by Sidney Rutberg and Michele Ocejo
W
hile the sun shone brightly in San Diego
through most of the 61st Annual Convention
of the Asset-Based Financial Services
Industry, the lending business may be facing
some bumpy weather.
At the breakout sessions on problems facing the
industry, it appeared that, although the economy is strong,
there is simply too much money chasing too few borrowers. And adding to the mix is the growth of the hedge fund
industry as aggressive competitors for the sub-prime
loans. Hedge funds, which were originally mutual funds
that added leverage and short selling to the arsenal of
investment tools, are now diversified financial powerhouses with rapidly growing capital resources that have
moved into the turf of asset-based lenders. Total funds
under management by the hedge fund industry is now
estimated at $1.1 trillion and still growing.
According to Alec H. Petro, of Gamma Investors,
King of Prussia, PA, moderator of a panel on hedge funds,
the funds are not very active in senior-debt markets yet,
but their interest is growing rapidly. He said that returns
are getting smaller on most investments so they are more
interested in the debt markets.
Mr. Petro said that originally hedge funds were
purchased by high net-worth individuals, but that type of
investment is slowing down and now endowments and
58
foundations are becoming significant investors. Ten years
ago, he said, plenty of universities had no money in hedge
funds. Now many have about 10 to 15 percent of their
endowments in hedge funds and Harvard and Yale have
about 35 percent, Mr. Petro said.
He added that, while returns to investors are slimming, the capital inflow is still growing.
There are now about 7,000 hedge funds, but about a
quarter of these go out of business every year. They
provide higher compensation at higher risks, he said.
Another speaker at the session, Kenneth M. Sands,
Fortress Credit Corp. and Fortress Investment Group, New
York, said hedge funds have been mainly buying high-yield
debt and buying into syndicated deals. “Hedge funds don’t
have the personnel to be in negotiated deals.”
In order to provide the returns expected by hedge
fund investors, the funds must employ leverage, according
to Mr. Sands. With leverage of 4 to 1, hedge funds can lend
money at five, six, or seven percent and still provide a yield
that their investors expect.
Michael Szwajkowski, managing director,
CapitalSource, Chevy Chase, MD, said that he started as a
lender and built a business on the origination side. He
noted that his firm operates with a more moderate risk
(Continued on page 60)
THE SECURED LENDER
than other hedge funds. Generally, hedge funds’ target is a
20 percent return on equity, according to Mr.
Szwajkowski.
It was explained that because of the return requirements, which are based on a percentage of equity, gross
returns may start at 20 percent but, since the fund takes two
percent as a fee, the return is down to 18 percent. Then the
fund takes 20 percent of the profits, which comes to 3.6
percent of the equity in a $1 billion fund, and reduces the
investors return to 14.4 percent. Among the problems hedge
funds face is the possibility of a run on the bank since most
offer redemption that allows investors to take their money
and run. However, some funds have restrictions on withdrawals. One panelist noted that his firm offers annual
redemptions, with provisions for slow pay and fast pay. The
fast-pay method provides for payment when the money is
available, but provides no yield until payment. The slow
pay, he said, can take years, but the yield continues until
payment. It’s like the roach motel, he said, “You can check
in, but you can’t check out.”
There was also a hedge fund representative at a
session on what is happening in the asset-based lending
industry. Kevin P. Genda, managing director of Cerberus
Capital Management, said that the $16 billion hedge fund
has about $3.5 billion in loans outstanding. He pointed out
that more hedge funds are coming into the market every
week. Some funds originate transactions, but most still
just buy pieces of others’ deals.
“There is so much capital in the market that I think
there will be real trouble for those who can’t originate
their own credits,” Mr. Genda said. “Lending is still a
relatively new strategy for opportunistic hedge funds, “
Mr. Genda pointed out.
60
While the hedge funds will be growing as competition
for loans, there is another side: Hedge funds may also
become an important financing source for finance companies.
Others on the panel with Mr. Genda were John Fox,
chairman and CEO of Rockland Credit Finance, LLC,
Owings Mills, MD, who represented the relatively small
entrepreneurial firm; Michael J. Maiorino, executive vice
president and managing director, Sovereign Bank, Iselin,
NJ, representing the middle-market lenders; and Terrence J.
