Investors are forced to take on more risks in a dizzying market of confusion. Bond yields are at record lows, usually a signal of impending economic stress, yet equities are at near all-time highs. Investors are unable to reach return objectives staying on the sidelines or resorting to the “safety” of bonds, and are left with no alternative but to bid-up already stretched valuations of risk assets. Studies show that banks, mutual funds, and pension funds disproportionately invest in riskier assets when interest rates are low.¹ Portfolio managers, flush with liquidity, have the incentive to overinvest in risky assets, reach for yield and contribute to the formation of asset bubbles. Credit markets remain fertile ground for a bubble. The Fed’s actions have accelerated the prospects for a credit blowoff.

Must Come Down…

The S&P/LTSA US Leveraged Loan Index (the “LLI”) was up 8.64% in 2019. A great headline number that unfortunately says more about the indiscriminate speculation of investors than the fundamentals of the corporate credit markets. The share of loans in the LLI carrying a rating of single B or below increased to 50.49% in December 2019, the highest that share has ever been. Approximately US$70 Billion of leveraged loans are currently priced below 80 cents on the dollar, a common measure of distress, versus $20 Billion a year ago. The BCA Corporate Health Monitor, a composite of six key financial ratios for the non-financial corporate sector in the U.S., shows the credit quality of U.S. borrowers worsening; at the same time, return on capital for U.S. firms is rapidly falling (see Figure 1).

We painted a similar picture of the overall health of Canadian corporates in our last quarterly report. Part of the reason for worsening fundamentals among non-financial companies in Canada and the U.S. is that a lot of the debt issued post-crisis has not been for productive purposes and, therefore, has not been matched by as much asset growth as in previous cycles. In our Q3-2018 Investor Report, we posited that too many borrowings were being used for opportunistic purposes, such as dividend recapitalizations and share buybacks. Therefore, borrowings are not backed by the same extent of collateral as in the past. As we outlined in our last quarterly report, the more cushion there is to a defaulted debt instrument, the stronger the recovery. According to S&P LossStats, which tracks U.S. institutional loan recoveries, a record 35% of first-line term loans were issued in 2019 without any debt cushion; in other words, there was no layer of equity or subordination to potentially absorb losses in the event of default. As a result, the debt cushion of outstanding loans shrank to a low of 20% in 2019, versus 29% in 2009 when loan defaults peaked. When credit markets hit their tipping point of rising defaults and downgrades, recovery rates will suffer more than investors expect.

Figure 1: Deteriorating Fundamentals of U.S. Corporates, Source: BCA Research

Snap and Crackle at the Banks

Following up on our prediction made last quarter that Canadian banks would post higher loan loss provisions in coming quarters, credit performance at the big six Canadian large cap banks was worse than expected in the fourth quarter of F2019, driven by a combination of credit losses and margin compression. Bank CEOs are finally beginning to express a more negative tone on the credit outlook and acknowledged that risks had been elevated. Total provisions for credit losses were up 31% in F2019 and reached the highest absolute ratio reported by Canadian banks since 2012 (even above 2016’s provisions caused by a downturn in the oil and gas sector). Some of this increase could be caused by scenario-driven accounting changes under IFRS 9 – seventy-three percent of the year-over-year dollar increase in loan losses came from Stage 3 provisions (loans in Stage 3 have defaulted and are non-performing); however, this still reflects guidance on weakening credit fundamentals.

The deterioration in credit is concentrated in the commercial loan book; the impaired loan ratio of consumer portfolios actually decreased for 5 of 6 of the big banks in Q4-F2019. CIBC saw the highest jump in credit loss provisions – up 53%. The bank disclosed, in an earnings call in December 2019, that it took a $52 Million provision on a syndicated loan to Eagle Travel Plaza, which operates retail gas stations, truck service centers, and fueling stations across Ontario. According to receivership filings, the borrower engaged in a large-scale fraud by concealing transactions and siphoning off cash from the business. The borrower evidently “lacked centralized record-keeping, proper controls, or a traditional governance and management structure.”² Bank of Montreal was also affected by the fraud but has not disclosed its expected losses.

CIBC, along with Bank of Montreal, Royal Bank of Canada, and Canadian Western Bank, also announced having aggregate exposure of $200 Million to Calgary-based commercial real estate company, Strategic Group, which in December 2019 announced that was seeking credit protection under the Companies’ Creditors Arrangement Act (“CCAA”), a federal law allowing insolvent corporations that owe their creditors in excess of $5 Million to restructure their business and financial affairs. Although none of the banks involved have disclosed credit loss provisions, we believe, given the high vacancy rate for commercial properties in Alberta, that the amount and timing of recovery will be grossly overestimated.

