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October 14, 2022

Edge of Tomorrow

Edge of Tomorrow is a 2014 science fiction thriller starring Tom Cruise. The movie is about a soldier who is caught in a time loop repeating the same day while trying to save the world from an alien invasion. Tom Cruise becomes an expert soldier over the course of many time loops and in Hollywood fashion defeats the aliens and crosses the edge to tomorrow. Transfix this to the lending world and we are at the proverbial edge of tomorrow. Lenders have been on a time loop for several years now waiting for a market correction. The “lending time loop” has been COVID, which brought PPP (plus all the other government programs) and low rates, which in turn stimulated demand and the stock market. Everyone thought COVID was the edge only to be delayed by PPP, but now the liquidity created is being rapidly sucked out of the system and inflation is running rampant. Absent another government intervention we are now at the edge of tomorrow, and while we are not being attacked by aliens, we are dealing with a number of unseen events or at least not seen since the 1970s. Right now, all we see is the edge.

This is what the edge looks like – COVID was not free, and the bill is now coming due. The Federal Reserve is now aggressively increasing rates and moving to shrink the stockpile of $9 trillion of government bonds. On main street, most people are going to back to work and majority of trends that happened during COVID are reversing such as work from home, Peloton, online shopping, Zoom and others. are all decreasing. Most retailers are now facing an inventory glut. FedEx recently issued a notice of falling global demand and prices are up across the board. The facts are as follows: Demand has now slowed, consumer prices have increased, home prices have decreased and the Federal Reserve has kept its word. The list goes on for every economic and personal consumption trend that is being reversed with the liquidity being taken out of the system. There are outliers, but banks’ portfolios are generally balanced across most major industries, so they are now finally starting to prepare for tomorrow. A global slowdown in publicly announced deals also seems to support this.

According to Refinitiv, 2022 global M&A volume was $642 billion between July and September, a 42 percent drop from the prior quarter and the lowest Q3 figure in a decade. This implies the slowest overall quarter since pandemic ravaged Q2 2020. U.S. deals were down by a similar percentage, to $278 billion and the number of global deals was at its lowest mark since Q1 2015. That’s notable because it illustrates how the volume declines weren’t just tied to falling valuations. Several factors contributed to the Q3 deal slowdown including stock market declines – which sidelined many sellers and buyers – and the aforementioned factors such as rising rates, inflation and geopolitical risks among other things. This is what the edge looks like with valuations down, M&A down, liquidity down and key economic indicators causing market turmoil. It’s not guaranteed we will enter a significant recession, but it brings the question of what may be next.

What is tomorrow? Tomorrow, seen through the eyes of ABLs and the surrounding ecosystem of turnaround advisors/professionals, is seeing a transfer of assets from banks to ABLs and other non-bank lenders. Many of these firms have been in a time loop the past few years thinking every quarter would be the one where banks start either taking precautions or start getting in front of the confluence of economic factors affecting most borrowers today. Q3 is now over, and it is going to be quite telling for both the senior management teams at the large banks and the entire non-bank world meant to partner with them. Commercial bank portfolios, which have been clean as a whistle for years, now face real challenges. Banks took reserves, reversed the reserves, and are now re-implementing the reserves. Commercial banks are now actively monitoring all criticized risk-rated credits and are more proactively communicating their concerns to clients in order for them to start seeking non-bank alternatives.

Ironically, the multi-year time loop has shaped the non-bank world to be ready for tomorrow – at least those that stayed disciplined on credit underwriting. COVID helped to accelerate consolidation and scale in the non-bank world. We are now in the world where BDCs are the driving force in non-bank asset-based lending and driving down the cost through capital efficiencies. The bigger firms have been preparing for several years for what should be a seminal event once we go over the edge. That said, lending is a hard business and many lenders have made credit “concessions” to attract borrowers whether it is bank or non-bank. We will see if those lenders can pull in the reins in time. Time will tell if we are now finally at the edge, but the real questions is whether your firm is ready for tomorrow.

Link to original article here.