Overcoming credit market uncertainty
Strategies for the growing business
By James Cockey and Phil Worden
Businesses often use credit as the primary source of capital to fund their growth. Credit markets most often move in tandem with the general economy, and when the economy softens, as it appears to be currently, the availability of credit tightens.
So companies must stay aware of the dynamics of the credit markets to manage risks that arise from the uncertainty of credit availability during downturns in the credit cycle.
The last trough in the credit cycle occurred during the first quarter of 2002 when defaults of bonds and loans peaked. Since then, default rates have declined to what many see as unsustainable lows. Along the way, several dynamics have affected the character of the credit markets and will certainly influence the next downturn in the credit cycle. These include:
• Increased financial leverage: Financial leverage has increased dramatically since 2002, due to a period of very accommodative monetary policy that has created a flood of liquidity, particularly for capital-flush LBO funds, spilling over into the non-LBO market.
• Different sources of capital: Capital sources for loans have changed dramatically. Institutional investors now provide $2 for every $1 provided by more traditional lenders, including banks. In 2002, traditional lenders provided approximately $4 for every $1 provided by institutional investors. These institutional sources require liquidity in the debt paper, and as a result the trading of loans has expanded rapidly. Many institutional sources have never managed loan portfolios through a credit cycle trough, and the jury is out as to how they will act when credit tightens.
• Increased financial innovation: The flood of liquidity in the unregulated institutional sector has spawned new debt capital products that allow investors to capitalize on gaps in the traditional credit risk continuum. A "second lien loan," where investors seek to exploit the "unmargined" collateral or enterprise value of an issuer, is one prime example. In 2002 less than $1 billion of this type of paper were issued; this year, that number should top $24 billion. Again, these lenders’ agenda in a distressed situation is unknown.
• New distressed debt funds: Many market participants are raising large distressed debt funds. They are betting that when credit tightens, opportunities will arise to buy assets (debt instruments and/or equity securities) at "distressed" prices.
• Preparing for credit market changes
A business that seeks growth must accept that access to credit could change significantly during a downturn. Here are some tips to help through a downturn.
• Engage your capital providers in an open and honest dialogue. Discuss company strategies and plans, and disclose problems and successes with equal weight. Above all, find out how they would react if the business plans and strategies don’t play out exactly as hoped.
• Maintain relationships with potential capital providers. Identifying who your alternative "go-to" firms might allow you to leverage them for market intelligence and different perspectives – and you just might need them for capital as well.
• Maximize your credit flexibility now. Don’t wait until you have no choice. Prepare for the tightening phase of the credit cycle by ensuring the business can maneuver its way through execution of its strategies with some "wiggle" room in case they are not executed as planned.
As we likely enter a less attractive phase of the credit cycle, the importance of the relationship between a growth-oriented business and its credit providers may have never been as great. Building the right relationships takes time and resources; and there is no time like the present to start or expand those efforts.
James Cockey is senior vice president and marketing manager with Bank of America Business Capital. Phil Worden is senior vice president and senior business development officer.
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