Perer: How active is the second lien lender finance market?
Soiefer: The market is quite active. We have had multiple transactions close this year and have a very active pipeline of deals we are evaluating. We believe tightening from the banks is creating favorable tailwinds for the second lien market.
Taratus: There are really two markets for second lien/senior unsecured. There is the market for investment grade rated transactions which is a fixed rate product and is sold primarily to insurance companies. That market comes and goes but is currently open for smaller deals (up to $75 million) that receive an investment grade rating. The more traditional non-rated private market is usually open but currently priced wider than the rated deals and is a floating rate product. It is most active when the rated market is closed, or the deal cannot get an investment grade rating. We look at both markets when we are placing a junior security.
Chang: The number of players focused on smaller opportunities is very limited. For larger opportunities, there are quite a few structured credit funds that are active. ELF has established partnerships with key second-lien providers, allowing us to collectively deliver a one-stop solution to our clients.
Perer: Talk about the partnership and competition between and among bank and non-bank lender finance groups.
Taratus: I really don’t see much of a partnership other than non-banks reaching out to commercial banks to provide back leverage through a first-out piece for the first 40 to 50 percent of the advance rate. Usually that is done behind the scenes, where our borrowers see only the credit fund as the lender. The more subtle partnership is many times when we call our friends at various banks or credit funds, if a transaction may not be a fit for them, they are typically very helpful in suggesting who they have seen do that type of deal and in making introductions if necessary.
Chang: Despite the large number of players in lender finance today, it remains a “small world” with very few degrees of separation. We’ve generally all worked together on previous deals. Thankfully, ELF has tremendous relationships with many trusted banks, and we’ve found numerous opportunities to partner together on transactions. Referrals flow regularly both ways, and ELF also directs a healthy flow of treasury management opportunities to its banking relationships. ELF infrequently competes against banks, and banks will often send us referrals of deals that aren’t a fit for them. ELF traverses a wide space between large bank lender finance shops and credit funds, and we can offer the best of both worlds.
Soiefer: We have worked alongside many banks when we are providing financing solutions. While we typically lead financings, typically speaking for the entire tranche, we have worked alongside several other non-bank lenders. We are most focused on finding good counterparties and welcome partnership with both bank and non-bank lenders.
Katz: A few years ago, Texas Capital changed its approach to either be the sole lender or agent on larger, syndicated transactions. For transactions we syndicate, our goal is to bring in like-minded firms that have a lender finance focus and the capabilities to grow from their initial commitment. It’s pretty rare that we run into the non-bank lenders from a competitive standpoint given the cost of funds differential.
Perer: Is there too much focus on hard assets versus emerging sectors such as software?
Soiefer: I think there is an increasing amount of capital in emerging sectors like software. Our platform has a significant amount of experience in hard asset lending, and it is where we have been most active, but we are always looking for other asset classes that we might be able to leverage knowledge from the rest of the SLR platform.
Taratus: I would not say it like that. There are lenders for just about every deal. Some focus on the hard assets and some focus on the balance sheet light companies. When we look at software companies or other balance sheet light companies such as asset managers, we look at recurring revenues or “re-occurring” revenues and get comfortable with those.
Chang: For traditional commercial finance companies, not at all! Emerging sectors such as software tend to be a better fit for lender finance companies that target enterprise value lenders and private credit platforms.
Katz: Our core industry focus will remain the same for the foreseeable future, but we will allow for concentration buckets on a case-by-case basis as long as the borrower/prospect can show a successful track record coupled with an experienced management team.
Perer: Has the evolution of the lender finance market driven the growth of the ABL industry or vice versa?
Chang: It’s both. Many bank ABL groups delved into lender finance as a natural product expansion. As the number of lender finance entrants grew exponentially across banks and non-banks, independent ABL companies were able to access deeper pockets of capital, resulting in the large number of ABL players you see today.
Soiefer: I think it is a combination, but ultimately the growth in the ABL market and the demand for specialized SME & consumer lenders has prompted the growth of the lender finance market. The increased availability of the lender finance product has helped enable those companies to scale.
Taratus: I would say it is the latter. As our clients find new assets and markets where they can lend attractively, the lender finance groups at both commercial banks and non-banks have followed.
Katz: Great question! My belief is that the ABL market would continue to grow and flourish without dedicated lender finance debt providers. Other debt providers would have stepped up once they understood how ABLs work, assuming it met their return hurdles. It’s a great business when run and monitored correctly.
Perer: Are the smaller non-bank ABLs and factors capitalized well enough to withstand a deep recession that might severely impact their current portfolio?
