Factories vs Tailors (Q4-14)
Dec 30th, 2014
The following was excerpted from Third Eye Capital Management Inc.’s Q4 2014 Investor Letter.
We cannot blame borrowers for wanting the lowest cost of financing – this is the easiest way for management and owners to increase the value of its company’s future cash flows, all other things being equal. Sometimes, however, borrowers are faced with imminent liquidity issues or cannot defer an investment decision, and will be inclined (if not compelled) to tradeoff cost for certainty and speed. The proliferation of private debt funds in recent years has intensified competition and turned the lending business into a transactional credit factory rather than a tailored relationship. Deal closings are achieved in record days, no longer weeks or months, and capital is committed with limited due diligence and conditionality. This might seem like a boon for borrowers but a lender that considers a loan a commodity and does not intimately understand a borrower’s business will quickly withdraw credit in the event of a covenant breach or crisis.
Transactional lending is characterized by a single instance financing that relies on “hard” information readily available and views a loan similar to a trade. Transactional lenders are usually large and apply standardized processes to manage their loan portfolios. Since they invest in many loans across many industries, transactional lenders tend to apply statistical methods in determining pricing and credit availability. When competition is high, and the lending environment is more borrower-friendly, transactional lending increases due to the low (or no) costs of servicing a borrower relationship. Examples of transactional lenders today include large BDCs, CLOs, multi-strategy credit hedge funds, and leveraged finance companies.
Relationship lending involves working one-on-one with the borrower in order to gain insight into its business that cannot be revealed from the “hard” information alone, including management, customers, suppliers, owners, competitors, and key stakeholders. For a borrower in exigent circumstances, building a relationship should not be considered a sacrifice of limited time. Today’s most prominent alternative lending firms have in-house operational and management experience in targeted industries and can quickly understand a borrower’s unique financial or business situation. Also, since many relationship lenders gain information by maintaining borrower bank accounts and sometimes serving on their board of directors, they are able to attenuate the noise in credit evaluation and reduce adverse selection risks. Relationship lenders are willing to maintain concentrated portfolios with high conviction loans due to familiarity with borrowers’ industry, business, and management familiarity. They also experience recurring business from repeat borrowers and referrals from borrower stakeholders.
One of the prerequisites of relationship lending is experience: information gathered over time has significant value beyond a firm’s financial statements, collateral, and credit rating. This is another reason why new entrants into the private debt market are necessarily transactional in nature. But experience is expensive and, by definition, time-consuming to build. Market and regulatory reforms are mandating higher equity buffers and putting pressure on banks and other financial institutions to reduce costs, such as laying off loan officers and other frontline lending staff, which further de-emphasizes relationship lending. The ability (and apparently, willingness) of lenders to distinguish between borrowers with and without solid growth prospects is diminishing, and this will exacerbate credit market damage during a downturn.
There is extensive theoretical and empirical research on relationship lending (see the July 2013 study from the Bank for International Settlements entitled “Relationship and Transaction Lending in a Crisis” for a summary). Relationship lenders show lower credit risk sensitivity and less exposure to defaults than transactional lenders due to superior monitoring capabilities and, from our direct experience, because borrowers regard relationship lenders as long-term partners rather than arms-length capital providers.
In our ten year experience as active direct lenders, we have witnessed a distinct pattern in the volume and margin between lending approaches.
Transactional lenders are more prolific as the economy recovers and expands and can quickly capture margins through credit growth and lower fixed costs in making credit decisions. Established relationship lenders, like us, perform best at the peak of the cycle and through the cyclical downturn due to lower variable costs and by growing loans at the expense of transactional lenders faced with rising defaults and losses. Margins of relationship lenders rise due to the contraction in transactional lending. Relationship lenders experience less variability in margins than their transactional brethren but lag in loan volume especially as increasing competition from transactional lenders magnifies the amplitude of the credit cycle.
Lenders and their investors need to carefully evaluate whether their current business approach can flourish in today’s crowded credit market. Some lenders will choose to compete by further lowering costs and moving farther away from relationship lending. We believe the relationship between lenders and businesses must be based on more than just credit, but predicated on expert advice and tangible support to nurture future growth. This will give borrowers confidence in credit availability and a greater chance for growth, and provide lenders with less churn and insulation against a credit incident.