As the current economy cycle ages, more losses can be expected on commercial loans (see below for comments on the alternative loan market). Such loans have been the fastest growing assets on bank balance sheets for the past few years, a phenomenon that has been widespread across all banks (see Figure 2). Eventually, this bubble will “pop”, credit spreads with widen, banks will tighten lending standards, and the negative knock-on effects to the economy will ultimately lead to a recession. Historically, wider credit spreads have been an excellent indicator of recessions. ³

Figure 2: Corporate Loan Growth at the Big-6 Banks, Source: National Bank Financial

Bargains in the Patch

Distressed debt investors are sitting on more than US$80 Billion and feeling pressure to invest. With very little distress in credit markets since the financial crisis, distressed debt investors are desperately waiting for the credit cycle to finally turn. We believe that a broad default wave is on the horizon but exact timing is hard to predict given accommodative monetary policy and “covenant-lite, covenant-less” loans that extend credit excesses. However, distressed lenders can find a deal-rich environment today in the oil and gas industry. Energy investments look remarkably inexpensive and have unchallenging valuations in our opinion.

Oil prices (measured by West Texas Intermediate or WTI) were up 34% in 2019 but energy producers were still the worst performer in the S&P 500. Since commodity prices bottomed in Q1-2016, oil prices have rallied 125% while the average oil stock rose by only 12%. In contrast, copper rallied 45% from its 2016 low while the average copper stock rose 130%.⁴

Traditional energy companies are facing a full-frontal assault from politicians, investors, and activists concerned over global warming and CO2 emissions. Capital is pouring out of investments perceived to violate environmental and sustainability concerns causing the forced liquidation of producers and service companies in the oil and gas industry. The energy transition from fossil fuels to renewables is a powerful downward force on oil and gas valuations. However, this transition is likely to take decades.

Morgan Stanley estimates that oil and gas represent 57% of the world’s primary energy mix; 86% of global energy demand still comes from fossil fuels. Wind, water, and solar account for close to 2% of the global energy mix. It took coal a half century to grow from 2% to 10%; oil and natural gas took 26 years and 33 years, respectively, to do the same. Even if oil demand peaked today, there would still be over US$40 Trillion needed, according to the International Energy Agency, for drilling, completion and field development activities before objectives under the Paris Agreement and the IEA’s own “net-zero” by 2070 target can be achieved. This means the returns on capital investment have to be attractive enough for investors, which can only occur if either oil prices rise or existing assets sell at steep discounts.

The oil and gas industry may be the only place today where lenders have the upper hand over borrowers. Investors can be extremely selective and not worry about bank or other competition driving down returns or credit protections. Existing owners, particularly private equity firms with defined exit horizons, are stranded with no liquidity. According to Reuters, an average of 67% of all oil and gas sales transactions in the last two years failed to consummate due to lack of financing. Exploration and production (“E&P”) companies are being forced to maintain capital discipline, defer non-essential capex, and maximize cash flows to investors. The CEO of one prominent, private equity-backed E&P company in Canada told us that his company had to achieve a minimum US$1 Billion in market capitalization, by consolidating or merging with competitors, before equity markets would open up liquidity options.

In the current energy environment, where oil and gas companies are forced to redefine themselves due to rapidly changing market dynamics, investors have to make their money on the buy not the sell. This means backing companies with strong competitive positions and differentiated offerings that command premium pricing. For example, as producers direct cash towards cleaning up balance sheets rather than the drill bit, drilling and completion activity will falter and oilfield service companies will struggle to stop revenues and margins from declining. As our investment in a market leading flowback production testing company proves, the most successful oilfield services companies deliver products, services, and capabilities that help operators boost productivity and reduce costs. This portfolio company enables producers to save millions in capital investment on midstream infrastructure and increase free cash flow, which makes it a critical supplier even when market sentiment is low.

Similarly, when investing in E&P companies, asset composition matters. Over the past several years, the market has generally failed to recognize any value or multiple increase for producers that own and control their own midstream and field infrastructure. We believe this is flawed because with less growth capital available to fund new infrastructure, upstream companies without owned midstream assets will become increasingly dependent on pure midstream players or, even worse, competing producers. We witnessed a similar phenomenon five years ago in the mining industry, where gold producers that owned their own processing mills could better adjust revenue mix and manage costs when commodity prices fell. Producers that own their infrastructure could position for midstream monetization events and unlock significant upside given the current valuation gap between E&P companies and the midstream sector. According to AltaCorp Capital, the multiple difference is currently approximately 7x on an enterprise value-to-cash flow basis; compared to May 2016, when intermediate upstream and midstream companies both traded at 11x cash flow. We expect the market to give credit to producers for their midstream assets as stakeholder pressure for companies to curtail spending and consolidation activity in the Canadian energy industry continues.

