Commercial Banks and Leveraged Lending: Why, It’s a Day at the Beach!

Man in surfWhile the death of commercial banks in the leveraged, sponsor-backed sector is a bit exaggerated – it’s tough to argue that the industry is not in the Intensive Care Unit. Recent reports from S&P Capital IQ show that U.S. banks’ share of leveraged lending in the middle market has fallen to 9% in 2013 – less than half the 20% share in 2011. Yet debt continues to be readily available with a record $600 billion new-issue debt last year. Meanwhile, CIT reports that nearly 80% of middle market executives are satisfied with the variety of financing alternatives available to their companies. So, as banks retreat, non-bank debt providers are filling the void – and the market marches on.

What happened to the banks? An argument is often made that they were caught flat-footed in the sweeping regulation after the recent financial crisis. While it is beyond the scope of this note to address the whole host of banking regulations, the question we see repeatedly asked is: Will banks ultimately be marginalized in leveraged lending – especially sponsored-backed transactions?

For a perspective – let’s go to the beach!

Imagine you are propped up in a comfortable chair (drink in hand, perhaps) looking out at the ocean of the leveraged lending market. Here is how I see the commercial banks appearing:

Banks on the Beach – these are banks that have no desire to get into the leveraged lending ocean: not to swim, not to wade, not to dip toes…nothing. For whatever reason – skill gaps, perceived risks, or otherwise – these banks have an explicit policy of not participating in leveraged deals full stop. This is fine – probably a good thing in many cases. But, these banks have also make a major implicit determination that healthy, growing companies in their portfolio – who will most certainly need more sophisticated capital options – will not be served as there is no in-house capability. Consequently, the incumbent bank with years of history with the client is prepared to let the relationship go to a competitor. It is a tough strategy – and over the long-term, you would be right to wonder if the portfolio’s quality would not, on average, be diluted as high-performing customers migrate out and are not replaced on a similar pace – as borrowers more smartly choose lenders that can support their growth over a relevant range. Indeed, one would expect that customers of banks with no leveraged loan capability are quite ripe for poaching by a competitor that does (a market strategy with which we’ve had successful, first-hand experience).

However, we have also talked with a number of these land-bound banks that are appropriately questioning a “Do-Not-Swim” policy. First stop is to intelligently investigate how leveraged lending really works in the middle market; what skills, techniques, policies, and procedures are effective in risk mitigation; and how a leveraged platform can be built even in smaller banks. This is not the right answer for all banks, but many will benefit from preparing robust leveraged lending services for their prized clients – and from opportunities presented by the competitors who will not or cannot follow suit.

Deep Water Swimmers – there are a few notable banks that have invested in the skills and techniques to successfully manage the dynamics of the leveraged lending ocean – from changes in conditions driven by exogenous factors (regulatory changes like inter-agency leveraged lending guidelines) to industry dynamics over time (rise and remodel of competitors, etc.). These banks are benefiting from being reliable, known quantities and long-term participants in the sector.

Irrespective of data to the contrary, many Banks on the Beach cling to ephemeral notions of danger and tremble at ill-supported perceptions of risk: “Aren’t there sharks?” The Deep Water Swimmers make a habit of understanding the true risks and benefits – e.g. knowing where to swim, and how to swim. Good outcomes don’t come to those that panic. [As an aside, statistics show one is more likely to be struck by lightning on land, than killed by a shark. Hopefully, we will not now see a spike in bankers who have nightmares about sharks that shoot lightning bolts…]

Crashing Surf Banks – Let’s face it, when we go to the beach this is where the most entertaining people watching comes in – and if it weren’t so serious, the same holds in banking. Lovely people with varying degrees of skill in the surf, muddle in-between the warm beach and calmer deep waters. They wade in, dash back to dry land, go a bit deeper into surf, skitter back, venture a little further out – and, Wham! – they are tumbled helter-skelter in the foamy surf. Tragically, this lack of skills can become deadly if weaker swimmers misjudge the characteristics of the surf and find themselves in a rip current that carries them far beyond their capabilities. In the banking world, we see similar novices creeping up exposure through small holdings in under-baked syndicated deals – certainly not lethal, but often quite expensive.

