Editor: With the current contraction of credit, how do you view the prospects for financing generally?
Wink: A credit crunch is a sudden reduction in the availability of loans or a sudden increase in the cost of attaining those loans. The economic conditions we are seeing currently are that banks have slowed down their lending and have begun charging higher rates for those loans. One of the factors that brought about this credit crunch was first the anticipation and then the realization of the decline in the value of collateral backing certain mortgage loans.
I still see good companies having access to capital in both the credit and equity markets in spite of a shrinking number of jobs, plummeting housing prices, rising household prices and swelling debt levels. However, at the lower end of the middle market, where we spend a lot of our time, we are beginning to see that small business loan payments are being missed or paid late. Several years ago middle market lenders threw out good underwriting standards and started giving out business loans as if they were credit cards. I think in the future entrepreneurs are going to find it really difficult to get the same type of funding they received several years ago. In a recent Wall Street Journal there was an article citing a recent study commissioned by the Federal Reserve that showed that 50 percent of U.S. banks are tightening their standards on loans to small businesses. Nearly two-thirds of those banks have raised the rates on loans that they are presently authorizing. Borrowers are now being required to put up more collateral. It takes much longer to obtain a loan and borrowers are being subject to much stricter restrictive covenants. So it is an interesting time for people looking to find debt.
On the equity side I believe that the marketplace for middle market companies is more promising - one where there are a number of private equity funds that have raised substantial capital over the last four or five years. This is in part owing to the fact that there was a tremendous increase in the number of private equity funds whose capital was geared to the middle market. Good quality middle market businesses are still attracting the eyes of the private equity community. The larger deals, like the multi-billion dollar deals, are really having a very difficult time finding funding in both the equity and debt markets.
Editor: Is this also because many of the major lending institutions still have a big inventory of loans from the mega buyouts on their books?
Wink: Some of them do, and unfortunately a lot of these loans have not really performed. Many of the companies that gave banks projections for tremendous growth in revenue and cash have not been able to deliver owing to economic conditions of the market place. Large numbers of leveraged buyouts have failed and the banks have been fighting hard in the courts not to honor their commitments.
Editor: Loan covenants are much tighter today. Would you like to elaborate on that?
Wink: As you know, loan covenants are the conditions that the borrower must comply with in order to adhere to the terms of the loan. Violating these covenants on the part of the borrower results in a default situation with the lender having the right to accelerate payment in full immediately. Therefore, violating covenants is something that every borrower tries to avoid. Even in the private equity space today, many of the private equity buyout deals are highly leveraged transactions, since the private equity component furnished by a private equity fund, seeks to leverage with bank debt as much as will be allowed by the banks in order to maximize the equity return. Private equity funds that are overseeing or operating a portfolio company try very hard to avoid violation of any of the debt covenants. We are now seeing covenants with minimum insurance coverages, the requirement for audited financial statements from one of the top 30 accounting firms from around the country, quick ratio and current ratio requirements, minimum return on assets and equity requirements, minimum equity maintenance requirements, minimum working capital requirements, and caps on leverage. The banks want approval for any M&A transactions that the company might embark upon in the future. They may also stipulate that the company may not incur any additional debt - only a working capital line, and limitations on dividends, employee loans and withdrawals of any kind. So the covenants really are stringent today as the credit crunch has become a reality. This is in sharp contrast to the situation that prevailed a year ago where "light" covenants were the rule.
Editor: Are you seeing more onerous indemnification provisions in acquisitions?
Wink: We are not. Indemnification provisions have been consistent throughout.
Editor: Where do you see the capital flows in the market today?
Wink: We are seeing a lot of capital being raised in the marketplace to take advantage of the subprime debacle. Vulture funds are buying into pools of individual home loans, buying real estate directly, and even buying home builders. They are snapping up loans that a lot of banks are trying to offload from their books. An article in Business Week reported that there is an estimated forty-seven billion dollars of capital in these vulture funds. They are opportunistic investors; with the present economic conditions people who have access to capital can take advantage of the opportunities in today's market- place.
Editor: What do you see as the future for the private investment firms which have been doing mega buyout deals?
Wink: Now that credit has dried up, the future for large private equity buyouts has become uncertain. Because of the lack of available debt financing we are now seeing many buyout firms trying to compete in the middle market. Besides coming downstream they are looking to expand into foreign deals. The other interesting thing is that we are seeing that a lot of private equity funds are teaming up with strategic buyers and corporations in different types of transactions. A good example of that is the recent purchase of Wrigleys where Berkshire Hathaway, M&M Mars, and Goldman Sachs came together in pooling their capital to get that deal done. That might be another area that private equity funds will exploit in the future.
Editor: What is happening in the private placement market?
Wink: I think a year ago the private placement market was business as usual with anticipated increases in overall issuance volume. In 2008 with the credit markets coming off a terrible second half of 2007, it seems that the private placement market is really trying to negotiate a recovery. Private placements have been very sluggish in 2008. This may be an issue of investors and agents having a difficult time knowing where to price new private placements. With private placement spreads well above 2007 levels, I think issuers are very hesitant to bring new deals to the table. So I see it as a market place trying to find itself.
Editor: What are the opportunities for leveraged buyout firms and venture firms to take advantage of some of the potential purchases of viable mortgages or companies that are unable to secure bank financing? Are they vying with the so-called vulture funds in this arena?Wink: I think you are seeing a scenario where people coming out of the larger financial institutions (such as investment banks, private equity or venture capital funds) around the country have formed vulture funds and have raised very large pools of capital. These funds are buying up debt, equity, real estate, and even entire companies. As the economy continues to weaken you will see this asset class grow in significance in the future.
Editor: Have you seen any bank or mortgage failures, both in your practice and in the wider arena of transactions, where the institution has simply disappeared and not been taken over by a better capitalized institution?
Wink: I think we all followed the media a few months ago when Bear Stearns' difficulties were communicated to the public. We would probably agree that it would have been disastrous if JP Morgan had not come to the rescue of Bear Stearns. Today you are seeing some banks going to the capital well to raise cash. Many large banks are going through the process of selling common and preferred stock and subordinated notes to raise cash to improve their capital positions. Many banks need to raise capital to cover anticipated and actual rising delinquencies in their commercial loan portfolio. As we speak, the Wall Street Journal announced that Sovereign Bank Corp in Philadelphia plans to raise over $1.5 billion dollars through the sale of common stock and subordinated notes.
Editor: Do you share the sentiment often expressed that banks may be over reserving?
Wink: A lot of the problems that banks are having now were brought on by their own abandonment of good lending standards. With the tremendous economy of the last ten years, banks took their eyes off the target and lowered underwriting standards. They made loans that in prior years under normal, conservative credit conditions would not have been made. To say that the banks are too conservative in over reserving today is inaccurate. I think they are doing the right thing.
Editor: What are your thoughts about any change in the regulatory picture with this most recent crisis?
Wink: I think the Federal Reserve is going to become more stringent in its oversight of the banks in seeing that credit quality standards are observed. As a nation we cannot afford to see a major financial institution going under right now. I think the non-depository institutions, such as the investment banks, are all taking a hard look at their capital requirements and how they are going to survive a downturn in their business. Most transaction activity has come to a slowdown or a grinding halt. I think the bankers are going to be going through some lean years in the next round. I hate to be a pessimist, but that is the outlook right now.
Published June 1, 2008.
