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October 26, 2018

Tastes Great vs. Less Filling: ABL vs. ABL Light

Link to article here.

During the Great Recession in 2008 senior bank executives started to become keenly aware of portfolio risks associated with small business credits typically defined as facility sizes less than $20 million. These are the business banking clients throughout the country that are family or entrepreneur owned with no private equity backstop. The majority of these clients have traditional bank lines of credit with quarterly reporting and loose covenants. This product tastes great to the client – cheap money with few rules, but in recessions is certainly less filling to the banks.

Flash forward 10 years later and senior bank executives are having the same premonition about potential credit risks related to business banking clients. To add to the stress, special assets groups are thinly staffed given defaults are at a low and there are less qualified battle tested execs for when the downturn comes. One could argue the banks are unprepared for the next downturn when it comes to maintaining a deep bench of skilled workout professionals. Why keep them if there are no cracks in the economy in sight as it would be a meaningful addition to overhead. The borrowers, of course, are oblivious to this concern and are quite happy with their commercial banking relationships.

Borrowers love the traditional commercial banking line of credit product otherwise known as ABL Light. This product is basically a formula based line that typically comes with quarterly reporting, few collateral audits and loose monitoring. This structure also enables borrowers to control their own cash. Contrast that with traditional ABL that comes with cash dominion, daily/weekly collateral monitoring, semi-annual appraisals, constant field audits and high frequency interaction with the asset-based lender.

What banks have realized is that the ABL product is starting to taste great to them. Moreover, there is a fundamental reason that banks both big and small have either started or acquired ABL groups within the past decade. There has been seminal consolidation in the ABL industry for several reasons including the obvious, which is that its better to transfer a client to ABL from commercial banking than lose a client to a competitor. The other less advertised reason is collateral monitoring and collateral preservation that can’t effectively be accomplished in an ABL light structure. Said differently, rather than staff a special assets group, which is a cost center, it would be better to buy or staff an ABL group focused on smaller businesses, which is a profit center.

The nation’s largest banks have the most daunting task as it comes to the risks and benefits posed with providing business banking clients with an ABL product. Business banking clients are typically sub-$100 million and $10 million in revenue and EBITDA, respectively, and typically have lines of credit at $20 million and below. The nation’s largest banks have the best ABL talent in the country, but these professionals are focused on corporate and private equity clients that have much larger facilities.

The challenge then becomes how do the nation’s largest banks serve the least monitored, but riskiest asset class as a whole? None of these clients individually pose a concentration or macro bank risk, however, as a group comprise billions of dollars and the bedrock of small business around the country. There is a reason that business banking serves these clients and the obvious reason is that much of the staff is sales and marketing facing to obtain clients and there are fewer resources to monitor and manage given these are typically stable clients. This is true in a good economy, but less so in a recession like the last one. Again, the key metric is scale needed to support the overhead. There is real scale needed to support a business banking ABL effort at the rates the banks charge.

Wells Fargo recently announced a new initiative to serve clients with smaller ABL facilities. Wells appointed a long-time factoring executive to spearhead its group, which makes sense given the credit profile of the typical factoring company and organizational needs to service it. This was a clearly strategic and thoughtful pick and Wells is laying the foundation for the future. This would seem to indicate that Wells Fargo is taking a leading initiative regarding providing a much needed ABL team as a counter to when its business banking clients get downgraded and as a path to on-board new clients. This new middle-market group should theoretically play offense and defense. They can take on clients transitioned to them and also on-board new clients that could not obtain an ABL light from Wells Fargo.

Bank of America has not formally announced anything to-date, however, they have assigned a group of professionals to aggressively start servicing and courting smaller clients. Presumably their senior business banking and credit risk folks see the same portfolio risks others do as it pertains to business banking. Time will tell what Bank of America’s formal lower middle-market ABL strategy is as it pertains to small credits, but recent moves possibly suggest that senior executives understand the need to provide middle market ABL product to counter the risk of the myriad ABL light clients.

There are clearly many other banks across the country going through this same thought process and internal risk reviews as it pertains to ABL light clients and the potential risks that these businesses face in a severe downturn. Ultimately, what tastes great to the client is often times less filling to banks.

For avoidance of doubt, all opinions and observations expressed by the author are his own. In addition, the author welcomes feedback from banks and ABLs around the country.