17 Oct BURN THE SHIPS (Q2-24)
Dear Investor,
In asset-based lending, underwriting paramountcy is given to the value of the underlying collateral. The fundamental premise is that the loan is secured against assets, providing a cushion in the event of default. This approach prioritizes the realizable value of inventory, equipment, real estate, or receivables, assuming that if things go awry, these assets can be sold or operated to recover the loan. As a result, the other classical “Cs” of credit – capacity, capital, conditions, and character – often take a backseat to the value of the collateral.
This asset-centric model is appealing for its simplicity – after all, it is easier to quantify collateral than character. Character, in the context of credit analysis, refers to the integrity, reputation, and trustworthiness of the borrower – in this case, the management team. It is an assessment of whether the borrower has the ethical standards and commitment to meet their obligations. Character is subjective and often becomes a secondary consideration in asset-based lending. In fact, many of the structural features of asset-based loans, such as lockboxes, blocked account agreements, and customer notifications, are designed to make management irrelevant. However, in our experience, character should hold equal if not more weight in the determination of making a secured loan. We have learned, sometimes the hard way that, no matter how promising a business model may appear or how attractive an asset might seem, the quality of management can determine the success or failure of an investment.
Asset values are not static, but they are generally more stable and less prone to volatility than earnings or cash flows. This relative stability is another reason why asset-based lenders often consider management quality to be of secondary importance. Unlike earnings, which can fluctuate with various market or industry conditions, and can be subject to aggressive accounting practices, assets have an intrinsic value that is less susceptible to short-term market fluctuations or management manipulation. This perceived reliability makes it tempting for lenders to focus primarily on the value of the collateral, with the assumption that even if management falters, the assets will hold their value and can be liquidated to recover the loan.
Management character is the cornerstone of how a business is run. Even the most valuable assets can quickly become worthless if mismanaged. A management team that lacks integrity, transparency, or the ability to make sound decisions can erode asset value rapidly, leaving lenders with far less than they anticipated. Poor management can lead to the misuse of assets, neglect of maintenance, or engagement in risky business practices that diminish the collateral’s worth over time. While collateral value is central to asset-based lending, the interaction between collateral and character is what ultimately determines the success of the loan. A strong collateral base can mitigate some risks, but it cannot substitute for poor management. Conversely, a management team of high character and competence can sometimes compensate for weaker collateral, using their skills to enhance asset value over time.
The synergy between these elements is where true security lies. A prudent lender recognizes that while assets provide a buffer, it is the character and quality of the management team that determines whether those assets will retain or increase their value. Evaluating management’s track record, their response to past challenges, and their overall business acumen is as important as assessing the current market value of the collateral.
The character of the management team is a non-negotiable criterion in our investment process. We believe that you cannot make a good deal with bad people. If we begin to question the integrity or character of management, our course of action is clear: we either exit the investment or replace the management. This principle is rooted in the reality that character flaws in leadership inevitably lead to deeper problems down the line – problems that can erode value, destroy trust, and ultimately lead to the failure of the business. We have observed time and again that leaders who lack integrity are more likely to engage in practices that are harmful to the business and its stakeholders. These practices can range from financial mismanagement and fraud to unethical business dealings and poor corporate governance. Such behaviors create an environment of mistrust, where stakeholders, including employees, customers, or lenders, become wary and disengaged. This erosion of trust can be fatal, especially in situations where a company is undergoing change, challenge, or complexity – the TEC “Cs” of credit!
Assets that are well-managed, well-maintained, and strategically deployed tend to appreciate or at least retain their value. Conversely, poorly managed assets can rapidly depreciate, become obsolete, or be misused in a way that diminishes their market value. Poor management, driven by short-sightedness or desperation, can effectively burn the very assets that were intended to secure the loan, leaving little to no value upon which to recover. Moreover, liquidation is not a straightforward process. The assumption that assets can be easily liquidated to recover the loan overlooks the complexities and costs associated with this process. In a distressed scenario, the market value of assets can be significantly lower than their intrinsic value due to the need for a quick sale, lack of demand, or the condition of the assets at the time of liquidation. Additionally, the legal and administrative costs of liquidation can further erode the recoverable value. If the assets are integral to the business’s operations, their value may be deeply intertwined with the company as a going concern, meaning that their maximum value can only be realized if the business continues to operate effectively – a task that requires strong management.
