Skip to content

February 25, 2022

Black Hawk Down: Understaffed Workout Groups Must Prepare for the ‘Next Battle’

Black Hawk Down is an epic war movie by the famous director Ridley Scott. The movie is a complex story involving significant amount of U.S. troops being sent to a war-torn nation to keep the peace. Just as soon as the U.S. military withdraws its presence, war breaks out again, this time with only a small amount of U.S. forces left behind.

Now replace this movie with the reality of banks’ special assets groups (SAG) recruiting thousands of line managers to act as SAG reservists during 18 months of the COVID-19 pandemic. These reservists were recruited to deal with a never-before-seen economic crunch that never happened. Now these thousands of folks, some of whom were recruited or brought out of retirement, can’t or won’t be called up again. The recruiting happened quickly and so did the disbandment that put these SAG groups back to where they started: understaffed at the top of an economic cycle. This means there is a very high likelihood that there is going to be meaningful economic stress coming to banks and SAG groups will be wholly understaffed. Banks sounded the alarm for COVID-19 and are not likely to sound the alarm again over stress in the economy.

The major banks dodged a bullet thanks to the government stimulus programs, but it’s unlikely they will dodge the economic insurgency that is starting to take shape. With rates as low as they are now, a 200-to-300 basis point interest rate increase over the next couple years could double interest expense for most lower middle-market borrowers. There isn’t enough cushion in most leveraged transactions to absorb that without a wave of defaults (except of course in no covenant deals, but those aren’t that prevalent in the lower middle market). This will be further compounded with EBITDA reductions when companies can’t/are slow to pass on cost increases. These EBITDA reductions combined with higher capital costs will be enough to cause a tremendous amount of stress to many borrowers as well as to the banks that reversed large reserves and reduced staff back to pre-pandemic levels. The reasons causing stress to banks might be different this time from prior anticipated events, but they are nonetheless real.

The saying goes if there is a 1% chance that something will happen, it eventually will. The potential causes of economic stress are too many at this point: interest rate increases, supply chain disruption, inflation, labor shortages, COVID variants and geopolitical risk, just to name a few. We are beyond the low percentage outcomes of economic stress and the new pools of non-bank capital are betting on this.  Issues related to the supply chain, inflation and interest rates alone present clear and present dangers that are already leading to more criticized credits. Work-out groups, for the first time in a long time, are seeing real signs of stress and don’t have the resources to handle larger than expected volume. Why would they? The government pumped massive liquidity into the system so banks fell for the false alarm once. Banks are not going to be able to mobilize a large-scale work-out force again, so the scaled-down SAG team are going to have to manage a wave of troubled credits on their own. This is going to happen.

This author has written extensively about this, but at some point, banks are simply not going to be prepared for what is on the horizon, partially because the extent of it is clearly unknown and partially because they literally disbanded the people they recruited for what turned out to be a massive false alarm. Each of the previous situations has been different and the next alarm will not be false for reasons that are clearly foreseeable and understandable. Furthermore, liquidity is starting to run out at smaller businesses and work-out groups are back to being understaffed. At the same time, banks are still profit machines focused on expense ratios and not incentivized to re-staff a non-revenue generating department. Banks do see the economic warning signs but are simply not likely to react until it is too late.

So, to summarize, the COVID-19 pandemic hit and the non-banks were ready to be pirates, only to be thwarted by the government creating an economic windfall for the banks. The banks, ironically, were prepared to be raided by distressed and asset-based lenders rather than for an economic windfall. However, the economic windfall was so good that it is going to cause over-inflating of the economy and cause suffering to lower-income populations. Separate from this, the pandemics effects are still rippling through the economy. There are too many disparate economic activities happening that portend trouble and too many variables that can’t be fixed. All the while, the banks called up the reservists and then promptly sent them home. So, just like the movie, there is another battle coming and the small teams of experienced work-out folks are the ones left behind for what will be hand-to-hand combat.

This next battle will be multi-faceted, as the amount of non-bank capital that has been raised and waiting for this event is truly at an all-time high. Small teams of work-out professionals are going to be facing off against well-staffed and well-capitalized non-bank distressed and ABL groups who have been waiting years to book assets. The ideal scenario for the non-banks is for the banks to be caught off guard with understaffed groups. This confluence of events might just play out if any one of the aforementioned economic events take hold.

Legends are borne out of every war movie and economic cycle. Work-out, ABL, turnaround and distressed legends were created in the 1980s and as recently as 2008. Fortune favors the brave and there will be fortunes made soon enough.

Link to full article here