Insights

CapX / Insights / Markets / The Current State of Lending: We’re Open for Business, But…
Markets

The Current State of Lending: We’re Open for Business, But…

By Rocky Gor

Early February was mostly business as usual—borrowers were healthy with predictable cash flows, asset valuations were reliable, equity markets were up, and competition among lenders was as fierce as ever. However, there was faint background noise of people getting sick in a Chinese city that most had never heard of.

By early March, the daily drumbeat of virus updates, local government announcements in large metro areas, and outbreaks in parts of Europe put the COVID-19 crisis on the radar for lenders. However, borrowers were still doing OK, the Fed was aggressively reducing rates and supporting capital markets, and problems in China and Europe still seemed far away. Carry on with business as usual, as this too shall pass quickly!

The second week of March was increasingly alarming, especially large gyrations in the equity markets. Finally, the announcement of a shutdown in California on March 19, 2020 eliminated any lingering doubts—this was serious. Denial immediately transformed into deep concern about credit portfolios.

Here’s what unfolded in the credit markets next:

Phase 1: Focus on portfolio, forget new deals

The first order of business was to understand and quantify the effect of the COVID-19 crisis on borrowers. While some of this information was obtained through close communication with clients, a lot of it was obvious, as a number of borrowers started drawing down on their lines of credit—in the absence of business uncertainty, cash on the balance sheet seemed like the most defensive strategy to many borrowers.

On the one hand, lenders wanted to help their clients weather the storm, so a lot of them did whatever they could to fortify the balance sheets of their borrowers. On the other hand, the combination of additional demand for capital from borrowers and the unpredictability of when, and indeed if, the borrowed capital would be returned, put lenders in a defensive posture—focus on portfolio, forget new deals. A number of firms replaced their new deal pipeline meetings with regular portfolio review meetings.

It’s Econ 101: when demand increases and supply declines, prices go up.

Some lenders were not immune from the lack of capital supply either. Those in the market with underwritten loans had to accept deep discounts to attract lenders to close deals. Some publicly traded lending institutions—the so-called Business Development Companies (BDCs)—had to sell some of their healthy loan assets to opportunistic firms in order to have enough capital on their balance sheets to remain viable and to support their borrowers. Others approached large commercial banks to borrow more against their entire portfolios, only to find large banks themselves focused on capital preservation versus new business. Private lenders with a flexible mandate opted to purchase loans trading in the secondary markets at deep discounts rather than chasing new deals: why work for weeks when you can lend the same amount at twice the yield in two days?

It’s Econ 101: when demand increases and supply declines, prices go up.

Phase 2: Long live the PPP (and higher interest rates)

By the end of the third week of March, Congress was sufficiently concerned about the pandemic to take on a massive stimulus bill that produced the Paycheck Protection Program (PPP). The PPP not only promised to fortify borrower’s balance sheets for a few months, it also paid lenders 1% of any loan they processed that was greater than $5 million. It had been a while since banks saw a 1% fee for their loans. Icing on the cake: under the PPP, they were not even lending their own capital, they were just doing paperwork. Banks shifted many employees to process PPP loans and completely shut down non-PPP new lending for almost six weeks, either by declining new opportunities or by increasing loan interest rates and minimum deal size.

Suddenly, this was a lender’s market and they had decided to re-price the risk.

Back to Econ 101: as banks focused on PPP and savvy private lenders scooped up loans being offloaded by other institutions, borrowers who could not get capital from PPP were left with few options, and all available options cost more, meaningfully more than just a few weeks prior. The Fed was reducing rates as well as buying treasuries and high-grade corporate bonds in the open markets, LIBOR was at historic lows, and still the majority of corporate borrowers were not going to benefit from low rates beyond the PPP loans. To the contrary, LIBOR floors, a bank loan feature designed to keep effective interest rates of loans above a certain level, reappeared after almost a decade. Suddenly, this was a lender’s market and they had decided to re-price the risk.

Phase 3: We are open for business, but…

After six weeks of PPP-induced hibernation, lenders slowly started emerging in mid-May. They all repeated ad nauseam, “We are open for business,” but were they? For front-end originators responsible for discovering new opportunities, they were open for business, albeit at a higher price.

But the guardians of capital, the credit professionals and underwriters, were more cautious. The result? A uniform demand for “pristine” credit quality: low leverage, high cash flow, non-consumer and non-cyclical business, lots of assets, reliable valuations, no customer concentrations, no story, and the willingness to pay more. Perfection is rarely attainable, as is pristine credit quality. Consequently, it takes much longer to get a response from underwriting teams, and often their response is not favorable.

It might take a while before the wire shows up in your bank account.

Credit teams are now also watching out for borrowers with difficult futures post-PPP loans, and are concerned about a potential surge of loan defaults starting mid-June. Lenders will have to go through the difficult task of identifying borrowers to keep versus the ones to “workout” or exit. While lenders are in the business of lending money, with the potential for loan losses, they are likely to be more selective and expensive for a foreseeable future.

Looking for capital?

If you are actively looking for debt capital, or if you just want to be prepared for the potential need as a result of current uncertainty, start the process today, as it might take a while before the wire shows up in your bank account. Prepare the right “credit story” with appropriate supporting information, and approach multiple lenders simultaneously to obtain several term sheets. Finally, explore the non-bank private-lender arena. While more expensive than banks, private lenders might be able to provide a practical solution for your capital needs more quickly and effectively. And if you’re in need of help, reach out to us to discuss how you can raise capital from more than 20 banks and non-bank lenders on CAPX.