Furthermore, the broader impact of poor management extends beyond just asset value. Bad management often leads to deteriorating relationships with customers, suppliers, and employees, all of which can further harm the business and, by extension, the value of the assets. For instance, customer contracts may be lost, supplier terms may become less favourable, and key employees may leave the company. These are intangible losses that can have a tangible impact on the overall value of the business.
Reflecting on our firm’s history, it is evident that the majority of our defaults can be traced back to one common factor: bad management. Whether it was due to poor decision-making, lack of foresight, or unethical practices, bad management has been the root cause of many of our challenges. In several instances, we entered into deals with companies that, on the surface, appeared to be solid investments. The assets were valuable, the market opportunity was clear, and the potential for growth was significant. However, what we underestimated, and did not fully anticipate was the impact that poor management would have on these businesses and more importantly our collateral.
In one particular case, we invested in an established oilfield maintenance, transportation, and surveillance company that used helicopters and fixed wing aircraft to service rural and remote energy infrastructure for blue-chip oil and gas companies. The company was a leader in its industry that provided essential services but due to an overleveraged balance sheet had to delay critical aircraft capex. Our financing was used to restructure existing debt and provide growth capital. The financial projections were promising, strong asset values were verified through third-party appraisals, and the initial due diligence did not raise any red flags. However, as time went on, it became clear that the CEO and his management team were misallocating resources and starving critical parts of the business such as pilot training and aircraft maintenance. Management was not forthcoming about spending decisions, was resistant to feedback, and overly optimistic about their ability to execute their strategy. Despite our efforts to provide guidance and support, the management team’s poor decision-making and lack of transparency ultimately led to the company’s downfall. In their desperation, they began to cut more corners and mismanage resources, effectively “burning the ships” – the very assets that should have secured the investment – leaving us with far less than anticipated.
This experience reinforced a critical lesson for us: no amount of financial engineering can compensate for bad management. A company’s success is inextricably linked to the quality of its leadership. Strong management teams are proactive, transparent, and willing to confront challenges head-on. They are open to feedback, willing to admit mistakes, and committed to finding solutions. In contrast, weak management teams are reactive, opaque, and often in denial about the reality of their situation. They are more concerned with preserving their own image than with addressing the issues at hand, and this inevitably leads to failure.
One of the key metrics we use to evaluate the quality of management is their level of transparency. We have a “no surprises” rule at our firm – a principle that we believe is fundamental to any successful business relationship. We implore management to communicate openly and honestly with us and all other stakeholders, especially when it comes to bad news. We understand that even the best leaders and the most well-run companies can encounter difficulties. Challenges are a part of business, and mistakes are a part of being human. What matters is how those challenges and mistakes are handled.
When management is transparent about the challenges they face, it allows us to work together to find solutions. It enables us to offer our expertise and support in navigating through tough times. However, when management chooses to hide or mask bad news, it not only undermines our ability to help but also signals a deeper issue: a lack of integrity and accountability. This is unacceptable to us, and we will not tolerate it.
Transparency is not just about being honest when things go wrong; it’s about creating a culture of openness where information flows freely, and all stakeholders are kept informed. It’s about ensuring that everyone is on the same page and that there are no hidden agendas or surprises. When transparency is absent, it creates an environment of uncertainty and mistrust, which can be just as damaging as the issues being concealed.
Management quality, reflected in the character of the leadership team, plays a pivotal role in safeguarding and enhancing the value of the collateral. A loan secured by valuable assets can still be a risky proposition if placed in the hands of poor management. Conversely, strong management with a commitment to transparency and ethical conduct can transform even modest assets into valuable, sustainable security. As such, the evaluation of character should be a core component of the underwriting process, ensuring that both collateral and leadership are aligned to protect and maximize the value of our investments.