So it goes with banks approaching the leveraged market with ad hoc, Band-Aid approaches too-often weighted to myths, legends, and politics and far less on the real, practical assessment of drivers of success in the market. These banks hop around in the surf chasing fleeting opportunities, but it’s only a matter of time before they are rag dolled by a wave generated from a deal they underestimated. Non-exhaustive symptoms of these to-be-knocked-about banks are: approaches relying on arbitrary credit “boxes” versus experienced, focused underwriting; rigid facility structures that don’t really mitigate risk – just fit someone’s concept of “feels right”; and lending teams that have very little experience in managing the credit pre- and post-close (cutting and pasting from CIMs to get into two loan participations does not an expert make).

We have written before on the real challenges of inexperience lending institutions and lending professionals to others in a leveraged transaction. Unfortunately, I have watched first-hand as weaker institutions in this zone fall victim to adverse selection: the good deals still flee – but dodgy deals find a home.

We have yet to see an ad hoc approach reach anything close to satisfactory scale or promise. One does not build a successful leveraged lending platform by taping a “Leveraged Lending Group” sign over the auto floor plan department (it is specialized lending, right?) and proclaiming “we are open for business”. You’d be surprised where some of these banks’ “deal professionals” come from – leasing a dentist drill to Dr. Blackmore today – calling on Blackstone tomorrow! But by not addressing a real skill gap, a bank remains in the crashing surf even though deal flow might increase. The latter only translates into an increase in the wave count – and wave height (as deal size and complexity increases). Ultimately, however avoidable, this predictably results in more spectacular, more expensive wipeouts.

I have seen these deals go from funding to 95% write off in under 16 months – root cause: insufficient grasp of how to underwrite and manage a leveraged lending deal (hint: it is not now, nor will it ever be “just a big middle market loan” or a “temporarily, [48 months] out-of-margin ABL deal” – and it is folly to treat it as such). And after these wipe outs – what is the typical next move? Is it to truly learn and become better at the craft? Unfortunately, no. Too often the reflective response is to skitter up on the beach, join the No-Swim Banks only to eventually wade back in later (to a similar, painful result – usually at the most frothy point of a credit cycle).

That said, here is where we are finding real promise for banks in leveraged lending. There are a number of banks that can and should undertake the transformation to become skillful swimmers in the leveraged lending ocean. Promisingly, we’ve found banks recognizing that they can and must develop skills and approaches designed to provide attractive risk-adjusted returns in the sector. Done correctly, this allows them to both defend existing market share and to penetrate the share of any No-Swim competitors.

We find that banks who build – and maintain the integrity of – a leveraged lending capability will find a material return on the investment provided they make: a) real, practical sense of the formal and informal ground rules (e.g. leveraged lending guidelines, cash flow lending techniques), b) investment in a scalable leveraged lending platform (real talent, real resources), and c) develop effective policies and procedures to mitigate risks in this specialty lending area both pre- and post-close.

Much like the myths and legends around swimming in the ocean, leveraged lending is shrouded in misconception. Those too afraid to truly understand either should rightly stay on the proverbial beach. Those with an interest in the benefits of conquering new horizons can find the help to develop the skills, approaches, and techniques to get past the surf – and to enjoy the returns on effort to safely swim in deeper waters.

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One Response to Commercial Banks and Leveraged Lending: Why, It’s a Day at the Beach!

  1. Mike Kipp February 25, 2014 at 3:44 pm #

    Experience on two bank boards over last 12 years suggests regulatory constraints and loan loss reserve requirements have kept most on the beach and put more than a few on the rocks. Consolidation and alternate sourcing a certainty