Ullrich, senior vice president of Chase Business Credit, New
York, speaking for the large lenders. Michael D. Haddad,
executive vice president of Marquette Business Credit,
Dallas, was moderator.
Mr. Ullrich described the economy as “healthy” with
low unemployment, low inflation, rising but still low interest
rates and default rates at cyclical lows. About the only soft
spots, he said, are the auto and airline industries. “Banks
are earning a lot of money and looking to put on loans.
They are looking to expand and grow.” He added that all
markets are open, IPOs and the high-yield market are good.
“There is a lot of money around and pricing is low.”
He noted that institutional investors continue
growing more active in the leveraged market and are now
an extremely important source of liquidity. They provide a
majority of funds raised in highly leveraged transactions,
particularly in new leveraged buyouts. Also, Mr. Ullrich
pointed out, LBOs are becoming increasingly leveraged. In
the first nine months of 2005, the average equity contribution in LBOs dropped to 32.3 percent from 37.8 percent in
2000.
Mr. Maiorino outlined the optimal strategy for the
middle-market lender. These included customized solutions, working within a
company’s skill set, developing niches to add value,
looking for geographic
opportunities, spreading risk
with strong syndication
capability, understanding the
nuances of collateral and
controlling internal leakage of
ABL deals with a strong credit
policy.
He described the middlemarket asset-based lender as
squeezed by bank middlemarket lenders, a lack of
opportunities within traditional
framework, hedge funds,
ignorance, air balls and
compressed margins. However,
he cited under “good news,” a
potential economic downturn
which will increase problem
THE SECURED LENDER
loans and create opportunities, better margins and a more
rational structure of asset-based loans.
Among the problems for the small finance companies, Mr. Fox said, were the need to get reasonable lines of
credit, getting and keeping good people, strong competition and compressed rates.
In order to be competitive, Mr. Fox stressed the need
for automation to lower costs and improve efficiency,
improve service to clients, help spot problem areas, and
prospect for new business. It was Mr. Fox who cited hedge
funds as potential sources of financing for the small
finance company.
Another assessment of
the economy came at a
session on capital markets
and it pretty much was in
line with Mr. Ullrich’s
vision. Jay Bryson, vice
president and global
economist at Wachovia
Corp., Charlotte, said the
economy in the third quarter
of 2005 grew 3.5 percent,
which he called “a pretty
decent growth rate.” He said
the growth was led by the
consumer sector, which
accounted for 2 ½ percent
of the growth with business
investment providing one
percent. However, for the
next year or so, business
JANUARY/FEBRUARY, 2006
spending will be the
engine for growth, he
said. “Business capital
is growing at doubledigit rates and balance
sheets are strong,” he
said. However, Mr.
Bryson said he did see a
possible consumerdriven recession in
2007 or 2008.
Another speaker
at the capital markets
session, David Hinman,
portfolio manager at
Ares Management,
LLC, a Los Angelesbased hedge fund,
agreed that the next
recession would be
consumer-led and noted
that all the savings are
in corporations. He said
that corporate balance sheets show $800 billion in cash.
The CFA convention, held at the Marriott Hotel and
Marina, attracted some 1,600 delegates, who, in addition
to the breakout sessions, were enlightened and entertained
by several high-profile speakers. Former Secretary of State,
General Colin L. Powell, spoke at the opening session and
outlined his philosophy of leadership. He avoided politics,
but managed to keep the audience spellbound with his crisp
sense of humor and anecdotes of his personal experiences
with world leaders.
61
Patricia A. Redmond, also with Stearns
Weaver, explained that under the new law, if
someone moves within two years of bankruptcy to a state with higher exemptions, the
exemptions would be limited to that of the
state where the person or company was
based before the move.
The third panelist, Michael R. Enright,
Robinson & Cole, Hartford, spoke about the
new restrictions on payments to key
employees.
Other notables addressing the convention
were Howard Putnam, former CEO of Southwest Airlines, one of the few profitable airlines,
and Carly Fiorina, former chairman and chief
executive officer of Hewlett-Packard Co.
Among the breakout sessions that attracted enthusiastic crowds were ones on the
new bankruptcy law; a discussion of the role of
accountants in relation to asset-based lenders;
international financing for the entrepreneurial
finance company; evaluation of intellectual
property; and trends in junior debt financing.