Our investments in the upstream oil and gas sector have always been to companies that own and control their own infrastructure. This ensures that our borrowers have uninterrupted processing capacity, can increase and diversify revenues if utilization falls, can lower operational costs, and are not beholden to third parties. It also means better exit options for us in the event of distress. The critical in-field infrastructure owned by a non-performing borrower that defaulted in 2018, for example, was a significant driver behind our successful sale of its upstream assets in 2019. Similarly, our current exposure in the CCAA restructuring of ACHL, a private, intermediate oil producer, will benefit from our collateral security and control over key processing facilities.

The restructurings affecting the oil and gas industry are ripe fruit for hungry distressed debt investors. An advantage of undergoing and emerging from a restructuring process, such as CCAA in Canada, is a clean balance sheet, a reinvigorated team, and a renewed perspective on the business This provides investors a more solid platform on which to add more reserves, either through drilling or acquisition, in order to increase scale and more easily exit.

Arif N. Bhalwani, CEO

[1] Acharya, Viral and Hassan Naqvi, 2016. On reaching for yield. Working paper. New York University Stern School of Business
[2] Receivership documents. See https://www.bdo.ca/en-ca/extranets/eagletravelplaza/
[3] BCA Research, The Bank Credit Analyst, January 2020
[4] Goehring & Rozencwajg Research

The post What Goes Up (Q4-19) appeared first on Third Eye Capital.

The average nominal recovery for all the corporate bonds and loans tracked in LCD database is 66%; the average discounted recovery is 59%. Looking at just bank loans, the historical average nominal rate is 86% and the historical average discounted rate is 79%. However, for newly tracked loans added by LCD in the last year (up to August 2019), the recoveries on bank loans has underperformed the historical average: average nominal recovery of 77% and the average discounted recovery of 76%. Two major factors have influenced lower recoveries for recent defaults in the LCD database: (1) these bank loans had a lower safety cushion than is the case historically – 20% versus 43%; and (2) these bank loans contained a higher concentration of covenant-lite terms.

Safety cushion, which can be measured by total loan-to-collateral coverage, or amount of junior debt or equity below the senior, is the most significant factor determining recoveries. Loans with more than a 75% cushion (an LTV of 25% or less) have a 94% average discounted recovery, with a coefficient of variation of just 0.18. The average discounted recovery is 86% for bank loans with a 51–75% cushion, 73% for those with a 26–50% cushion, and 69% for a cushion of 25% or less.

According to LCD, of all first-lien term loans issued this year in the U.S., only 66% had any kind of safety cushion, which is a record low. Not surprisingly, such loans are typical for smaller, closely-held borrowers, which prefer to preserve equity and provide loan guarantees from its owners. For all loans tracked by LCD, including revolvers and both first and second-lien loans, 26% did not have a debt cushion, slightly below the 27% historical high at end of 2018. In addition, the average debt cushion is now also at a record low of just 20%.

The prospect of lower loan recoveries should have investors more anxious about the timing of the next default cycle. Most loan managers in the U.S. remain sanguine about the default rate. According to LCD’s Q3-2019 buyside survey, loan managers say they do not expect an impending spike from the historically low trailing default rate at 1.29% in September 2019. In fact, consensus is that loan defaults will only push to 2.52% by the end of 2020, still below the 2.92% historical average. Yet, credit fundamentals do not support this optimism. Issuers listed in the S&P/LSTA Leveraged Loan Index (“LLI”) have weighted-average leverage of 5.59x, cash flow coverage of 2.95x, and annual EBITDA growth of 2%. The share of loans in the LLI that are rated single-B or below has been climbing since 2015 and is at a record 49%.

Private lending managers in Canada also maintain a benign outlook on defaults based on informal surveys at recent private debt conference panels in which the author participated. Not a single manager (other than the author) was concerned about weak loan structures or deteriorating corporate credit fundamentals, and nearly all of them believed that any credit downturn would be short-lived. A bottom-up analysis of eighty-five publicly traded companies since 2007 shows that the overall health of Canadian corporates has weakened dramatically: profitability metrics and interest coverage ratios are at their lowest levels.

