“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” — Chuck Prince, Citigroup, 2007

Chuck Prince became a media punching bag when, shortly after this quote, Citigroup suffered credit losses resulting in a 97 percent reduction in share price. But his account amounts to a straightforward explanation of why credit bubbles persist. Even if Citigroup’s executives were worried that loan terms had gotten too loose, it made little sense for them to pull back. They could not know for sure when the music would stop, and they would risk ceding market share and revenue for the year or two or three before it did. So, they kept dancing.

In our business, we tend to fixate on what the economy will look like in six months, a year or two years, as if any of us can predict the timing of the credit cycle. How many times over the last five years have we sat through panels about the “upcoming dislocation” in which prognosticators attempted to draw broad inferences from discrete data points? I have found myself listening to people cite “the imminent wave of C&I defaults” regularly since 2015.

At the same time, we know with each passing day we are one day closer to the next recession and corresponding credit deterioration. As Howard Marks detailed in his June article, “This Time It’s Different,” the recent simultaneous realities of economic growth, low inflation, low interest rates and rising asset valuations are inherently incompatible and haven’t coexisted historically. It would be foolish to assume they will continue to do so.

So, there you have it. We tend to be poor predictors of the timing of the economy, and yet we all know that future conditions are more likely to worsen than improve. We face this dynamic at a time when general investor enthusiasm has pushed loan structures to a minimal margin of safety. Indeed, asset-based lending industry leaders with decades more experience than me say that the current market is the most borrower friendly they have seen in their careers. Returning to Chuck Prince’s original premise, should we still be dancing and how do we do it without getting burned?

Should We Keep Dancing When the Floor is Overcrowded?
In a word, yes. As direct lending platforms tasked with increasing franchise value over the long term, we are required to find ways to stay active throughout the cycle. It is critical to attracting and retaining talent, managing throughput and utilization of team members, cultivating referral sources, and maintaining the value of our sourcing engine.

Momentum is a real force in our business. At Veritas, we have lived through periodic stretches without a loan closing. This has pronounced negative effects on all areas of the firm. It’s an experience that can stop a firm’s momentum cold, giving competitors a chance to capture mindshare and influence. The opposite is also true — when we have bounced back with a closing, a wave of new opportunities tends to follow. Activity begets activity. Finance companies cannot pull back significantly on a downbeat without losing momentum. When the opportunity set expands, they will not be able to accelerate fast enough to capitalize.

Choosing the Right Dance Partner Matters
The challenge we face in maintaining momentum is ensuring that we are taking quantifiable and manageable risks — ones that may leave us bruised occasionally but not slain when the downturn eventually does arrive. That way we are positioned to capitalize on the expanded opportunity set at that time. Honing and capitalizing on areas where we have an edge is a far more rewarding and profitable strategy than pursuing plain vanilla deals which typically become a classic race to the bottom on price and structure. Experience and capabilities matter, and lenders with a specialization can provide flexibility that others cannot.

For Veritas, in recent years that has meant providing more complex solutions that do not fit the traditional ABL revolver only model — for example, lending against real estate in conjunction with working capital assets, or partnering with other forms of specialty lenders (factors, PO funders, special situations investors) to provide a hybrid solution. For other firms, it is providing more robust equipment solutions. One of our direct competitors has distinguished itself by leveraging its expertise in inventory liquidation to provide compelling advance rates and balancers. I see various firms who have succeeded in developing industry niches and are now the “first call” in that sector.

Most of these examples involve greater complexity and structural risk than any of us would choose to take in a perfect world where we could dictate loan terms. But it’s a reflection of the current market reality combined with the underlying premise that (dare I risk my future by putting this in writing) — when the music is playing, we still have to dance. The penalty in terms of likely opportunity cost is too great to justify sitting on the sidelines while awaiting the eventual opportunity expansion. To be successful with this strategy, we emphasize deals with collateral packages and structures designed to limit losses in a decline, and generally trade margin for greater safety.

Judging the Dance Competition
The most successful direct lenders I have observed in my two decades in business do not spend a significant amount of time trying to predict the details of what will happen in the economy, interest rates or future changes in asset valuations. Rather, they use current data to get a realistic general sense of where we are in the cycle, adjusting their level or exuberance / caution accordingly. They then leverage their competitive advantages and time-tested credit management processes to consistently outperform the market on a relative basis.

In ABL, we are not paid to be forecasters. We are paid to build processes and talent that together reliably produce outcomes that in aggregate perform better than market. The value of a direct lending platform is not a function of being able to predict a downturn and fully avoid pain. It is a function of being positioned to reliably generate wins in the market, having a rigorous understanding of the risks being taken, and the credit management process and talent to manage the portfolio effectively. If we look at who in asset-based lending has successfully built real franchise value, it is those platforms who have done those things well over many years.

In our business, the most value is captured in the years following a recession. That is when lenders with capital and ability to execute can lock in relationships while dictating structure, freed from the competitive excesses experienced late cycle. I am extremely confident that the firms that will capture most of that value are the ones who execute on the difficult task of maintaining their momentum until that day comes.

So, when you see me at the next industry cocktail party, feel free to ask me what we are doing well and not well, who among my competitors I think is executing according to a winning strategy, and who I believe has succeeded in hiring the best people. But please do not ask me what inning of the credit cycle I think we’re in.