an overadvance? Maybe they have some IP we can lend against?”
“Thanks, Bob. I’ll be working remotely for the rest of the day but will follow up tomorrow.”
This story may be satire, but there’s no mistaking that times have changed. Society itself has changed and workplace norms are no longer conducive to the raised voice drama that characterized the old school ABL mentality.
But beyond the gentler tone, the business overall has loosened as ABL has morphed beyond tried-and-true collateral lending to include “ABL lite” and “senior secured lending” variants. The lines between ABL and other forms of commercial lending have blurred, and it has become commonplace for an ABL platform to lose what it viewed as a hardcore non-bank deal to a commercial bank. This article summarizes the evolution of the industry and who will succeed in this new environment.
How Did We Get Here?
1988-2008
As of the late 1980s, the dominant cultural norm across ABL had been to avoid taking a loss at all costs. Taking a write-off on a loan was not just a source of professional jeopardy, but of personal shame. Driving the ubiquity of this mindset was the entrepreneurial nature of industry leaders who had cut their teeth during the dawn of the industry and retained the mentality of an owner-operator with their own personal capital at stake. A zero-loss mindset permeated decision making, employee culture, and strategy.
Asset-Based Lending was at the end of a 30-year run as a cottage industry that marketed its product to a defined set of customers who were shunned by banks and lacked alternatives for working capital financing. With minimal external competition, ABL lenders held pricing and structural leverage. Customer service was not a meaningful part of the value proposition to clients. An industry leader recently quipped about the era: “the term ‘customer relationship’ meant that we had a contractual relationship and we expected our borrower to operate in accordance with it.”
In the 1990s, ABL continued to evolve further into the mainstream and intertwine with the broader corporate finance marketplace. The growth in service providers such as liquidation companies and turnaround firms allowed lenders greater scale through outsourced specialization. Capital market intermediaries became increasingly comfortable with the product and more advisors entered the playing field. This in turn attracted more banks to launch ABL groups, blurring the lines between what was a bankable versus a non-bankable deal. By the end of the decade, ABL was largely a commodity product with various market players competing at each level of the size and credit spectrum with structures ranging from ABL lite through heavily-monitored.
These trends towards efficiency only accelerated during the 2000s as liquidity flooded into the debt markets. From 2001 to 2007, institutional capital allocated to U.S. private credit investments increased ten-fold, from $4 billion to $40 billion, whetting the funding appetite for all types of private credit, including ABL. The arrival of significant institutional capital greatly impacted the culture of the industry, as strategy shifted towards what products and processes could drive scale-capital deployment while maintaining acceptable loss rates. Doing so required greater appetite to evaluate and lend against broad collateral types and to pursue complex structures as well as more “creative” deals. It also required firms to focus more extensively on relationship building and client service in a race to capture market share in a more efficient market. This was a departure from the days where the predominant culture was “never lose money.” Students of history will recall that in some cases “creative growth” turned into “massive credit losses” a few years down the road.
2008-2018
When the Great Recession hit, ABL lenders fully expected that the violent collapse of the credit cycle would reset market terms to become more lender-friendly. If there was ever a time for the industry pendulum to swing back toward tighter controls and better spreads, that was it. Those of us who were in the industry at the time can remember the sense of optimism at the coming onslaught of low hanging fruit that we expected to come from the wave of bank exits.
But that wave never really came. Banks were able to rely more aggressively on advisors and a fairly rapid economic recovery allowed them to work with customers to “extend and pretend.” While the fairy tale of high-margin, low-risk deals didn’t materialize, clearly the dynamic economy led to significant opportunities. Savvy, well-run ABL platforms were able to seize compelling market opportunity during the recovery years. This only served to increase appetite among institutional investors for exposure to ABL – and non-bank ABL fundraising continues.
Asset-Based Lending’s latest battle is the unprecedented number of community and regional banks that have pursued ABL as a way of building their C&I portfolios. In the eight years between 2010 and 2018, total U.S. bank C&I loans doubled, from $1.1 to $2.2 trillion. It had previously taken 31 years for total U.S. bank C&I loans to double. The single most common complaint we hear in the ABL industry is frustration over losing what appears to be a down-the-fairway ABL deal to a commercial bank that is funding it either as an ABL-lite or term loan structure. In a lot of cases, it can feel like the lines aren’t merely blurred, but they downright don’t exist.
The 2019 (Or is it 2020?) Recession
A prominent head of an ABL firm recently stated: “The last easy deal I closed was in the 1980s.” We are currently in the midst of unprecedented growth in bank C&I loan activity into our addressable market, while at the same time a staggering supply of capital into private credit has increased internal competition in each segment of direct lending.
There are those in ABL who – once again – predict that the inevitable recession will give us the last laugh as overzealous banks and other non-cycle tested platforms head for the exits. We think that’s wishful thinking.
But there will be winners and losers, and we do believe the number of losers will be far greater than a decade ago. Community or regional banks who thought ABL was just a normal lending product and who lack expertise to liquidate or manage difficult ABL assets will exit the market, in many cases painfully so.
In a zero-sum game, a greater number of losers means there will also be greater number of winners. The winners will be those firms who have managed to apply a rigorous credit culture with today’s sophisticated market where no deal is ever going to be “easy” again.
So, who will be the biggest winners? In a commodity industry there are two ways to win:
- Get big. The winners in efficient markets are those who scale up and win through lowest cost of funds, operational leverage, and lowest equity returns hurdles from institutional investors who can’t be accessed by smaller competitors. A good rule of thumb is to assess if your firm has the talent and capital to execute on a plan to be one of the three largest in your direct competitive set.
- Focus. The other option is to hone in on a niche and compete where you have advantage. In large markets, there are pockets which don’t make sense for large scale players to serve. Smaller firms that have greater flexibility but a higher cost of capital can’t win competing directly; but they can win if they have differentiated capabilities, the ability to execute, and a keen sense of brand awareness. Unless you have the talent, capital, and timeframe to be the biggest, this is most likely the far more compelling and profitable strategy.
Asset-based lending can no longer be sold successfully into the market as a lender of last resort product from a prior generation. Even those players who have stuck to their knitting of formula based eligible collateral only deals face pressure to find ways to differentiate and take greater calculated risk in order to convert term sheets. These endeavors required greater levels of sourcing, underwriting and relationship management talent in order to compete effectively.
The true test of a business is how it performs during the most challenging parts of the cycle. Those firms that validate their performance in the downturn, are clear on who they are trying to be, and have the ability to execute their vision will seize outsized opportunity during the beginning of the next credit cycle.