Canadian non-financial corporate debt levels are very high (see Q1-2019 Investor Letter) and the export-intensive Canadian economy is vulnerable to any incremental deceleration in U.S. growth. Whether looking short-term or long-term, corporate credit fundamentals in Canada are bad. Private debt managers who choose to ignore the overwhelming negative information will bear the consequences of sticking their heads in the sand.

Banking on Losses

The big six Canadian banks are the largest players in the Canadian financial landscape and hold ~75% market share in consumer and retail banking (which includes small business loans and commercial lending) and dominant positions in wholesale banking (dealing with corporate and institutional clients) and wealth management, where market share is about 80%. Banks have adopted a secular trend toward favouring growth in non-interest revenues over net interest income. Since 1980, non-interest income has risen to 45% of total revenues from about 20% (it was close to 60% before the GFC in the second half of 2007) because of low interest rates pressuring margins and a de-emphasis on capital-intensive lending businesses (see Figure 3 below).

The greater exposure to capital markets was helpful to banks in Canada during the GFC. Loan losses tend to lag an economic recovery while asset values lead; therefore, by the time Canadian banks felt the effects of higher credit losses, wholesale banks were benefiting from attractive capital markets trading conditions. Return on equity (“ROE”) for Canadian banks was higher during the GFC than in prior downturns because of the increased diversification of revenues and lower exposure to traditional credit risk. ROE troughed at 13% in 2009 compared to negative ROE for U.S. banks.

Loans represent a smaller proportion of banks’ assets today than in anytime during the 20th century. However, loan growth has remained positive as total assets have increased. Business loan growth has traditionally coincided with the business investment cycle. Since the GFC, business loan balances for Canadian banks troughed in the first half of 2010 and total loan balance growth has improved since then to double digit rates. In addition, many larger businesses have locked-in low financing costs by issuing long-term bonds rather than borrowing short-term from banks, which has been positive for Canadian banks’ debt underwriting revenues. Banks have shown a willingness to price business loans aggressively for certain borrowers, specifically where they can generate non-interest income from sources such as account fees, cash-management support, foreign exchange services, payroll solutions, group savings plans, insurance products, and wealth management services to business owners. Their full-service capabilities have allowed the big six banks to capture more market share in business lending than their competitors including other chartered banks, trust companies, credit unions, mortgage companies, and other non-bank lenders combined.

Loan losses have historically been volatile at banks, with those having high concentrations in industries and issuers facing difficulty incurring the highest losses. Banks’ internal workout departments are small, regimented, and banal and are not equipped to restructure or turnaround distressed businesses to maximize going concern values. Bank personnel will generally give defaulted borrowers time to find a refinancing solution and, if that fails, resort to an asset liquidation under an expensive receivership process. Banks aim to mitigate risk through industry limits and single-name limits depending on the borrower’s risk rating. Credit risk and loan losses are inevitable for banks (it is the one of the primary reasons for their existence) but Canadian banks are less exposed today than in the past. In the peak yearfor loan losses in the early 1990s, losses represented 26% of revenues (and were even higher at 55% in 1987). In the early 2000s, they represented 15%, and in 2009 14%.

In 2009, some banks experienced loan losses well above their historical averages, which in large part reflected business mix (i.e., more exposure to consumer lending). This was predictable because the two credit cycles prior to the GFC (the early 1990s and early 2000s) were characterized by problems in the business sector, which shifted bank lending activity to consumers. The current credit cycle in Canada has, again predictably, seen an unprecedented surge in corporate credit. If you want to know where the next crisis will be, then follow the leverage.

The future size and direction of business loan losses can be forecast by tracking two metrics: (1) business health, and (2) the trend in business bankruptcy proposals and filings. On the first measure, we highlighted in the previous section (see Figure 2 above) a significant deterioration in the health of Canadian companies since the GFC. In a weakening economy, Canadian businesses will struggle more than ever to stay current on their debt. The second metric is showing worrisome signs for the near-term outlook of business loan losses at Canadian banks.

According to statistics published by The Office of the Superintendent of Bankruptcy Canada (“OSBC”), total business insolvencies in Canada increased 30% year-over-year in July 2019, with most provinces experiencing a material jump (particularly in Quebec and the Western provinces). During Q3-2019, the greatest number of insolvencies were concentrated in three main industries: residential developers and contractors (including sub-trades), freight trucking companies, and full-service restaurants. Incidentally, TEC has exposures in all these industries but in companies where fundamentals and outlook are strong. A total of 29 proceedings under the Companies’ Creditors Arrangement Act (“CCAA”), a federal law allowing insolvent corporations that owe their creditors in excess of $5 Million to restructure their business and financial affairs, were filed in the twelve month period ending September 30, 2019, mostly in the mining, oil and gas, retail and manufacturing industries. The primary objectives of the CCAA are to facilitate a successful restructuring, maximize value for creditors, protect the public interest, and rescue insolvent debtors.

