Non-Regulated Lenders Filling The Gap As Banks Pull Back by PitchBook
Q: Do you have concerns over low interest rates continuing to stimulate buybacks of shares and push up corporate earnings, among other effects, or since the Fed seems likely to raise rates in December, do you anticipate this being less of an issue?
Record low interest rates have been the reality for the last several years. However, there has been significant “talk” over the past 18 months of the Fed changing its strategy and beginning to implement rate increases.
Companies and sophisticated investors have incorporated the Fed’s interest rate strategy into their own strategic planning and financial forecasts. If the rate increase begins in December, it should have no material effect. However, for the general retail investor who relies on current headlines for their investment decisions, the Fed’s choice to raise rates or keep them flat has, and should continue to have, a material effect on the stock market volatility.
What do you identify as the main trends in lending markets that will shape the next few quarters? Are lenders still aggressive, and is that still shaping typical loan structures?
Financial institutions have been pressured to lend again, and are sitting on large pools of capital that need to earn returns. Thus, debt facilities for these quality deals are very competitively priced with pre-recession covenant-light structures.
While there is a large pipeline of potential transaction activity, current economic conditions have caused many companies to go to market for the wrong reasons—liquidity, financial performance, or the tax code, for instance. It may be that there are too many deals being marketed with ‘hair on them’, and too few good-quality companies for sale. In other words, banks are aggressively competing for a smaller number of attractive opportunities.
Banks seem to be more concerned about the leverage limitations being imposed upon them by the regulators than they are about pulling back due to credit concerns. Most bank economists believe that the economy will continue to grow at a moderate rate, so there is no recession forecasted in the medium term that could significantly impact corporate profitability. A potential increase in interest rates is, however, a concern in leveraged transactions to the extent they are not properly hedged. Also, banks appear to be getting nervous about covenant-light structures and how that may make the next cycle worse than the previous one. Generally speaking, banks are getting more conservative, but the gap is being filled by non-regulated lenders.
Today’s asset-based lending environment continues to get pushed beyond the traditional structures. As a result, lenders find it more difficult to meet growth objectives, deploy additional capital, and differentiate themselves from their competitors. As such, a key distinguishing factor among lenders has become their willingness to utilize the value of certain intangible assets within their loan structure. As a matter of practice, intangible assets have historically been viewed as “boot collateral”, or as a way of stretching advance rates on traditional assets. This thought process, however, ignores the fact that certain intangible assets have true liquidation value. As such, loan structures should take into account the potential amounts that can be realized upon the liquidation of these intangible assets.
What are the factors buyers nowadays are looking at most closely as they conduct pre-acquisition diligence?
It is extremely difficult to arrive at an accurate valuation of a target company in today’s market. Not only has the economy wreaked havoc on a business’ operational, financial and strategic initiatives, but there are many other factors that contribute to the complexity of valuing a target company.
Current economic conditions are creating a tremendous amount of stress on operations and results. Companies are faced with severe liquidity concerns, unpredictable consumer demand, and challenges to supplier relationships. These factors are creating significant uncertainty and unpredictability regarding current performance, as well as a lack of visibility for future projections, which make accurately valuing an entity as a going concern an extremely challenging exercise.
Even in good economic times, there are many factors that must be addressed when valuing a target company beyond just financial results. Is the target a public or a private company? Is the industry growing, contracting, or plateaued? Is the industry global, domestic, or regional? How competitive is the industry and its participants? How experienced is the management team and are they capable of taking the company to the next level? Does the target company have strong relationships with its suppliers, vendors and distributors? Are there significant regulation or compliance requirements related to business? Does the business have intellectual property and is it properly protected from infringement? What is the value of the intellectual property and is it transferable upon a change of control? These are just a few major issues to address when attempting to accurately value a target company.
Publicly traded companies are generally easier to value due to the higher quality and quantity of available information for the company. There are, however, several additional factors to consider. Will the target require a significant premium over their current valuation or is the market fairly valuing the entity and its future prospects? Will the target welcome an offer from a potential suitor or will the situation be hostile? Are there cost synergies that can be extracted from the target to extract additional value?
Privately held companies are generally plagued by a lesser quality and quantity of information that can be used in an analysis. Also, a private company’s capital structure could be more complex with various classes of equity and debt securities.
There are, however, a few additional factors to consider. What is the corporate structure and will it create tax complications? Is the target company reliant on a few key individuals and would they be willing to join the acquirer? Has the current ownership group incurred extraordinary expenses or received large dividends or other forms of compensation that would not be incurred going forward post transaction? Is the proposed transaction an asset sale or a stock sale?
Which sectors are still seeing the most heated multiples and do you anticipate those to persist in the short to medium term?
The year has not been kind to the financial markets, producing negative returns after years of a frothy bull market. The energy sector (i.e. oil and gas) and commodities (i.e. metals, mining, etc.) have experienced severe downward pricing pressure. However, there have been certain sectors that have continued to drive high valuation multiples, including healthcare and technology.
Expectations are that these sectors will revert back to their normal trading prices. However, several opinions believe the downward pressure on the energy and commodities sectors will get worse before it gets better.
Where do you think undervaluation exists in the current market, if it does?
As previously stated, the energy and commodities sectors are experiencing material downward pricing pressure, with many investors experiencing significant losses. However, one person’s loss can be another person’s gain. Long-term strategic investors holding patient capital who believe these sectors will recover to historical levels can buy now and lock in a low base, only to achieve long-term gains when the market turns.
What’s your take on cross-border M&A right now and where it is heading?
As the world gets smaller every day in our growing global economy, there are various challenges to consider, including specific