PRIVATE DEBT MARKET AND OUTLOOK
Annual loan default rates have historically mirrored the trend in corporate bankruptcy filings. The number of U.S. Chapter 11 fillings in the first half of 2024 are 39% higher than the same period in 2023, and 46% higher over the number of first half of the year filings in the ten-year period 2015-2024.2
As we have indicated in previous letters,
the number of business insolvencies in Canada has also surged at record rates. Canadian corporate bankruptcies are up a whopping 70% in the first half of 2024 from a year ago. Yet, current empirical data and survey information about the credit risk of small and middle market companies report unusually low default rates, below the historical ten-year average. So what explains this surprising anomaly?
Professor of Finance at the NYU Stern School of Business, Dr. Edward Altman, recently penned a note aimed at dispassionately assessing where we are today in the credit cycle. His research since the 1970s has looked at the U.S. credit cycle’s associations with economic expansions, slow-downs, recessions, and depressions – essentially, the business cycle. According to Altman, the credit cycle has distinct stages characterized by varying levels of interest rates, default rates, recovery rates, liquidity, and required returns for investors:
• Benign Stage: Characterized by low interest rates, below-average default rates, high recovery rates, and ample liquidity. Investors require lower returns due to favorable credit conditions.
• Average Stage: Marked by moderate interest rates, default rates, and recovery rates that align with historical averages. Liquidity is balanced, and required returns reflect standard risk and reward.
• Stressed Stage: This stage sees increasing interest rates, higher-than-average default rates, declining recovery rates, and reduced liquidity. Investors demand above-average returns due to rising risk perceptions.
• Credit Crisis Stage: Defined by very high interest rates, extreme default rates, low recovery rates, and a severe lack of liquidity. Investors require significantly higher returns as risk becomes severe, with yield spreads much above average.
Based on this spectrum of credit market activity, we appear to be in the “average” stage of the credit cycle, which is contrary to where we expected to be today and certainly disconnected from the business insolvency data. Altman agrees and has his doubts about whether default rates will continue to stay at low levels. We have previously written about the unprecedented levels of liquidity support and intervention by governments and central banks in the financial markets over the past few years, which provided a critical lifeline to many businesses, enabling them to manage their debt obligations despite challenging economic conditions. At the same time, banks were obliged to forbear from enforcement and provided relief through indefinite waivers – activity which we termed “forced compassion.” We have also highlighted the recent rise in liability management exercises (LMEs), or the negotiation of debt restructurings, that prevent an immediate default and can extend debt maturities, further contributing to the low default rates observed.
The increase in corporate bankruptcies has been heavily concentrated in certain sectors that were more vulnerable to economic disruptions, such as retail, hospitality, and energy. However, many small and middle market companies, especially those in essential or resilient sectors, have managed to maintain stable cash flows and meet their debt obligations. According to the Golub Capital Altman Index, U.S. middle market companies experienced positive year-over-year growth in sales and profits throughout the second half of 2023 and into the second quarter of 2024. This sectoral disparity has contributed to the lower overall default rates. But the presence of large, secured liabilities at bankrupt borrowers begs a different explanation.
We believe the anomaly in the relationship between loans defaults and corporate insolvencies is primarily due to the delayed impact of broader economic conditions. The effects of economic downturns and rising interest rates on default rates often lag behind the initial triggers, such as increased bankruptcies. In our opinion, the full impact of current economic conditions has yet to be felt in terms of defaults, which could manifest more clearly in the coming quarters. Recent bank earnings reports in Canada reminded investors that business loan losses can be highly unpredictable and idiosyncratic. Some of the larger losses at Bank of Montreal, for example, were to commercial loans made during the pandemic – over three years ago!
Annual default rate trends have been a leading indicator of recessions in the U.S. over the past forty years (but understandably less so in 2020, during the short-lived pandemic recession). Economic uncertainty persists on both sides of the border, but with the Bank of Canada well into its easing cycle and expectations mounting for the Federal Reserve to begin cutting rates in September, the “higher-for-longer” thesis is beginning to fade. The critical question now is not just the extent of these anticipated rate cuts, but more importantly, their timing and impact on
credit conditions, which, while not dire, are undeniably deteriorating. As we move forward, the focus will be on how effectively these rate reductions can stabilize and eventually improve the credit environment and keep loan defaults low.
The outlook for the credit cycle is anything but “average.”
Yours very truly,
Arif N. Bhalwani
President & CEO