Through this author’s work at a corporate recovery and public affairs strategies consulting firm, a number of opportunities have arisen to interact with a variety of lenders. Over the last few months, thanks to the magic of informally polling some of these middle-market lenders about the current state of the marketplace, it is clear that several trends have emerged. All seem to agree that there are opportunities, but in the current low interest rate environment, things are competitive. This article touches on new clarifications from the Office of the Comptroller; leveraged lending favoring non-bank alternatives, loan structures and pricing eerily similar to what we saw pre-crisis; shifts in FDIC insurance premiums, and; opportunities for larger Small Business Administration (SBA) loans.

OCC Clarifies Views on ABL “Revolver Only” Facilities

In March 2014, the Office of the Comptroller of the Currency (OCC) issued a Comptroller’s Handbook providing new guidance for evaluating ABL loans under their supervision. OCC scrutiny has intensified significantly since the great recession but, until recently, there was not sufficient guidance as to what parameters by which ABL lenders would assess credit-risk ratings under the new guidelines, so it was unclear exactly where the pass/fail line was in this new environment. The new handbook replaces the ABL guidance in section 214 of the October 2009 Office of Thrift Supervision’s (OTS) examination handbook.

While post-recession OCC guidelines have focused heavily on leverage ratios, this handbook does provide guidance for risk rating ABL revolver-only facilities on a liquidity basis -- essentially a “collateral deal” carve-out. The OCC’s position is clear that the ABL revolver must be properly structured and fully followed in order to risk rate on a liquidity basis as opposed to a cash flow basis.

What is sufficient liquidity? New guidance states that, “Liquidity is usually considered sufficient if it can cover the borrower’s actual cash burn over the last 12 months and upcoming 12 to 18 months.” Other required factors outlined in the handbook include stable trends, reliable projections, reasonable operating performance, collateral that is self-liquidating, and a stand-alone (not pari passu) credit facility. In the case of a “turnaround” situation, the handbook suggests that performance needs to be reasonably tracking to a viable turnaround plan.

When speaking with ABL lenders about the new handbook and guidance, they are appreciative of the clearer guidelines. John Sorber, a senior vice president with FirstMerit Bank Business Credit, indicates that, “This new guidance from the OCC is an important development in evaluating new credit opportunities. We had been, to some extent, operating in the dark as it came to our ability as a regulated bank to pursue tougher, more collateral oriented credits. This gives us some tangible guidelines on how to evaluate and properly risk rate these types of opportunities so that they may be added to our loan portfolio without inviting additional OCC scrutiny.”

Leveraged Lending Favors Non-Bank Alternatives

So what exactly is ‘Leveraged Lending’? 2013 OCC guidance defines leveraged lending as deals that are 3x senior secured debt to EBITDA or 4x total debt to EBITDA (with second-lien debt included in both senior and total debt). The OCC further clarifies that deals that exceed 6x leverage will raise supervisory concerns.

Now that the OCC has clearly defined what leverage levels are acceptable, one wonders what percentage of deal flow is currently within these parameters. Depending how you classify the “middle market,” well over half and approaching three quarters of deals in 2013 had leverage (including second-lien) in excess of 4x senior, or 6x total. Any way you look at it, leverage ratios are increasing from levels in 2011 and 2012 and in many cases are exceeding pre-crisis levels again. The trend has been, and seems to continue to be, toward greater leverage.
Regulation and the current low interest rate environment has made non-bank alternative lenders a popular choice for smaller companies that are seeking leverage levels which no longer fit work in a regulated environment. Time will tell if this trend of relaxed structure and pricing will cause problems down the road.

Is It 2006 Again?

It sure feels like it, particularly from a loan structure and pricing standpoint. A common theme continuing into 2014 is that lenders are trying not to lose loans to structure and pricing in an environment where capital raised continues to exceed deal flow. Senior cashflow and mezzanine lenders have been forced to reduce amortization and pricing given the current ratio of available capital to financeable deals. It is certainly a favorable environment for companies with reasonably healthy balance sheets looking to refinance existing debt.

In an environment like the current one, with many lenders chasing a limited number of deals, there tend to emerge “creative” deal structures. An example of this in the middle market is when a prospective lender reviews and appraises collateral and determines that the maximum availability on an ABL revolver-only facility comes up short. In a less-competitive environment, they would walk away at this point. However, there currently appears to be a willingness to entertain a term piece to make the overall deal work.

As discussed earlier with respect to new OCC guidance, a path for collateral deals has been provided. However, when a term piece is creatively inserted to close a collateral gap, this will subject the lender to leverage ratios and could call into question the entire facility. Will this lead to problems? Again, time will tell. There’s certainly little reason, based on past experience, to expect that it won’t.

FDIC Insurance Premiums Priced on Portfolio Risk Instead of Deposits

One trend that has not been discussed much is a shift in FDIC insurance premiums. Historically, premiums were based on the bank’s level of deposits. Post-crisis guidance has shifted this to assess higher insurance premiums (i.e. – higher cost of funds) to institutions which have more high-risk assets (HRA’s) or a more leveraged portfolio, as defined by the criteria discussed above.

This shift presents yet another cost of funds issue for regulated institutions. While not an overwhelming cost according to lenders we interviewed, it is measureable and does provide one more hurdle to competing with the non-bank alternatives. Combining increased competition for deals with reduced margin per transaction leads to the trend of increased creativity (which used to be called relaxed covenants) with the hopes of making up the cost on volume. This harbingers continuation of the trend towards creativity in response to deal competition.

Middle- Market SBA Opportunities with Loans Up to $5MM

“Middle Market” no longer means “too big” for the U.S. Small Business Administration (SBA). In 2010, the SBA increased its loan limit to $5MM on its flagship 7(a) term loan program. This has provided a viable lending source to middle-market companies who may still be under the misconception that SBA assistance is strictly for start-ups or “mom and pop” businesses.

A middle-market company of $20MM in sales often has a large real estate facility and/or significant equipment needs, especially when facing a turnaround situation or adverse relationship with its bank. While there are many ABL lenders to service the working capital and revolving credit needs of these companies, restructuring long-term debt and extending some permanent working capital utilizing the hard assets is often a need that goes unmet. That’s where an SBA 7(a) term loan can make a lot of sense for a middle market company.

Historically, SBA lenders had structured their loan departments to service the previously mentioned market of start-ups and “mom and pops.” This has been changing in recent years with the increased $5MM loan limit. We now see more sophisticated lenders emerge who have extensive experience in both commercial lending and SBA Standard Operating Procedures (SOP). These lenders are equipped to service middle market businesses not previously able to benefit from an SBA guarantee.

One such entity is 44 Business Capital, which has a niche specialty in assisting businesses in obtaining SBA 7(a) term loans -- that is all they do. Its President, Greg Poehlmann, explains, “The SBA allows equipment debt to be financed over ten years and real estate debt over 25 years. Throw in some permanent working capital to pay down a “stagnant” line, and a borrower can change the complexion of its balance sheet dramatically.”

In summary, we are seeing that regulated institutions now have more clarity from the OCC, and while a carve-out exists for revolver-only ABL deals, leveraged lending is trending towards favoring non-bank alternatives that have more flexibility than the latest OCC guidance allows. Loan structure and pricing is extremely competitive in 2014, due to an abundance of liquidity in the marketplace. Overall, middle-market borrowers with reasonably healthy balance sheets have numerous sources of debt financing available to them, including an often-overlooked SBA option. We expect these trends to continue until there is a downturn in the economy, a significant rise in interest rates or some combination of the two.