New players, new products changing the credit markets.
We've recently been riding quite a wave: The last trough in the credit cycle occurred during the first quarter of 2002, when defaults of bonds and loans peaked. Since then, default rates have declined to what many believe are unsustainable lows. Along the way, several dynamics have affected the character of the credit markets and will certainly influence the next downturn:
* Increased Financial Leverage
Since 2002, financial leverage has increased dramatically. The flood of liquidity created by a period of very accommodative monetary policy pursued the yields available from income-producing assets, namely loans and bonds. With so much excess debt capital available, buyers--particularly the leveraged buyout (LBO) funds, which are also flush with capital--have used increasing amounts of financial leverage. This has spilled over to the non-LBO market as well.
* Different Sources of Capital
The overall sources of capital for loans have changed dramatically. Today, institutional investors provide $2 for every $1 provided by more traditional lenders, including banks. In 2002, traditional lenders provided approximately $4 for every $1 provided by institutional investors. Many institutional investors--prime funds, collateralized loan obligations (CLOs), hedge funds, etc.--have never managed portfolios of loans through a credit cycle trough, and the jury is out as to how they will act when credit tightens. These institutional sources require liquidity in the debt paper, and as a result, the trading of loans has expanded rapidly.
* Increased Financial Innovation
This flood of liquidity in the unregulated institutional sector has spawned new debt capital products, allowing investors to capitalize on gaps in the traditional credit risk continuum. The "second lien loan," in which investors seek to exploit an issuer's "unmargined" collateral or enterprise value, is a prime example. While there was less than $1 billion in total outstandings of this paper in 2002, 2006 will likely see issuance top $24 billion. Again, because many investors in this type of paper have never managed portfolios through a downturn, there is great concern about how they will react and impact the restructuring process.
* New Distressed-Debt Funds
With the downturn in the credit cycle on the horizon, large distressed-debt funds continue to be raised by an array of market participants. Some of these funds have interests in other parts of the debt capital markets, as well as the equity markets. They are betting that when the credit cycle tightens, opportunities will arise to buy assets (debt instruments and/or equity securities) at "distressed" prices.
* Preparing for Credit Market Changes
A business that seeks to grow has to realize that access to credit could change significantly during any downturn. To prepare, consider some of the following actions:
** Engage your capital providers in an open and honest dialogue. Discuss company strategies and plans and disclose the problems, as well as the successes. Above all, find out how they would react if your plans and strategies don't play out exactly as hoped.
** Maintain relationships with firms that aren't currently capital providers, but who you've screened and believe have the potential to play some future capital-providing role. Identifying alternative "go-to" firms allows you to leverage them for market intelligence and different perspectives--and you might need them for capital as well.
** Seek to maximize flexibility in your credit agreements now rather than waiting until you have no choice. Prepare for a tightening of the credit cycle by ensuring the business can execute its strategies with some "wiggle room" in case problems arise.
** Don't be complacent, believing that most capital providers are interchangeable. There are very real costs associated with relationship change, especially when that change occurs during a time of need. Volatility usually increases during times of uncertainty, and this can accelerate the timing of when credit needs have to be addressed.
As we likely enter a less attractive phase of the credit cycle, the importance of the relationship between a growth-oriented business and its credit providers may have never been as great. Building the right relationships takes time and resources, and there is no time like the present to start or expand those efforts.
James D. Cockey (firstname.lastname@example.org) is Senior Vice President, Marketing Manager, and Phil Worden (email@example.com) is Senior Vice President, Senior Business Development Officer, Central Region, Bank of America Business Capital.
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|Date:||Jan 1, 2007|
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