Chang: Many are not. We’ve seen companies that do not have sufficient junior capital to address noise in their portfolio. When their loans to customers become delinquent or defaulted, those ABLs and factors are out of formula with their lenders without an ability to cure over-advances.
Soiefer: We often find the management teams of small non-bank ABLs and factors are very good operators and obviously manage their own capital structures very efficiently. Accordingly, we do think these firms are well positioned, and if any need supportive capital in the event their bank lines tighten up, that is where we come in.
Taratus: It all depends on the asset class. Certain asset classes such as factoring have very low default rates so they should be fine. On the other hand, those asset classes that showed weakness during COVID may have a concern.
Katz: It is hard to answer that question on a global basis, but I personally can only respond on balance sheets I have seen. Our standing underwriting practices include an analysis of the capital on balance sheet and if there is ample additional capital available when needed to support losses.
Perer: Should there be more consolidation in the non-bank ABL industry?
Taratus: Definitely! There are so many non-banks in the market that we don’t see how they can all get enough volume to support themselves. Some are able to differentiate themselves through advance rates or interest rates, industry relationships or structures, but many are fairly similar in what they offer.
Chang: I believe most of the consolidation will come from vertical expansion, as larger non-bank ABLs acquire specialized ABL lenders. Aside from that, consolidation in non-bank ABL has been fairly limited, and I believe it will stay that way. It’s been more cost-efficient to build out an existing platform versus acquiring a peer/competitor at the rich multiples we have seen over the past several years.
Soiefer: I think the last ten years have proven that a market opportunity exists both for stand-alone, non-bank ABL players and also for businesses with a more consolidated product offering. We have opted for the latter via both acquisitions and through building new product lines from scratch. We continue to be on the lookout for new businesses, teams, and business lines to add to our ABL and specialty finance offering in the years ahead.
Katz: I don’t think there should be consolidation; more options for potential borrowers is always a good thing. But new entrants into the ABL space will make it tougher to grow, so I believe consolidation is inevitable.
Perer: Do you see the vertical expansion in ABL continuing?
Chang: Yes. To use your analogy from last year, I believe we are near the middle innings of vertical expansion in ABL. SLR, eCapital, White Oak, Great Elm and others have been doing it for many years, and it’s brought tremendous value to their businesses through footprint expansion, economies of scale and cross-penetration. As ABLs look to grow, vertical expansion continues to be an attractive proposition.
Katz: Yes, and we have seen it recently. For example, Oxford Commercial Finance offering PO financing and Gibraltar getting into equipment financing. You can say the same for factors that are diversifying into ABL to enhance product offerings.
Taratus: We would expect to see this trend continuing as lenders are looking for more specialization in order to be competitive.
Perer: Where do you see portfolio companies such as ABL groups taking too much risk?
Taratus: It can happen in any asset class. In my view, the problems come when an ABL lender does not understand the risks of a particular asset class and does not structure their transactions properly.
Soiefer: To us, it always comes down to experience and capability of the management teams. Groups that have worked through cycles and put in place strong credit policies & procedures should outperform in the long run. In times of tougher competition there will be some firms that stretch outside of their typical knitting which can be a bit dangerous.
Katz: The risk I see are ABL’s, factors and other commercial finance companies expanding and entering markets without hiring an expert in the new product being offered.
Chang: It’s the same scenarios we’re all familiar with: Lending against illiquid assets that are subject to volatility in values, and lending into sectors where the ABL team has less domain expertise.
Perer: What is a perception you have about today’s ABL market that is not widely shared?
Taratus: The ABL market today reminds me of going to Baskin Robbins Ice Cream when I was a kid. There are many flavors, and some people liked the plain vanilla flavors (oddly enough, such as vanilla!) while other people liked the more exotic flavors such as Top Secret or 32nd flavor! There are plenty of different asset classes and there are plenty of lenders to finance them.
Chang: Despite the tremendous growth in bank and non-bank ABL over the last two decades, there remains a great opportunity in the space for new entrants. Yes, the space can feel very crowded at times. However, strong and experienced management teams remain successful in building new ABL platforms.
Soiefer: We think there are many fintech companies that utilize enhanced underwriting and portfolio monitoring systems, and this will be the way of the future. We do, however, continue to firmly believe in the benefits of not fully outsourcing these functions to technology systems. The ability to conduct primary due diligence and ensure credit quality of collateral we think remains the key element of any ABL lender and think those with experience to do this manually (with the help of technology) will continue to outperform for the foreseeable future.
Katz: That it is not a stagnant, old school financing tool. If anything, as technology improves, this market will continue to grow and continue to attract new capital.