A rise in Canadian business insolvencies has been a strong predictor of gross impaired loan (“GIL”) formations within banks. Loans are classified as impaired when the bank no longer has reasonable assurance of timely collection of the full amount of principal and interest. Bank published GIL figures are misleading, however, because they are netted with general allowances, which are meant for performing loans not impaired loans. Reported GILs are increasing at Canadian banks and are now higher than pre-GFC levels (see Figure 4 below).

Rising business insolvencies will drive higher loan loss provisions for Canadian banks in the coming quarters. This will, undoubtedly, cause a cyclical shift in the banks’ credit mix away from companies and further open the door for alternative lenders to fill the gap. Also, because banks lack the ability and willingness to restructure distressed borrowers, sophisticated alternative lenders like TEC with the specialized skills and experience to orchestrate major business and financial turnarounds will be positioned to prosper. The demand for debtor-in-possession (“DIP”) financings will increase with rising defaults. DIP financing provides liquidity to debtors seeking to reorganize and restructure in an insolvency process. As an incentive to extend credit to an insolvent debtor, DIP providers receive superpriority creditor status from a bankruptcy or CCAA court that grants them the right to be repaid from collateral proceeds before any pre-petition creditors, including existing senior secured lenders.

TEC has been providing DIP financing since its inception. Banks rarely provide DIP loans due to the high-risk weightings and capital charges imposed on them by regulators for such financing. In Canada, there are very few alternative lenders willing and experienced enough to navigate through a complex restructuring process using a DIP financing. TEC’s track record using DIP financings has been exceptional and is well known among Canadian insolvency professionals; recently, we have seen DIP financing requests increase significantly in line with the jump in business insolvencies. Research published in the Journal of Financial Economics shows that DIP financed firms are more likely to emerge from a restructuring process than non-DIP financed firms. DIP financed firms also have a shorter reorganization period; they are quicker to emerge and also quicker to liquidate. The time spent in restructuring is even shorter when the DIP lender also has a prior lending relationship with the debtor.

Canadian bank executives have been consistently providing positive guidance on the credit outlook. We believe such optimism needs to be tempered by a challenging macro environment and growing business loan losses. Despite their immense scale and market dominance, banks can very quickly change credit priorities and leave certain sectors stranded. For instance, after crude oil prices fell to decade lows in 2016, many Canadian energy companies defaulted on their loans and Canadian banks have been reluctant to support the sector ever since. Thanks in large part to the torrid pace of business lending by banks, alternative lenders in Canada, particularly those that know how to manage distress, should get set for another wave of outsized returns.

Excerpted from Third Eye Capital Management Inc.’s Q3 2019 Investor Letter.

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Credit investors know empirically that the demand for credit is pro-cyclical. Whether greater credit demand is the cause for economic upturns or merely correlated is a debate not frequently had in academic circles. In the first published paper that examines using credit data to forecast GDP growth, three economists from the Central Bank of Turkey[1] concluded that credit data can be used to not only explain the movements of GDP but also “nowcast” quarter-on-quarter GDP growth. Since most macroeconomic variables are made available to the public after considerable delay (sometimes months), credit data could be very valuable for early estimates of current GDP as it is available with only few days delay.

Comparing cycles in the stock of credit with cycles in the flow of GDP produces spurious outcomes. The Bank of International Settlements[2] used such a comparison to proclaim that credit cycles last longer and have much larger amplitudes than economic cycles, although empirical evidence shows these cycles are roughly of equal length. Michael Biggs and Thomas Mayer (“Biggs and Mayer”) of Deutsche Bank and Frankfurt University, respectively, argue that GDP is a flow measure and only comparable against another flow measure[3]. They use the second derivative of credit, the change in the flow of credit, rather than credit growth and show that GDP growth depends on whether the flow of credit, or new borrowing, is increasing or decreasing. They coined the phrase “credit impulse” to describe this flow of new credit in an economy.

Biggs and Mayer examined the U.S. Great Depression, OECD countries that suffered a financial crisis, and the recent Great Financial Crisis (“GFC”), and found that the flow of credit resumes at the same time as the economy starts to recover (even if the stock of credit continued to decline). The relevance of the credit impulse rather than credit growth to real domestic demand growth was particularly evident in the U.S. in 2010 (Figure 1). Credit growth was negative in 2010 (even weaker than the IMF forecasted) but credit growth was less negative than in 2009 (flow of credit was positive), and real GDP growth and private sector demand grew 2.4% and 3.7%, respectively.

