An Awakening in the ABL Market?
In 1990, Robin Williams starred in a movie entitled, “Awakenings,” about a patient who, after being provided with a specific medication called L DOPA, was “awakened” from a 30-year catatonic state, only to return to that catatonic state shortly thereafter due to a decline in the efficacy of the drug after repeated use.
The new administration in Washington sparked a “Trump Bump” during first quarter — which manifest itself in increased optimism for potential tax and regulatory cuts, a rising yield curve. and higher sustained GDP. In light of this environment, we suspect that the asset-based lending industry has the potential to awaken from the catatonic state induced over the last decade by recession, regulation, competition, and the blowback from central banks flooding the world with cash and extended ultra-low interest rates.
In this article, we will summarize the anticipated economic events and drivers likely to impact the second quarter (Q2) that we believe are predictive for the next evolution of banking, and the asset-based lending world, specifically. In working with private equity (PE) and middle-market companies in various industries across North America, we are observing the following general trends:
- Optimistic sentiment about the overall environment — The Small Business Index and the Michigan Consumer Sentiment have bubbled up to decade-long highs. However, underneath the sentiment, there appears to be caution induced by the cacophony of tweeting and the extended nature and quantity of legislative initiatives. Unless the noise subsides and specific initiatives get traction in Q2, we see sentiment seeping back to the slow GDP growth and grind of the last eight years.
- Rhetoric from business perspective — negative under Obama, positive under Trump. Under the Obama administration, middle-market business executives and bankers had an expectation of perpetual increases in taxation and regulation. Under Trump, the rhetoric is reversed in favor of less regulation and taxation (e.g., the “2-for-1” executive order requiring departments to discard two regulations for every regulation added).
- Sector confidence — “A Player” CEOs are optimistic in regard to opportunities in their sectors. “Animal spirits” are as strong as we have seen them, without being foolish (like in the late ‘90s). Lenders should look to back the U.S. middle-market executives who have catapulted their way through the recession to sustained growth over the last eight years.
- Applied technology is assaulting most business models. We are experiencing a phase of innovation in which most industries’ value offerings are materially impacted by technology. In this way, Darwin trumps Trump in terms of impact. As Darwin noted, “It is not the strongest of the species that survive, not the most intelligent, but the one most responsive to change.” Lenders should probe CEOs regarding the impact of technology on their business models.
- It’s the talent, stupid. The biggest issue that we hear from execs is finding and retaining qualified workers in the SMB space. This message is across all sectors, including consumer/retail, manufacturing/distribution, software/services, and healthcare. Moreover, given the complexities of today’s world, developing training programs is difficult, expensive, and requires a focused commitment over time.
With Regard to M&A and Private Equity:
- Private equity’s dry powder continues to outweigh the number of middle-market companies for sale. We believe this will keep prices elevated for quality assets. Asset-based lenders with knowledge and experience in deploying capital in an acquisition should see adequate deal flow throughout 2017 and into 2018, with a focus in oil/gas, healthcare, and manufacturing/distribution.
- The gradual process of increasing interest rates is not impacting the desire to make investments and complete transactions. Should there be a more substantial increase in rates (+ 100 basis points in a year), we would expect EBITDA multiples of new acquisitions to decline by several turns, and highly-levered or recapitalized acquisitions from 2014 to 2017 to experience stress and be potential work out candidates. Forward-thinking lenders will require highly-levered companies to perform the equivalent of a “stress test” at higher rates to understand how further increases in interest rates would impact their collateral.
- Congress is considering eliminating the ability to deduct interest expenses from taxable income. This is a substantial problem for private equity. The fuel for middle-market private equity is debt and this type of change drowns the heart of the PE business model. Unless purchase prices substantially decline, M&A volume will decrease, thereby significantly impacting new loan origination. Follow the interest clause in the legislation closely; if there is a chance that this provision will take hold, expect M&A volume and pricing to decline in the short-term.
