by Deirdre Martini, David W. Morse
The growth in the asset-based lending market throughout 2006 and 2007 was helped by the role those loans played in large, multitranched financings that included institutional term loans or high yield bonds for leveraged buyouts and refinancings. During that time, asset-based lending became firmly entrenched as a capital market product that worked alongside other products to fill out the capital structure for issuers (Figure 1).
During the first quarter of 2006, 123 asset-based loan transactions were completed, followed by 117 in the second quarter (Figure 2). In all, 423 deals were completed during the year. The following year started in similar fashion, with 111 deals in the first quarter of 2007. As the year progressed, the breakneck pace slowed somewhat, but 454 asset-based deals had closed by year end, with a total dollar volume of $74 billion.
But competition for scarce assets, plummeting pricing, and borrower-friendly structures were the real headlines of the era, at least through the first half of 2007. Asset-based lenders faced significant challenges to grow assets in 2007. Much of the volume during the year had come from upsizing existing transactions or otherwise involved existing asset-based loan issuers rather than new-money deals.
Companies returning to the market during the first half of 2007 were looking for reduced pricing, and with demand for deals chasing a limited supply of them, a borrower’s wish invariably came true. While perhaps pricing declines were more prevalent in institutional tranches at the time, asset-based lenders were inevitably dragged down, too.
In addition to the scarcity of new borrowers and the reductions in pricing, lenders were taking on more risk. A 2007 article about a conference at the Institute of International Finance quoted one banker as saying, “There appears to be an increasing lack of differentiation in the markets and lenders all too often are setting aside key documentation and credit standards.” Another said, “As liquidity has continued to be high and the deal flow has accelerated, we have seen a lowering of lending and investments standards in some markets.”
In August 2007, after the leveraged loan market had essentially shut down, asset-based lending continued to roll. But by mid 2008, asset-based lenders were no longer immune to the slowdown. Loan loss provisions limited banks to identifying capital only for use in “strategic” transactions based on cross-selling opportunities or major corporate relationships. Many participants in the asset-based lending market lost capital support or access to capital. Asset-based lending slowed to a crawl, and deal volume plummeted. The illiquidity that ruled the credit markets at the time, unlike in prior crises, landed for the first time with a resounding thud on asset-based lenders’ doorsteps.
But by 2010, asset-based lenders’ doors were wide open and business took off again, accelerating through 2011, when the volume and deal count set new records. That included record-setting volumes of $30.89 billion in the second quarter of 2011 and $82.9 billion through the first three quarters of the year. Clearly asset-based lending was back, exceeding even the frothy levels of 2006 and 2007.
But just as in 2006 and 2007, 2011 was characterized by a scarcity of new issuers. Even more so than in 2006 and 2007, the spectacular volume of 2011 resulted from refinancings, not new issuers finding their way to the asset-based lending market (Figure 3). And just as in those prior years, the scarcity of new issuers was again a major challenge for lenders desperately hungry to grow assets. In fact, through the first three quarters of 2011, only 17 percent of the record deal volume consisted of new-money transactions.
Debtor-in-possession (DIP) and exit financings were few and far between as a source of deals. While 2010 saw at least 16 DIP financings and exits of more than $100 million, including the LyondellBasell exit financing of $1.75 billion and the AbitibiBowater exit financing of $600 million, only six DIPs or exits exceeded $100 million in 2001, at least through the first three quarters of the year. The high-profile filing of American Airlines in the fourth quarter, at least in the early stages, did not involve either DIP financing or the use of cash collateral. It appears that this trend of a declining number of DIP financings and Chapter 11 exits is likely to continue in 2012.
Then, there was pricing. While pricing did not hit the lows of early 2007, a look at the spreads from 2011 shows a clear downward trend (Figure 4), with lenders again beginning to plumb the depths of returns. Given the few new-money transactions and the difficulties of displacing an incumbent lender, it was not surprising that pricing continued to be driven down.
Another factor, more present in 2011 than perhaps in 2007, was the pressure for banks to deploy capital to grow earnings. The imperative to meet the growth demanded by new budgets was a powerful force in the credit markets. In reporting on one bank’s third quarter earnings missing expectations, the Wall Street Journal, noted that the lender’s loan growth just wasn’t enough to make soaring deposits profitable. “While it did report strong business-lending growth,” the Journal said, “the bank couldn’t lend as fast as deposits poured in, slamming its most basic profit margin.”
Observers also suggested that lower pricing and looser structures were driven by regulatory pressures to grow the loan business. Meanwhile, banks have been steadily reducing loan loss reserves over the past three years because there has been less stress on portfolios, which has helped boost profits. At this point, it is unclear that there is much more room to reduce reserves to help in the search for profit growth.
Not only did banks seek to use their capital in 2011, but across the investor universe, the minimal returns from other asset classes also drove yield-hungry investors toward leveraged loans and high yield bonds. While choppy over the course of the year, the volume for such products ultimately provided fertile ground for pairing with an asset-based facility, but gave issuers greater flexibility in structuring their new capital raises to replace financing obtained in the more conservative and higher priced environments of 2008 and 2009. These opportunistic entries into the market by issuers served to further weaken structures and reduce yields for asset-based lenders.
Throughout 2011, market capacity in asset-based lending increased. Given the need to increase loan growth and to win new mandates or retain existing customers, banks took larger hold positions. The major lead arrangers in the market, Wells Fargo, Bank of America, and JPMorgan, took even greater market share by anchoring asset-based facilities with significant commitments.
At the same time, new entrants in the field and newly aggressive players re-entering the market ramped up the competition among lenders. Regional banks and investments banks made big pushes into asset-based lending, while announcements of institutions establishing new asset-based lending units, often staffed with familiar faces in the industry, were issued on a regular basis.