Figure 1. U.S. Credit impulse and demand growth
Source: Deutsche Bank, IMF

The implication of these findings is that after a credit crisis all that might be required for a recovery in demand growth is that new borrowing rises. The massive rise in new credit formations since the GFC have certainly characterized the last decade of economic growth. It has been demonstrated that, for many times periods and countries, credit impulse is a useful predictive indicator of GDP growth and other macroeconomic data that works with a lag of nine to twelve months.

Tracking the credit impulse of a country provides a helpful assessment of where the economy is heading. Prior to the GFC, the U.S., Japan, and Europe were the main drivers of the global credit cycle; however, since 2009, China’s credit impulse has become a dominant factor. For 2017-2019, China’s contribution to global growth will reach 35%, equal to that of the U.S. India, and Europe combined. China is also the world’s largest consumer of industrial metals, accounting for half of global demand. China’s credit impulse is key to the evolution of the global economy. According to Saxo Bank, one of only a few institutions that regularly tracks the credit impulse of major economies, global credit impulse is falling and is at -1.8% of global GDP. Half of the countries that Saxo Bank tracks are in contraction and the other half (except India and Russia) are experiencing a deceleration in the flow of new credit. In developed countries, the trend is most concerning in the U.S. where credit impulse is at -2.2% of GDP, the lowest level since 2009 (Figure 2).

Figure 2. Credit impulse in major economies (April 2019)
Source: Saxo Bank

According to BCA Research, short-term credit impulses in the U.S., E.U., and China are all entering down-oscillations. Saxo Bank notes that China’s credit impulse tends to lead the global credit impulse by one year (Figure 3). Unless the flow of credit in China reverses due to a very targeted policy response, which in China is a strong possibility, we can expect lower global growth ahead.

Figure 3. Credit impulse in China and Globally (April 2019)
Source: Saxo Bank

Since Q1-2010, a strong positive credit impulse in Canada has helped drive demand growth but a turn was inevitable given the record stock of indebtedness (Figure 4). By the end of Q4-2018, credit impulse in Canada was -1% of GDP, a potential signal for a further slowdown in GDP. In the Bank of Canada’s Q2-2019 Senior Bank Officer Survey; however, opinions on bank lending standards showed a slight easing of conditions, which does not confirm any shift in credit availability that might curtail new loan originations. Credit demand is receding in parts of Canada, especially in British Columbia and the Prairies where sentiment on the economic outlook is softening, so the national credit impulse is worth tracking closely.

Figure 5. U.S. Institute of Supply Management Indices (July 2019)
Source: BCA Research

Higher trade tariffs negatively impact corporate confidence, capex intentions, and near-term global growth. Trade policy has proven to influence the Fed’s deliberations. We disagree with the consensus view that the Trump administration will reach a resolution of China-U.S. trade tensions in order to improve re-election prospects. We believe U.S. President Donald Trump considers the U.S. stock market as his report card and thinks aggressive Fed stimulus is necessary to keep risk assets afloat. What better way of coaxing more cuts out of the Fed in the near-term than by escalating trade tensions?

Corporate fundamentals in the U.S. are weak. Results from second quarter reporting season shows that there have been 3.5 negative earnings revisions for every upward revision. Seventy-two percent of S&P500 companies issued negative earnings guidance for Q3-2019, which is above the 5-year average of 70%. Corporate debt as a share of GDP is at the highest level in the post-war era. Based on Compustat data that captures nearly 2,000 publicly-traded firms and covers the years 1999 through to 2018, non-financial corporate debt relative to both EBITDA and total assets are also well above their historical averages. Smaller companies have more debt and lower margins than larger ones. Approximately 600 of the Russell 2000 have no forward profits (note these companies are omitted from the forward P/E calculation of the index, understating how expensive valuations are in the small cap market).

Economic crises are severe but uncommon, which is why imbalances are not recognized until it is usually too late. The surge in risky lending evokes memories of the subprime mortgage build that helped trigger the GFC. The Fed will not be patient about letting such imbalances grow and we think they will keep financial conditions easy to sustain an economic expansion. We believe more rate cuts and excess money growth will cause a final blowoff top in credit markets. The Fed is not a cure-all – no matter what it does, a recession is coming.

[1] Ermisoglu, Ergun, Akcelik, Yasin, Oduncu, Arif (2013). “GDP Growth and Credit Data”. Central Bank of the Republic of Turkey, Working Paper No. 13/27.

