I was at a financial services conference a few weeks ago where a moderator asked a panelist a version of the same question we’ve all heard multiple times over the past few years: “This has been quite a long post-recession period, where do you think we are in the cycle?”
His response: “I don’t know if we are in the 11th or 12th inning, but this game isn’t going to be over any time soon.”
This view is consistent with sentiments I have either read or heard from other industry veterans.
He means of course that the market for credit (speaking about the middle market) is at a peak – driven by the unprecedented amount of capital flowing into private credit funds from investors seeking non-bank, higher yielding deals than are available in more liquid investment options. This abundance of capital exceeds the demand for financing opportunities – thereby leading to intense competition among lenders to win mandates. This dynamic creates a great situation if you are a borrower as it leads to very generous or friendly terms. However, if you are a lender it means higher leverage, stretch-advance rates, light-covenant packages and pricing compression.These attributes certainly don’t lend themselves to attractive risk-return opportunities.
According to the National Bureau of Economic Research there have been 11 post-recession expansion periods since 1945 with an average tenor of 59 months. The longest though, at the start of the 21st century, was 120 months. The official end of The Great Recession was pegged to be June 2009. Therefore as of February 2017, this latest expansion period has lasted 92 months – with two more years before the record is reached.
After the election results in November there was a noticeable shift in the economy’s momentum with increased levels of consumer and business confidence driven by expectations for tax cuts, reduced regulation and increased infrastructure spending. We are in unprecedented times and the only certainty is that uncertainty, or the unexpected, will now be the new normal with this administration. Yet, the prospect that policy changes will create a more favorable business and investing climate can be clearly felt.
With this backdrop, the way I’m thinking about the current economic environment and the ensuing impact to lending is that these perceived “extra innings” in this particular expansion period may really be part of a double header – albeit an unexpected one. The key question then for those of us in the lending business is how to grapple with these highly competitive markets where borrower-friendly structures that include things like substantial EBITDA addbacks, aggressive leverage levels, loose financial covenants and highly flexible loan documents are now the norm.
What makes this situation all the more challenging is that for those of us in the business of capital deployment – most often described as “deal junkies” – sitting out just isn’t how we are wired. Not only is this strategy highly unappealing to any typical deal professional who thrives on the pace and challenge of investment decisions and transaction activity, but it’s also highly unrealistic given we all have AUM (Assets Under Management) targets.
So, what then? I consider myself an intelligent investor and no one wants to be perceived as chasing market terms. Further, debt providers can’t afford the luxury of a portfolio theory approach to lending where a few homeruns can offset some losses. The returns for debt capital simply don’t justify this strategy as it takes way too many new loans to offset even small losses. On the surface my options don’t look compelling but here are three rules that I expect to follow:
Rule #1 – Discipline
Each year we evaluate hundreds of transactions and our close rate has historically been in the low single digits. That’s a lot of frogs to kiss. In this environment, there is no doubt that I will need an ample supply of Chapstick as it will be necessary to expand the number of opportunities I need to evaluate. It will be equally as important to be exceptionally patient in order to find situations with an attractive risk-return dynamic. In other words: Wait for the pitch.
Rule #2 – Focus
While I am searching the pond for more frogs, I need to quickly determine whether our capabilities, structural approach and pricing dynamics are a good fit for each situation I evaluate – and if not, I’d better move on quickly. This is easier said than done – especially when the pipeline isn’t as robust as one would like. For Crystal in particular, this means focusing on situations where non-bank, creative and flexible capital is more valued than a solution that offers the lowest cost. In other words: Play to my strengths.
Rule # 3 – Get Comfortable with Discomfort
I mentioned previously that “mistakes” or losses for a lender are incredibly costly and very difficult to offset. That said, staying within the confines of a narrow credit box isn’t likely to yield attractive results. Yet, one can be open minded and think about businesses and downside protection in creative ways. Fundamentally sound companies in generally healthy industries with solid management teams can typically survive a speedbump without leading to a risk of loss even in the instance of a default. When evaluating lending opportunities with these types of borrowers it can be a sensible approach to stretch my thinking regarding a potential debt structure to a point where I feel slightly uncomfortable. To me this approach is preferable to a conservative structure for a mediocre business or industry. In other words: Take calculated risks.
For any of you who have ever presented a deal to an investment committee there is no question that saying “no” is easy. There are always a myriad of reasons to pass. But since I am in the business of lending money (as well as getting it back), my challenge is to determine how to get to “yes” in a way that is aligned with the fundamentals of sound credit assessment and underwriting that I have honed over my 20 plus year career.
Check back with me at the 7th inning stretch during game two of this doubleheader and I’ll let you know how I’m doing.