Names like Huntington, First Niagara, First Merit, Amalgamated, Flagstar, Roynat, Rockland Trust, and Alostar emerged. US Bank and SunTrust continued to grow. These players added capacity to the asset-based market in general and offered more alternatives to their target middle market borrowers. Meanwhile Morgan Stanley, Barclays, and even Goldman Sachs ventured into the field.
With demand at new heights and supply at new lows, it was perhaps inevitable that, in addition to pricing, structures also would suffer. The convergence of these factors led asset-based lenders to more creative — and riskier — structures. Maintenance financial covenants in larger transactions are rare, and the thresholds of excess availability for testing of financial covenants have steadily declined. This has resulted in reduced ability by lenders to respond to circumstances when a company is off plan and has deprived lenders of the opportunity to react by triggering the testing of compliance with financial covenants.
Certainly on sponsor transactions, where equity cures were rejected out of hand during 2008 and 2009, they are now surfacing regularly again — albeit subject to limitations on amounts and on the number of times that they may be employed. But the equity infusions are being run through the earnings before interest, taxes, depreciation, and amortization (EBITDA) on the fixed charge coverage ratio, rather than only being used to increase excess availability above the testing threshold.
First in, last out (FILO) tranches within the asset-based facility were employed from time to time during 2011. BJ’s Wholesale, for example, had an $850 million five-year asset-based credit facility, together with a $50 million FILO tranche. There were at least 14 such transactions that included these additional facilities as part of a total credit facility of $250 million or more in 2011. As might be anticipated, six of these were retailers, but the use of this additional “stretch” into other industries reflected efforts by arrangers to be creative in fulfilling the mandate of aggressive issuers.
In addition to FILO tranches, second lien financings also have experienced a rebirth. According to Thomson Reuters LPC, almost $7 billion of second lien loans had been completed through the third quarter of 2011, compared to $6.5 billion for all of 2010.
To win mandates arrangers were underwriting with “flex” more narrowly prescribed, in addition to agreeing to large hold positions. However, besides keeping pricing, maturity, and testing thresholds within the universe of possible changes, it was not uncommon to see the ability of an arranger to “tranche out” a portion of the asset-based facility into a FILO piece with higher pricing and amortization.
Lenders continued to struggle with companies on limiting the amounts of add-backs to EBITDA for purposes of the fixed charge coverage ratio that is predominantly used in asset-based facilities and seemed to be holding the line in many respects here. Lenders also continued to attempt to preserve the distinction between struggling credits and high-quality, well-performing credits, and between the large revenue issuers and the true middle market company. However, as the trends pushed, there was some softening, especially in the case of sponsor-backed transactions.
The “unitranche” phenomenon seemed to resurface, but with some reluctance by asset-based lenders, given the additional risks and complexities it posed for them. The prospect of being found “undersecured” in the event of a bankruptcy, notwithstanding the various imperfect steps that may be taken to manage such risks, is not particularly appealing to asset-based lenders. Still, in some segments of the asset-based market, this structure was brought out as an alternative when it might appeal to a sponsor for a particular transaction.
All in all, the market in 2011 was not that of 2007, in particular since the forces driving the competition, as well as the size of the market and how far lenders have gone to accommodate borrowers, is different. But there were clear vestiges of the same patterns.
The Year Ahead
In 2012, asset-based lenders clearly face challenges. There seem to be few options for them to increase supply to deal with the trends affecting pricing and structure.
One trend that seems to have evolved during 2011 and may continue through 2012 is acquisition financing for strategic buyers, rather than just financial buyers. With corporations sitting on cash, some companies undervalued, and top-line growth limited, there seems to be an uptick in possibilities for acquisitions for which asset-based lending can provide the liquidity cushion that a company may be looking for after the acquisition.
Another possibility is for asset-based lenders to look to finance the overseas operations of domestic companies or even to set up shop outside the United States. Such efforts face real challenges in terms of adapting the U.S.-style asset-based product to the legal regimes and cultures of other countries. But if they are willing to engage these issues, asset-based lenders have an undeniable impetus to look beyond the United States for opportunity, given the obvious significance of globalization.
Transactions such as Office Depot and JBS done in 2011, along with the restatement of Aleris, suggest that there is an appetite for further ventures into this arena. For asset-based lenders that are part of commercial and investment banks, internal marketing within their organizations will need to provide a basis for new opportunities to a degree that has not been demanded before. Asset-based lenders with this option will need to look “inward” to see if it is possible to leverage off local bank franchises and investment banking products to find a way to grow. Historically this has been a challenge, but the circumstances that asset-based lenders confront in 2012 may lead to a new drive in this direction.
The question for 2012 seems to be whether between strategic acquisitions, cross-border financing, and leveraging off investment and commercial bank franchises, asset-based lenders can find a way to do battle with the challenges they experienced in 2011 and are expected to continue to face in 2012.
The opinions expressed in this article are general in nature and are not intended to provide specific advice or recommendations for any individual or association. Contact your banker, attorney, accountant, or tax advisor with regard to your individual situation. The opinions of the authors do not necessarily reflect those of Wells Fargo Capital Finance or any other Wells Fargo entity.
 Thomson Reuters LPC
 Maria Dikeos, Gold Sheets, June 4, 2007
 Gold Sheets, pg. 22, June 4, 2007
 Gold Sheets, pg. 2, June 4, 2007
 Thomson Reuters LPC
 Thomson Reuters and Wells Fargo
 David Benoit, Wall Street Journal
, October 18, 2011
 Randy Schwimmer, “On the Left”, pg. 1, June 6, 2011
 Thomson Reuters LPC
 Thomson Reuters and Wells Fargo
 Thomson Reuters and Wells Fargo