[2] Borio, Claudio (2012). “The financial cycle and macroeconomics: What have we learnt?” BIS Working Papers No. 395

[3] Biggs, Michael, Mayer, Thomas (2010). “Bring credit bank into the monetary policy framework!” Political Economy of Financial Markets, Oxford University, Policy Brief.

The post Go with the Flow (Q2-19) appeared first on Third Eye Capital.

LCD, a unit of S&P Global, released its Q1-2019 default survey of buyside credit managers, which saw default rate forecasts being trimmed after the Fed’s surprise reversal on monetary policy normalization: 1.82% for the end of March 2020, down from 2.12% in the Q4-2018 survey. Investor sentiment has improved since the end of 2018 but it is not expected to last. The same LCD survey showed 75% of managers predicting loan defaults to climb above the historical average of 3.1% in 2021 – this is up from 42% in the previous quarter. No respondents expected it would take longer than 2022 for the default rate to eclipse the historical average; this is a sharp contrast from the previous read when 17% of credit managers were more optimistic. Default conditions remain benign for the time being, but LCD notes more dispersion in pricing and terms based on actual credit risks.

In the broadly syndicated markets, the share of issuers rated B+ or lower accounted for half of all U.S. leveraged loan issuance over the past six months, down from a high of 68% in the third quarter. In Q1-2019, 80% of non-bank institutional volume of issuers rated B+/B was priced at spreads 350 basis points or more above LIBOR. This is close to double the percentage volume for similar spreads on average in 2018. Looking at issuers in the S&P/ LSTA Leveraged Loan Index that file results publicly (approximately 18% of the index), weighted-average leverage fell and cash-flow coverage increased in the first quarter of this year.

In direct lending markets in the U.S., large non-bank players have reported higher spreads and better documentation as a result of the Q4-2018 volatility. At last, it appears that lenders are becoming more discerning. Maybe not.

Borrower-friendly conditions are not positioned to change despite the first quarter “noise” in the credit markets. Already, in April 2019, the share of deals in the leveraged loan markets that saw interest rates and fees be cut in favor of borrowers, reached a one year high. This is symptomatic of a market where lender demand for deals overwhelms supply.

We think the Fed’s recent shift will amplify the already extreme speculation in credit markets. Investors have, not surprisingly, become complacent in thinking that that Fed will save them from the negative financial consequences of bad investment decisions. The GFC did not end because of the Fed – it began because of them. Intense yield-seeking speculation in mortgage-backed securities by investors seeking cover from a prolonged monetary policy of low interest rates largely caused the last global recession. Now, the Fed’s actions are encouraging even more yield-seekers but this time across diverse securities, mostly illiquid and with greater implications to a larger part of the economy.

Blaming the Victim

An inevitable aftereffect of any credit downturn will be a sorting out of fault and liability for failed borrowers. Lenders will be depicted as one of the primary villains, accused of putting their own interests – to be repaid – ahead of the interests of its borrower, other creditors, employees, shareholders and the community at large. Moreover, because the number of affected parties could be significant, lenders risk being exposed to class action suits. This is not a theoretical scenario – there are several examples of aggressive lender liability claims against lenders following economic and industry recessions. In 1986, for example, the Hunt Brothers of Dallas, Texas filed a $3.6 Billion lawsuit against their lenders on theories, among others, of fraud, breach of fiduciary duty, duty of good faith, and breach of contract after defaulting on a $1.5 Billion loan that was hastened by a collapse in silver markets. After the dot-com crash in 2000, massive litigation was filed against lenders in cases involving Enron, Adelphia and WorldCom. More recently, during and after the GFC, several lenders including Citibank, Credit Suisse, Bank of America, and Goldman Sachs, were sued for various alleged violations such as refusing to advance funds, manufacturing a default, interfering with a contract, and deepening insolvency. Every case involved some attempt by a borrower or its unsecured creditors to blame the company’s lenders for its distress.

Lenders have big targets on their backs because of their deep pockets. It is very common in U.S. insolvency proceedings to see threats of litigation made against lenders. In Canada, this practice is rare, in part because court-appointed receivers and monitors are reluctant to take actions against banks that are regular clients representing long-term recurring business. The same courtesy may not be extended to alternative lenders, especially those without established reputations and track records.
Lenders have typically been swift to settle lawsuits against them to avoid bad publicity. In contrast, we have been more aggressive in defending litigation and do not want to set precedents with borrowers that we can be extorted to reduce legitimate loan obligations and allow defaulted borrowers to obtain a windfall recovery to which they would not normally be entitled. In a case that the courts resolved last year, a CEO who personally guaranteed one of our loans accused us of failing to honor a loan modification and charging usurious rates (the maximum allowable interest rate in Canada is 60%), which the CEO claimed led to the failure of his company. The CEO sought to void our loan entirely. After mounting a rigorous defense and refusing to negotiate any settlement that involved TEC paying out monies or reducing the amount of debt owed, we prevailed against the CEO. The judge rejected the claims because there was no evidence supporting the CEO’s case. The court correctly distinguished between us legitimately trying to protect our risk exposure and acting in bad faith.