The bankruptcy session reviewed some of the changes in
new bankruptcy law that apply to business bankruptcies,
particularly Chapter 11. The moderator, Stuart D. Ames of
Stearns Weaver Miller Weissler Alhadeff & Sitterson of
Miami, opened the session by noting that, while part of the
title of new law is “Consumer Protection Act”, the law is
“anything but a consumer protection act. It is purely a
creditor piece of legislation that has most effect on
consumers.”
However, there are some changes in business
bankruptcies related to preferences, fraudulent transfers,
homestead exemptions and payments to key employees.
Robert F. Zadek of Buchalter Nemer Fields & Younger,
San Francisco, pointed out that under the new law payments within 90 days before filing bankruptcy remains the
time frame for preference actions, but the defenses against
these actions have been liberalized. Instead of having to
show that the payment was made in the ordinary course of
business and in the normal terms of the industry, the “and’
was changed to “or” so either of those defenses would be
sufficient. On fraudulent transfers, Mr. Zadek noted that
the look-back period has been increased to two years from
one year.
62
The panel on international finance for the entrepreneurial finance company covered purchase-order financing,
the Export-Import Bank’s program for guarantees on exports
and a review of overseas factoring chains.
Edward P. King, managing partner of King Trade
Capital, Dallas, covered purchase-order financing, which
he said allows undercapitalized companies to fill orders
that they would be unable to fill without capital provided
by purchase-order finance companies. Otherwise, the
company with the order would have to pay cash or obtain
letters of credit, neither of which it is able to obtain.
In order to finance purchases, Mr. King said, rather
than depend on the client’s balance sheet, the finance
company must look at the creditworthiness of the client’s
customer and the ability of the supplier to deliver the
goods, or what he called “the integrity of the transaction.”
The help of purchase-order financing may be
needed by start-ups or companies with seasonal businesses
that require additional financing at peak seasons, according
to Mr. King.
Len Blum of Westwood Capital, New York, pointed
out that international trade is booming and trade is growing
faster than world gross domestic product. Additionally, the
THE SECURED LENDER
use of LCs is waning and there is more international
business done on open account terms.
He noted that there are a number of overseas
organizations of factoring firms, including Factors Chain
International, which has 204 factoring firms in 50 countries. A U.S. company working with this type of group
obtains credit protection along with local knowledge of
the exporters’ customers, Mr. Blum said.
Wayne Gardella, vice president at the Export-Import
Bank of the United States, said that the bank offers to
guarantee 90 percent of the export invoices so long as the
merchandise exported is at least 50 percent of U.S.
content. It also provides advances up to 75 percent on
inventory and up to 90 percent on receivables.
In the session on the relationship between accountants and lenders, it became clear that, while lenders depend
on figures provided in financial statements, the
accountant’s first loyalty is the client. “It’s the client who
pays us. Lenders can communicate with the accountant
after first obtaining the permission of the client,” said Bruce
Madnick, partner in Friedman, LLP, New York. Mr. Madnick
also described the different types of statements issued,
making it clear that compilations and reviews, in which
accountants do little more than the arithmetic, are a com-
Sidney Rutberg is the retired financial
editor of Fairchild News Service,
Women’s Wear Daily and the Daily
News Record. He is a contributing
editor to THE SECURED LENDER.
pletely different breed than certified audits. However, even
with certified audits, the lender “needs to do some of its
own investigation,” Mr. Madnick said.
The other panelist, Roy Grossman, senior vice
president of Israel Discount Bank of New York, agreed,
noting that “the financial statement is only one of the
components of the credit decision.”
Mr. Grossman also complained, “It is a struggle to
get timely statements.” Mr. Madnick conceded that there
are delays in preparing statements, but it is usually the
result of the client not being ready.
Moderator for the panel was Neville Grusd, executive vice president of Merchant Factors Corp., New York,
and chairman of the CFA Committee on Cooperation with
Accountants.
In the session on evaluation of intellectual property,
it was clear that it is much more difficult to evaluate that
type of asset than it is to evaluate traditional assets such as
receivables and inventory. But there are techniques that
can help in appraising intellectual property. It was also
JANUARY/FEBRUARY, 2006
explained that securitization of intellectual property involves the organization of a special-purpose entity to sell
securities backed by an income stream, usually of royalties, while collateralization is the use of intellectual
property as security for asset-based loans. It was also clear
that the use of IP as collateral is growing rapidly.
