As the depths of the pandemic fade farther behind us, and the proverbial light at the end of the tunnel starts to shine brighter in front of us, one might wonder whether the volume of M&A transactions will start to pick up in the asset-based lending and receivables factoring sectors in the coming months. The answer, in one emphatic word? Absolutely.
Before looking ahead, let’s take a quick look back. The year 2020 started where 2019 left off, with more transactions across the commercial finance sector, including the continued consolidation of the equipment finance industry. But with the pandemic’s onset, as has been duly noted in numerous publications, the commercial finance M&A market effectively ground to a halt in March and April of last year.
Activity picked up ever so slightly in the late spring and summer months with a few announcements (i.e., Thunder Funding selling to SE Capital and eCapital continuing its acquisition success with Prosperity Funding and Advantedge Commercial Finance), but overall, M&A deal announcements have yet to get back to even the modest number of announcements that this subsector typically sees.
Of course, it’s not surprising that there hasn’t been a significant amount of activity in the last year or so given the more important tasks that buyers and sellers were both forced to undertake as the pandemic took hold – helping borrowers, modifying payment due dates, amending borrowing bases, assisting borrowers to obtain PPP loans and so forth. Buyers certainly didn’t want to step up and pay a big price for a target in the middle of the unknown of the pandemic. Credit quality was expected to worsen considerably and that was enough to scare off most buyers.
Likewise as a seller, unless a company was operating in a unique niche that was benefiting from the pandemic (i.e., transportation factoring), loan balances were down dramatically from borrowers taking PPP funds to pay down their high-cost borrowings. It’s hard to sell for a top premium when your loans, revenue and earnings have all taken a hit. Thus, not a lot of buyers or sellers were in the market and few deals were announced. But that’s about to change.
Given current pipeline activity, and discussions taking place currently across the commercial finance marketplace, a lengthy list of M&A transactions are likely to be announced in the coming weeks and months involving asset-based lenders and factoring companies of all shapes and sizes. The fact of the matter is, the M&A market for commercial finance companies has become a “seller’s market.”
Why and how is this the case? The answer lies in the massive, seemingly never-ending amount of liquidity that has found its way into the coffers of likely buyers and investors, coupled with the lack of activity from the last year mentioned above. Thanks to the multiple rounds of government stimulus, the capital markets – including both institutional and retail investors – have never had so much capital with which to work. What do you do with all that money? You can’t put it all in the stock market. The fixed-income market offers little to no yield currently. Bitcoin? Maybe for some.
The reality is that much of the cash that found its way into the financial system has landed largely with banks, asset managers such as debt and equity funds, and insurance companies. And what these types of buyers have in common is they want steady yield without material downside credit risks. That’s where specialty finance has grown to be a bigger play for a wider variety of buyers.
To be fair, this isn’t a terribly new phenomenon. Banks have sought the yield and net interest margin enhancement that ABL and factoring can offer for decades, building these businesses organically or via acquisition. Debt funds – namely business development companies or BDCs – have been attracted to the steady cash on cash return they rely upon to make dividend payments and the added benefit of enhancing product offering beyond leveraged loans.
But today, banks have been thrust right back to the super low interest rate environment that we had just finally started to climb out of in 2018 and 2019. Only now, this low-rate environment is exacerbated by the previously described mountains of liquidity that have appeared on bank balance sheets. As a result, banks have never been so aggressive in trying to find niche lending businesses to enhance profitability. M&A announcements involving banks have been seen in the equipment finance and residential mortgage sector in recent months. Expect it to happen in the ABL and factoring space as well.
Likewise, you should expect to see more asset managers make the move into asset-based lending as some have done in years’ past (i.e., SLR Capital, White Oak Global, Ares Management and Benefit Street Partners, to name a few). The limited partner or shareholder capital these types of firms have to work with has only increased considerably and there is only so much organic growth to be had out in today’s competitive lending market.
Even insurance companies should not be counted out – they have been active in lending to specialty finance platforms (i.e., AllState) and owning select origination platforms (like Security Benefit owning Stonebriar Commercial Finance in the equipment leasing sector). The key will be obtaining a credit rating on the underlying assets, or borrowers, of the commercial finance company that, in turn, qualifies for appropriate risk-based capital treatment for the insurance company. This funding source is likely to become a bigger part of the market in future years.
On top of the incremental buyer interest in today’s market, many sellers are back at the table trying to figure out a strategic game plan. At the time of this writing, the majority of ABL and factoring companies have yet to get loans outstanding back to where they were at the beginning of 2020. That’s to be expected with the most recent round of PPP, a highly competitive market and the aforementioned boost of liquidity hitting the street. But that too leads to more sellers needing to consider how to be good fiduciaries and protect their investors’ capital. Many sellers had expected 2020 to be the year they would exit but then the pandemic hit. These sellers perhaps can’t sit on the sidelines much longer for one reason or another and are now back in the market looking for an exit, even if it will result in a lower sale price because of earnings not getting back to pre-pandemic levels.
Another possibility, if a once attainable sky-high premium doesn’t appear doable imminently, would be a merger into another like-sized, like-minded and like-challenged lender. There are various ways to effect a transaction of this nature, but the goal would be the old adage of “one plus one equals three.” In other words, add each business’ loans and revenue, chop some duplicate overhead, and the combined company’s bottom line and return on equity look better than each did on a standalone basis. Both company’s owners receive stock in the combined company in hopes that they ultimately own a smaller piece of a much bigger, and more profitable pie. Sounds easy enough but the reality is that asset-based lenders and factoring companies are really people businesses. Thus, company culture and team fit, both at the most senior ranks and in support positions, can be really difficult to figure out. But we’ve seen some try and expect that others will attempt this deal structure as a way to forge an intermediate step before an exit down the road in a more fully recovered loan balance and profitability situation.
In summary, it’s quite clear today that demand for quality commercial finance companies currently outstrips the supply of quality, differentiated commercial finance companies looking to sell. New entrants continue to emerge as well, multiplying both the competitive dynamic in the market and the need for buyers to seek acquisition targets as a way to grow. It all adds up to a return to pre-pandemic M&A transaction levels. Keep an eye out – you’re going to see some interesting announcements.