There are two key reasons why the conduct of alternative lenders will be heavily scrutinized in the next recession. First, there are more of them than in any time of history – banks in the U.S. are outnumbered by a factor of ten. Secondly, alternative lenders generally have private investors, do not publicly report their activities, and are less sensitive to reputational risks. Alternative lenders will be more likely to intentionally interfere with the economic relationships of borrowers that default and take control of their operations and business affairs. Unfortunately, even if their objective is to mitigate losses, alternative lenders found to be acting too earnestly or aggressively will risk being sued and liable. It is rare in the context of any lending relationship that a lender owes a fiduciary relationship to a borrower – their relations are governed by a contract. However, if the lender takes actions that alters the relationship into one that becomes “special” (1) based on excessive control or domination, then the lender will owe greater duties to the borrower than set out in the loan documents.

Alternative lenders tend to be more hands-on about monitoring business operations of its borrowers than their non-bank counterparts. If a lender, in the course of its monitoring, exerts control over the day-to-day operations of a borrower such that it effectively becomes a part of management then a special, fiduciary duty-creating, relationship could exist. Actions that could trigger liability to a lender include board representation, directing which payables the borrower must pay and when, dictating product pricing, and negotiating business contracts. While there are several examples in U.S. jurisprudence whereby courts have found lenders liable for damages resulting from taking control of a borrower’s affairs, the Canadian experience has been much different and more favorable to lenders. In Canada, courts have identified key hallmarks constituting operational control (2):

(i) veto over management decisions; (ii) positioning lender’s personnel in borrower’s management; (iii) ownership of voting shares; and (Iv) effective control over borrower’s business.

Generally, unless all of these facts existed, a lender did not owe a fiduciary duty to the borrower. In our position as primary secured creditor, we have the capacity to exert great pressure and influence – after all, such power is inherent in any lender-borrower relationship. The existence and exercise of such power, alone, does not constitute control. Merely participating in control, even active management, is insufficient. The lender must have absolute control to be liable. Borrowers have the onus of proving that even if lender control is present that such control was misused and caused them harm.

A paramount consideration in assessing lender liability are the contracts governing the lender-borrower relationship, namely the loan agreement and the security documents. Claims against lenders will pose difficulties for borrowers if the lender is acting in accordance with its contractual rights and in the interest of protecting such rights. TEC routinely receives equity in the borrowers that it finances in consideration of the value-added services provided but it does not use this equity to exert control – the purpose of the equity held by TEC is compensation for adding value. Our loan and security documentation provide a broad set of covenants and remedies, and our actions flow from the rights granted by the documentation. It is when a lender deviates from the loan contract that its responsibilities to a borrower and other claimants increase.

We are constructivists. We exert a large degree of influence and prioritize having the best management teams running the companies in which we invest. However, we do not wait for the phone to ring when borrowers want our input; instead, we share ideas, raise issues, challenge assumptions, and ask questions to ensure management teams are stretching their thinking and utilizing our knowledge and networks to maximize value. We engage in collaborative discussions with management but ultimately the borrower is accountable for its decisions and responsible for execution.

As the number of non-performing loans increases from the impending credit market reset, alternative lenders, even the best-intentioned ones, will find themselves in situations where they will have to defend against potential liability risks associated with their decisions. The facts of the particular lender-borrower relationship will be critical in assessing exposure, especially as the chorus of borrowers trying to avoid liability for their debts and divert blame by alleging lender misconduct and fiduciary duty increases. Private debt managers and their investors should re-examine the loan and security documentation underlying their loan portfolios in order to ensure that the contracted rights and remedies match the activities and conduct of the managers.

1 Scavarelli v. Bank of Montreal, Ontario Superior Court, 2004. The general rule in Canada is that the relationship between borrower and lender does not give rise to a fiduciary obligation owed by the lender absent “special circumstances.”

2 Royal Bank of Canada v. Woloszyn, Federal Court of Appeal, 1998. The court found that there was no operational control where the lender had a security interest in the assets of the borrower.

Arif N. Bhalwani, CEO

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