The first speaker was David C. Drews, president of
IPMetrics, San Diego, a specialist in evaluating IP. He said
that among the criteria for evaluation is to determine the
Michele A. Ocejo is executive editor of
THE SECURED LENDER. She received
a B.A. in journalism from Rutgers
University, Newark, NJ.
cash flow attributed to the asset, cost of reproduction of the
asset or replacement of the asset. He also advised that any
appraisal must pay attention to the opportunity costs. And,
if there are a bundle of intellectual assets, it is important to
understand how the assets relate to each other. He also said
a lender should try to evaluate what the asset would be
worth in liquidation.
Andrea Kutscher, managing director of Westwood
Capital, LLC., New York, said securitization is possible
when there is cash flow, generally from royalties. The
seller gets cash upfront available for other investments
while the buyer gets a high return, she said. Also, she
stressed that in a securitization, the asset is rented, not
sold. The seller gets the asset back after the securities are
paid off, Ms. Kutscher said.
The third panelist, Edward Meintzer, senior vice
president of business development at IP Innovations
Financial Services, Charlotte, conceded that IP is more
difficult to evaluate than traditional collateral, but noted
that his firm has made asset-based loans against receivables and inventory and added in some intellectual property. He noted that the IP piece might help close air balls.
Among the financial trends is the growth of second-lien or
tranche B lending. In a session on this type of lending, it
was pointed out that just five years ago second-lien lending
totaled about $1 billion. It is now above $20 billion.
Matthew R. Kahn, president of GB Merchant Partners,
LLC, Boston, a division of Gordon Bros., was moderator.
Panelists were Susan Chen, vice president of D.B. Zwern
& Co., New York, and Greg Walker, Silver Point Capital,
Greenwich, CT.
Mr. Walker explained that while the first-lien lenders
are secured by collateral, the second-lien lenders depend on
the enterprise value of the borrower. However, as a defense
(Continued on page 73)
63
CFA convention shows strong economy...
(Continued from page 63)
against the first-lien holder selling the collateral cheaply just
to get its money out, the second-lien lender generally requires
buyout rights, so it can pay off the senior lender and liquidate
the borrower in the hope of getting a better return.
Both panelists said that they never exercised the
buyout rights, but that it was good to have.
Attendees were queried about their experiences.
Keith Gerding, vice president, Citigroup, New York, said,
‘This was my first CFA convention, and I must say that I
was thrilled to have the opportunity to attend. General
Powell’s speech was really spectacular, and the panels I
attended were all well-presented and relevant to current
issues in our industry, but I have to say the best part of the
convention was the opportunity to meet and network with
many of the individuals that I work with regularly, but don’t
seem to have a chance to just sit down and chat with.” He
added, “Given the huge increase in the participation of
hedge funds in the debt capital markets, I found the hedge
fund panel to be particularly intriguing. It was interesting to
hear what others are thinking about the effect this will have
on our industry both in the near term and down the road.”
This was the first CFA convention for Nicholas
Reason, credit analyst, LaSalle Business Credit, Chicago.
He said, “It was well-organised, well-attended, with a good
choice of seminars, an excellent venue, good networking
and a broad cross-section of CFA members in attendance.”
Mr. Reason found the hedge fund and second-lien loan
panels to be the most helpful. “Such liquidity in the U.S.
market is not seen in the UK where I work, and has had a
market impact on deal structures and pricing. It is interesting to see how these funding vehicles have developed and
how they plan to continue.”
Angela Brown, senior vice president, GMAC-RFC
Health Capital, Dallas, has been to three CFA conventions.
“Overall, I thought the conference was very successful. I
especially enjoyed listening to Colin Powell. The panel,
Second-Lien, Junior-Secured Financing, was particularly
helpful as this market niche continues to draw a lot of
attention throughout the industry,” she said.
Mark Picillo, vice president of Siemens Financial
Services, Inc. Iselin, NJ, gained the most from the panel,
“What is Going on in Our Industry? We Tell You.” He said,
“They talked about the current state of affairs in ABL. It
validated what we were explaining to our bosses regarding
what is happening in our market place. ▲