Covering the Middle Market in Chicago and the Midwest
The Journal for Middle Market M&A Professionals & Dealmakers
Credit Market Anomalies
It is no secret that under TARP and during the Great Recession many U.S. lenders have been guided by a principle of "amend, extend, and pretend" whenever U.S. borrowers experienced covenant defaults and loan maturities. Given the harsh market realities and dim prospects for refinancing much anything other than the highest quality credits, it was in the best interest of all parties - including bank regulators - to take a liberal and cooperative approach on loan terms and accommodations.
For the most part, as banks re-liquefied regulatory capital, recently an increasing number of "permanent debt" situations have been asked to find another senior lender. For better quality credits, this task is substantially easier in the current market. Likewise, for credits with solid Financial Sponsors, new lenders have been increasingly interested in delivering competitive proposals. However, for the storied, hairy, or troubled situation, the senior debt markets continue to be uninviting and daunting.
Expect a steady stream of hairy and troubled credits to get booted out of the "amend and extend" program over the next 12 months, and into the realm of the recovery professional.
Fundamental Structural Challenges
Six dominant issues support my prediction that the middle market will have a tough 2011, including:
Taking these points in order, setting aside select technology and healthcare companies, in general Business Confidence remains uncertain, although somewhat improved since the midterm elections. The CEO Confidence Index, compiled by CEO Magazine for December 2010 was 103.3, an improvement from November, and for the past year this index has fluctuated between 80.0 and 100.0. Again, this index needs to be compared to the normalized benchmarks between 160.0 and 180.0 from the Q1 of 2004 to Q3 of 2007. While a nice improvement from the low point, many middle market businesses are unable or unwilling to hire new employees or invest in capital equipment because of a profound lack of confidence.
- Lack of Business Confidence
- Political & Tax Battles
- Challenges to the Wal-Mart Consumer
- Commercial Real Estate Overhang
- Foreclosure Hangover
- Unfunded Public Pension Mess
While the business community may have been encouraged by the midterm elections, it is difficult to fathom anything other than brutal partisan politics between now and 2012 with the Political & Tax Battles ahead. Even in those situations where the Obama administration is "back-dooring" regulatory measures over legislative initiatives, the delays in implementing regulation often take 6 to 24 months, making it exceptionally challenging to manage or invest in your business.
Defining the Wal-Mart Consumer as that consumer with disposable income below $25,000, this consumer faces such high unemployment, high foreclosure rates, and high consumer debt levels that make it difficult, if not impossible, to spend in a manner like 2006. Given that 70% of the U.S. economic growth is consumer driven, challenges faced by this important consumer subset makes it hard on many businesses, especially in the middle market. And while the unemployment rate dipped to 9.4% last month, that reported rate sets aside the 14.5 million people who have exited the job market, plus the millions of people that have been forced to job share in order to preserve a less lucrative position. Will the combined unemployment and under-employment rate be greater than one in five at the beginning of 2011?
In April 2009, real estate analyst Richard Parkus of Deutsche Bank reported that some $1.8 Trillion of Commercial Real estate loans were maturing, and it was clear that at least two-thirds of those loans could not be renewed under the previous underwriting methodologies. The situation has not improved or resolved, and in terms of one of the remaining potential shockers to the underpinnings of the U.S. financial system, the Commercial Real Estate Overhang remains a material challenge to all business, especially as these pressures may squeeze out funding available to the middle market.
Despite a Herculean effort and all the noble and good intentions on the part of both the Bush and Obama administrations, residential foreclosures are winding inevitably through the financial system like a pig in a python. For the U.S. housing market to clear and return to anything even remotely normal, the Foreclosure Hangover has to work through the courts and into the resale market to the greedy and cruel hands of new investors. Until that hangover clears up, it is hard to fathom how residential construction or the home consumer market companies will ever rebound, and in some markets it is hard to fathom how it will ever improve as housing starts are a key leading economic indicator, and a key driver of middle market business.
And finally, add a new mess to the challenges of managing the U.S. economy. In the coming year, municipalities will be forced to choose between raising taxes against a politically hostile voter, cutting critical government services, or honoring contractual commitments to the pension requirements of current and retired government workers. The Unfunded Public Pension Mess contributes to the morass of challenges facing the economy, and this dynamic will play out in a particularly vitriolic manner; entertaining if vicious political theater.
So What is the Shape of Your Recovery?
