Back to The Future: The Future of Bank-ABL

The bank-ABL world is going to go “Back to the Future.” Just like in the movie, before visiting the future one needs to understand the past and present-day world of asset-based lending (ABL). Consolidation (past) and ABL product acceptance and proliferation in all levels of banking (present), have paved the road for the future. The way to think about the future is as a three-layered cake with the top layer being the Super Powers (Wells Fargo Bank, JPMorgan Chase Bank and Bank of America), the second layer being the Super Regionals (Bank of Montreal,  PNC Bank, Fifth Third Bank and Truist Bank, among others) and the third layer being the Super Communities (Wintrust, Western Alliance Bank and Synovus to name a few). Each layer of bank-ABL presents unique opportunities, challenges and threats, but there will be change as that seems to be the constant.

Here are a few key predictions for the next decade:

  1. Consolidation plus a twist – do not be surprised to see two separate ABL groups housed under one Super Regional bank,
  2. The hybrid bank-ABL coverage model will gain real traction and be successful,
  3. ABL (at least ABL-light) will truly become more of a product within banking, and
  4. Today’s big non-bank ABLs will achieve scale, capital efficiency and look like bank-ABL 20 years ago (Phase 1).

The bank-ABL industry is transitioning quickly from Phase 1 – which is banks simply owning ABLs as a separate business line – to Phase 2, which is banks integrating ABLs as a product platform. Phase 3 is too far away and could be any number of things including a tech-enabled transformation, but first let us start with consolidation. There are simply too many market participants right now – although that may change, quickly I might add, as we will soon see which firms were prepared for the new lending environment.

If you want to understand the future, look at the past as the same thing happened the last two cycles; consolidation is going to happen in one form or another. Every generation thinks it created lending and this is true if you go back to the days of Heller, Congress, Transamerica, Fleet, Foothill, Finova, Textron, Freemont, Sanwa, and the list goes on. These onetime giants are now part of ABL lore. Business Development Companies (BDCs) have been this last cycle’s most aggressive buyers of ABLs, but it remains to be seen what will happen to BDCs in the post-COVID world let alone ten years from now. To a BDC, ABL is an asset class; to a bank it is a product class. One industry veteran counseled the author to look at the CFA (now SFNet) membership list for the past 40 years to understand the past cycles of ABL formations and consolidation. The key takeaway is that per the firms mentioned herein, competition and consolidation has been going on for decades. History tends to repeat itself, but with variations.

Anything is possible, but it is unlikely that ten years from now we will find ourselves with BDCs being the dominant non-bank force in the non-bank ABL industry. BDCs will of course be around, but what remains to be seen is their industry-wide commitment to ABL through a difficult cycle. It’s hard to think about the future while there is so much uncertainty in the present, but uncertainty often spurs conversation and innovation. That is exactly what is happening right now as innovative leaders at the leading bank-ABLs are taking this time to think about the future.

The last 20 years saw two waves of ABL cycles from big banks buying ABLs, to the rise and consolidation of the non-bank ABL industry. The next ten years will bring real refinement to the bank-ABL business model.  This is going to happen as the ABL “market” is now mature, with both bank understanding AND client acceptance. Neither of these two points should be taken for granted.

Regarding two ABL groups under one Super Regional bank, the distinction being that one will be ABL-light and one will be true ABL. Yes, this may actually happen, but it certainly won’t happen within the nation’s largest banks (Super Powers). Products, risk-ratings, and yields have diverged enough over the past few years for bigger regionals (Super Regionals) to make a case for effectively owning a finance company apart from its ABL light product. Much of what may happen in the future will be driven by some “stroke of the pen” risk in terms of the regulatory landscape. Despite this risk or potentially due to it, many industry leaders think having two ABLs under one Super Regional is a possibility. Super Regionals have already ventured into specialty finance and there is an argument to be made this will indeed happen based on the white space created by risk-ratings alone as regulations, strategy and reserve requirements keep the Super Powers from pursuing a finance company. The thinking is linear in that a client within one bank could go from commercial banking to bank ABL- light to bank-owned ABL (full dominion, no springing). Right now, the bank-ABL folks often recommend the non-bank folks they are transitioning their clients to, so it is not a stretch – same client, better yield.

While history will repeat itself from a consolidation perspective, the bank-ABL business model is becoming much more innovative, collaborative, and tactile. The bank-ABL model is now mature and has evolved to the extent that it will drive and shape future consolidation. To make a long-story short, there are three bank-ABL business models:

  1. ABL as a product solely servicing the bank,
  2. ABL as a separate business line, and
  3. A hybrid of 1 and 2.

We are entering what many industry executives call Phase 2 or the hybrid period where bank executives have spent the better part of a decade or more understanding and integrating ABL into their bank’s culture. The past ten years every top bank in the country that understands ABL has been intensely focused on utilizing ABL for both client retention (defense) and new client acquisition (offense).

The hybrid model will only become stronger and commercial banking groups will continue to learn to work with their ABL groups. While at the same time these ABL groups still maintain their ability to go out and pitch new business in addition to servicing the bank. This is a real departure from a decade ago when ABL groups were a separate business line and coordination with commercial banking was not part of the business plan. Many things have changed over the past ten years, but platform integration became paramount at the nation’s largest banks, as did client retention. The OCC also played its part by enforcing stringent rules at pretty much every level imaginable, so customer retention became a point of focus. Enter stage right ABL – in other words, it’s showtime for ABL to enter main street banking, but with a diluted twist to make the product more palatable for the bank’s clients.