- Regulatory uncertainty has created a business model fog for certain sectors. Private equity is applying a higher level of diligence in making new investments in healthcare, manufacturing, and retail until the fog of rhetoric related to the Affordable Care Act and proposed Border Adjustment Tax is replaced by the high pressure of real legislation.
On the Policy Front:
- Tax simplification and lower rates are very positive. We believe simplified and lower tax rates are driving the optimism of business leaders, consumers, and investor communities. This is good news for lenders, as there would be additional money to support prudent loan origination and debt repayment.
- Border Adjustment Tax is a bad idea. Americans want cheap stuff – just look at all of the “dollar stores.” Furthermore, we do not believe that the administration has fully considered the unknown secondary and tertiary effects of this novel proposal. Does the administration truly want to clash with Walmart and its shoppers who voted for Trump? We hope the math work tempers Congress’ enthusiasm for lower tax rates and convinces them to settle for a proposal that falls between the current state and initially desired state.
- Reducing regulatory wet blankets is beneficial for banking, energy, and manufacturing sectors. In the third quarter of 2016, we began to see investment dollars return to the oil & gas regions; the Trump election has accelerated this trend. Lenders should see opportunities in this industry segment without the euphoria of the commodity boom of 2011 to 2015.
- Removal of less efficacious provisions of Dodd Frank would be beneficial. Ideally this should make it easier for all banks to engage with customers while providing a tailwind for small and community-based banks to return to the business of lending. The “non-bank” lenders have filled a void over the past five years and competition could intensify if the regulatory hand cuffs are removed from traditional lenders.
A Look at Manufacturing:
- Manufacturing in 2017 is not manufacturing in 2007. We believe there is a real opportunity to expedite the onshoring of manufacturing facilities due to the following:
- Decline in labor arbitrage between the U.S. and developing nations, as well as labor as a percentage of total production cost.
- Automation and 3D printing fundamentally changing how manufacturing facilities operate.
- Demand for speed and customization, resulting in higher value tied to having manufacturing facilities close to the consumer.
- Customers are demanding more services in conjunction with their products, and companies whose products are tightly wound with services will win.
A January 2017 report on U.S. manufacturing competitiveness from the Boston Consulting Group noted: “When indirect costs for shipping, inventory, and other expenses are included, it is now less costly to manufacture a wide variety of goods in the U.S. if that is where they will be consumed.” Manufacturing-focused lenders should expand marketing efforts in their local communities to get an early look on who might be relocating or expanding in their area.
Proximity of R&D centers to manufacturing facilities results in effective applied innovation. Understanding how to make a product is crucial to improving upon it. Innovative ideas that can be conveniently tested lead to better products and processes, which in turn can benefit other manufacturers in the future, regardless of industry. Oil & gas exploration, production and service companies have substantially driven costs down, proving the industry has found a globally competitive cost structure and is here to stay. Manufacturers realize the inherent value of positioning a facility near reliable, low-priced energy; with U.S. shale O&G fields and related transportation infrastructure in place, expect the “Rust Belt” in Texas to continue advancing.
Auto appears to be peaking, which could expose lenders to auto supplier risk. In February 2017, 1.33 million vehicles were sold in the U.S., down about 1% from February of 2016. Furthermore, the “days to turn,” or the number of days a vehicle is on the dealer lot before being sold, hit 74 days in February – the highest of any month since July 2009. Lenders with exposure to this sector should pay attention to the monthly financials and quarterly covenant calculations.
In conclusion, we believe that Q2 2017 will be a bellwether quarter for the subsequent eight to ten quarters. If the current administration can push through the policy initiatives that are valuable to the business community without doing something shortsighted, such as the Border Adjustment Tax, then 2017 will be an excellent year. If the administration has limited progress, 2% GDP growth remains, and/or a crazy political, self-inflicted, or major terror event occurs, all bets are off.
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