Optimism is uniquely American. For over 235 years a core value of our citizens is one who can meet and overcome challenges by industry, hard work, and a little luck. Back in August 2007, beginning with the sub-prime contagion, the roots of what became the Great Recession started to undermine confidence in our financial system. Wall Street was vilified by politicians, the media, and Main Street, and the U.S. government decided to dump enormous tax resources to prop up the economy and a number of rouge financial institutions and banks within the international economy. While Federal Reserve Chairman Ben Bernanke argues that the economy indeed is statistically growing, the recession is over, and that unemployment will improve in at least over the next five years, with the five business cycles in my 30 years of professional experience, it certainly looks like the next 12 months are going to be tough and rough for the middle market company.
We have not seen the typical U-shaped recovery from this recession, although a few pundits have argued for the "bathtub shaped" recovery. The W-shaped double-dip feels like the most likely to this analyst, although we may be facing what Professor Ed Altman of NYU calls the "inverted square-root" shaped recovery, a.k.a. the Japanese economic cycle of past two decades, before we witness material improvement in the U.S. business climate.
For the meantime, bet on it - 2011 will be a rough and tough year.
Until the next issue,
Publisher & Sr. Managing Editor
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BDO's Jeffrey Manning on Why 2011 is Going to Be Really Tough in the Middle Market
February 22, 2011
Jeff Manning is Managing Director and Group Head of BDO Capital Advisors with 29 years of industry experience.
BDO USA is a global accounting and consulting organization providing services to a wide range of publicly traded and privately held companies.
A lot to cover today in the excellent article below, so right to business: We've invited BDO's Jeffrey Manning to weigh in on how he and BDO see things playing out in the middle market this year. If you're looking for pie-in-the-sky, please flip over to the Financial Times; if you're seeking truth-with-substance, you're going to benefit from this article.
BDO Research & Analysis: 2011 Middle Market Forecast
By Jeffrey R. Manning - Managing Director, BDO
While not generally in the "Nostradamus business," write down the following: 2011 is going to be a tough and rough year for most of the middle market in the U.S. Although this New Year brings arguably the best business outlook since January 2007, because of credit market anomalies and fundamental structural economic challenges, the middle market - i.e., those companies with sales under $1.0 billion - will for the most part be looking in from the outside of a year that is shaping up much better for larger corporate and multinational companies.
However, a number of positive economic indicators are driving good news in the business press. Chief amongst them, equity markets have rebounded nicely over the past 18 months from the nadirs of March 2009, including the Dow and the S&P, in both large and small cap stocks. Likewise, U.S. manufacturing has seen genuinely encouraging signs of improvement, as the Purchasing Managers Index ("PMI") has scored a 50+ over the past 17 months, reflecting growth and expansion within the manufacturing sector. Since PMI monitors new orders, production, employment, supplier delivery, and inventories (per the Institute of Supply Management), it nicely reflects core manufacturing activities and sentiment.
Optimists -- including the vast majority of my fellow investment bankers -- point to unprecedented high levels of liquidity in the U.S. capital markets, including corporate cash balances as a percentage of total assets in excess of 7.4%. According to the Federal Reserve, these levels have not been seen since Eisenhower was president. According to international data supplier Prequin in October 2010, Private Equity Sponsors have more than $400 billion in funding that needs to be committed before the end of 2013. Flush liquidity means strategic and financial buyers are highly motivated to put that cash to good use, and the volume increases over the past two quarters in M&A activity have been impressive as a direct result.
The money has to go to work somewhere, so goes the investment premise.
Also, credit markets have clearly picked up, and high quality transactions are getting done in a favorable interest rate environment. Even non-sponsored middle market loan issuance has shown steady improvement from Q1 2009 with a respectable $7.34 billion of deals completed during Q4 2010, according to Thomason Reuters.
It is easy to be lulled into a dreamy outlook that happy days are here again, but middle market business leaders, lenders, and investors need to "peel back the onion" and take a deeper look. Consider the business press' relatively positive spin on 2010 Holiday retail sales. Yes, sales were higher than 2009 dismal levels - the Johnson Redbook Index for U.S. chain store sales was up 3.6% from December 2009 but shoppers were brutally selective this year within limited budgets. Although Internet sale trends were encouraging, retailers will not be able to fully assess the impact of the 2010 holiday season until margins are examined at the end of January. Note Wall Street has already punished the stock price of Target and Gap, and at the time of this writing Borders is facing a number of ugly choices.
The middle market cannot afford the Pollyanna perspective coming out of the majority of business media outlets. Another example can be found in the Conference Board's Consumer Confidence Index ("CCI"), which has been up in three of the past five months, with December's number down only slightly to 52.5%. While people peer into the CCI tea leaves for positive momentum, a more significant point is that in a "normal" economy the healthy CCI benchmark is typically 90 plus!