JPMorgan Chase Bank deserves special mention because ABL has always been a “product” for them rather than a business line, and the relationship has been managed by one Relationship Manager (RM).  Their model is unique, and they have spent many years building what should be considered an integrated and proprietary model.  Management made the decision many years ago to build an integrated team internally whereby in contrast you can trace the roots of Bank of America and Wells Fargo to Fleet and Foothill, respectively. There is no right or wrong model, but it should be noted that JPMorgan Chase Bank started where others are migrating toward due to an organic rather than acquisitive approach.

This strategy positions ABL partially as a collateral monitoring business and also allows for seamless on-boarding and transferring of clients. It also eliminates competition within the same bank. Too many times we hear about two different groups within the same bank competing. Under this model, the same RM can deliver two proposals and let the client decide. The client needs to decide the trade-offs between invasive reporting, high-tough monitoring, minimal covenants, and often-times no personal guarantee versus a strict covenant packaging (including total leverage) and an occasional guarantee, but less monitoring. The same RM can navigate through both groups, and over the course of a relationship a client might have a stint in each group.

This also keeps the RM involved throughout the relationship, which now becomes cradle-to-grave. Bank RMs are not used to staying involved when a credit migrates to ABL, work-out or worse, bankruptcy. This model keeps them involved rather than have a client potentially rotate through different groups (such as entering work out before either transferring to the ABL group or exiting the bank entirely). Ask a business owner if a trip to special assets made them want to stay with a bank? You won’t get too many positive answers! The RM has an enormous ability to keep a client and hence forth revenue and navigate a client versus what happens when you keep the business lines separate, creating a full client hand-off. It should be noted that the hybrid model allows for this type of flexibility as well.

Interestingly, both models (#1 Product and #3 Hybrid) appear seamless on the front-end. However, once the client goes to ABL the corresponding administration, credit review and account management is fundamentally separate and different from the commercial bank – same RM, but different credit and portfolio management. Said differently, the back-ends remain separate as cash flow lending at a bank is largely an asset-gathering endeavor, while ABL is largely an asset monitoring endeavor. The business model debate comes down to a few key decision trees of which the first is whether bank-ABL groups should be a product within a bank, their own business or a hybrid, as certain groups are very strong in the sponsor world. This fundamentally defines the single biggest point banks need to decide. The banks that have ABL as a product are truly relationship-focused because the RM who has spent in some cases years building a relationship is going to handle the relationship irrespective of loan classification.

To gain adoption in the biggest banks, the ABL product has diluted to springing rather than full dominion, among other key points such as diminished reporting frequency. It is an open secret that bank-ABL is really ABL-light. Even with that, it’s a big shock to the system when a client gets transferred from commercial banking to the bank’s ABL group. Said differently, it’s a shock to go from a 20-page laser-pro loan agreement to a 100-page ABL loan document – surprise! The competition has proved fierce for these borrowers, so a new bank-ABL product has been evolving over time with springing everything. This product is really risk-rating based more than anything else as the truly risk-rated companies get pushed out quickly. Think I am wrong? The author would like to ask every ABL with at least 20 years of bank-ABL experience how many liquidations they did the past ten years versus the non-bank world. This is only partially due to the appetite for risk from non-banks versus banks, as opposed to the ongoing trends in bank-ABL.

Several important and disparate trends are driving huge differences between how bank-and-non-bank ABLs conduct business. Bank-ABL today has truly migrated to an ABL-light and OCC regulated product. It is effectively classified under the same rules as C&I. Just as importantly, the covenants are light, the field audits are less frequent, and everything is springing. There is a fundamental issue that each bank-ABL executive will say – credit rating and credit risk are fundamentally different risks with one being real and the other being perceived. Pre-COVID-19, bank-ABL executives relished a good retail bankruptcy restructuring or liquidation. They would make the DIP a fee opportunity or be supremely confident in the liquidation value and then some. The risk-rating of these credits would have absolutely zero correlation to the real risk. The need to retain customers and the bridge between perception and reality should make for an interesting next decade in ABL.

This is just one of many examples that has created different business models in the ABL world with the bank-ABL going one direction and non-bank going another – better structures and relatively higher yields. That all said, where the convergence is going to come into play is where the non-bank ABL market at the upper end is going to achieve scale, capital efficiency and further margin compression. They are effectively going to become the version of bank-ABLs ten years ago! Yes, that is right, and it is also why it should lead to consolidation. At some point, this will be self-evident to the strategy departments of banks that can get strong yields, keep tougher clients, and reduce operating expenses in special assets. Just as importantly, most of the clients will come from the banks.

This leads into Super Communities joining the fray. The Super Communities defined as $10 billion in assets and above, compete regularly with the Super Regionals and Super Powers, but in their specific communities. The world changes once you are a C&I focused community bank that gains enough steam to get on the radar of the regulators. This means many things, especially increased costs in the risk management department. It also means that these banks need an ABL group, special assets or in several cases both.  A few years ago, this would have been considered a luxury, but it is now becoming table stakes for the Super Communities as it is very difficult to get the clients and sometimes just as hard to keep them. What they have found is that bank-ABL can be effective when done right. What is new about this trend is the amount of community banks that have transformed into Super Communities via successful acquisition strategies.

It is hard to think about the future while there is so much uncertainty at the present, but uncertainty often spurs conversation and innovation. That is exactly what is happening right now as innovative leaders at the leading bank-ABLs are taking this time to think about the future. The last twenty years saw two waves of ABL cycles from big banks buying ABLs to the rise and consolidation of the non-bank ABL industry. The next ten should bring real refinement to the bank-ABL business model. This is going to happen as ABL is now a mature one with both bank understanding and client acceptance.

So, what does the future of Bank-ABL look like?  Dr. Emmett Brown (Christopher Lloyd) said it best: “Roads? Where we’re going, we don’t need roads.” The future has not been written yet. No one’s has. Your future is whatever you make it. So as an industry let’s make it a good one.

Link to full article here.