By: John O’Neill Managing Director, National Transaction Advisors – A Riverbend Company
With all of the talk of market peaks and asset bubbles, I don’t want to be an alarmist. Nevertheless, it certainly appears that there could be a black swan hiding in plain sight in the middle market asset-based lending world.
A little background. Prior to the Financial Crisis of 2007-8, commercial banks owned the middle market lending space, and there really weren’t alternative funding sources for healthy businesses. At that time, leveraged loans on LBO’s were priced at approximately LIBOR plus 250 bps in 2007, and middle market borrowers typically borrowed at Prime plus 150-300 bps from commercial banks (equivalent to LIBOR + 400-550 bps). This indicated that larger companies with significant cash flows were considered less risky than smaller companies with minimal cash flows. After the crisis (around 2010), leveraged loans moved up to pricing of LIBOR plus 450-650 bps, and middle market loans somehow moved down to LIBOR plus 300 (or less). At the same time, many of these asset-based loans moved from commercial banks to unregulated “alternative” lenders. This change in the risk-return paradigm was driven by a huge backlog of “hung” leveraged loan syndications tied to LBO’s during the crisis, and new pressures from bank regulators, who placed a higher value on the collateral coverage in asset-based loans. Since the financial crisis, this new pricing has largely persisted, despite the clearing of backlog in “hung syndications.”
Although most banks created their own asset-based lending divisions, they were slow to give up the prime-plus loans in their middle market portfolios, and non-regulated lenders took advantage of this opportunity and gained significant market share. Today, it is not uncommon for a middle market company to borrow from a Business Development Company or loan fund that probably didn’t exist before 2010. Many will argue that this is just the natural evolution of a market to a more efficient provider of capital and to a certain extent, they would be right. However, it isn’t quite that simple. Banks gather liabilities from diverse sources to fund their loan portfolios, including checking accounts, savings accounts, CDs, inter-bank deposits, Fed loans and long-term bonds. The blended cost of these liabilities make-up a bank’s cost of funds, which is subtracted from its loan income to determine net loan margin or essentially gross profit. Unregulated asset-based lenders are not able to access many of these sources of funding. In fact, certain term loans can be financed in the structured credit markets using collateralized loan obligations (CLOs), but revolving credits are primarily financed by a bank line. As it turns out, Wells Fargo Capital Finance is one of the biggest lenders in this industry. Sources estimate that Wells Fargo could be involved with financing nearly 50% of the “alternative” asset-based lenders in the market.
Having a critical source of financing in the middle market concentrated within one lender is problematic; and given the recent history of Wells Fargo, this is even more frightening. Wells Fargo is currently under investigation by the Senate Banking Committee, the Department of Justice, the SEC, an Independent Board investigation and the California Attorney General. On April 20th the Office of the Comptroller of the Currency and the Consumer Financial Protection Bureau announced a combined fine of $1 billion regarding issues in Wells Fargo’s mortgage and auto loan units. These fines were in addition to “remediating harmed customers, and addressing risk and compliance issues that precipitated the unfair practices.”
It is unclear what pressures may be applied to the bank as a result of these investigations. It is also unclear whether these regulators will expect Wells Fargo to ensure that their borrowers (the ABL lenders) are not engaged in similar practices. With such a significant position in the market and so much negative exposure involving the bank, any small change in underwriting at Wells Fargo could lead to a seismic shift in middle market, “alternative” asset-based lending environment. Obviously, this could result in a lack of available ABL capital in the middle market, which might have serious consequences for unsuspecting middle market ABL borrowers. Hopefully, this is a potential “black swan” that never materializes.
John O’Neill is a Managing Director at NTA-Riverbend. He is a former middle market, commercial lender, who has spent the last 17 years working primarily with middle market, distressed companies that have lost favor with their senior-secured lenders.
National Transaction Advisors (NTA) provides financial restructuring, difficult capital raises and sell-side M&A investment banking advisory services to under-banked, middle market businesses. The firm’s professionals have significant experience selling, investing in, raising capital for, and/or consulting with numerous companies, representing billions of dollars in transaction values. NTA is the corporate finance vertical of Riverbend Solutions Group, which is a multi-disciplinary advisory and investment firm set up to seamlessly navigate the myriad of “special situations” that middle-market business owners and stakeholders encounter. The firm’s independent business lines cover the entire spectrum of “special situations,” including performance improvement, crisis management, corporate finance and distressed investing.