Dr. John Rutledge
Chief Investment Strategist at Safanad
The Safanad Weather Map identifies major economic and financial Storm Systems– investment opportunities created by return differentials that are large enough and last long enough to allow an investor to capture extraordinary returns as they run their course. This analysis discusses the forces behind the Regulatory Fallout storm system and examines ways to harvest resulting opportunities by making direct loans and equity investments to orphaned lower middle market companies.
Weather Map Investing
Identify forces that produce unsustainable return differentials — economic storm systems – and broken markets where non-price rationing restricts access to capital, creating opportunities to earn extraordinary investment returns. Carefully deploy capital in the paths of storm systems. Withdraw capital when storms have run their course, return differentials have been extinguished, and total returns have returned to normal levels. Storm systems come in two qualitatively different categories that we can think of as mild and violent. In nature, when temperature or pressure differentials are small, i.e., when systems are near equilibrium, adjustment to equilibrium is smooth, gradual, and temporary. When differentials are extremely large and systems are far from equilibrium, however, change can be abrupt, discontinuous and violent as we see in hurricanes, tsunamis, earthquakes, and volcanic eruptions. These far-from-equilibrium storms create violent change that often leaves collateral damage in its wake that can permanently change the physical landscape long after they have spent their energy.
In economics we refer to small return differentials– near equilibrium –as arbitrage opportunities and expect price and return adjustment to be smooth and gradual. We refer to equilibrium as the law of one price. In such near equilibrium systems, we expect price and return adjustment to be smooth and gradual. Investment opportunities presented by mild storms are best harvested by taking positions in marketable securities that can be quickly reversed when conditions change. In contrast, severe storm systems, like the sub-prime mortgage and subsequent global financial crisis, lead to market failure where networks of trusted relationships fail and market prices no longer reflect reliable information on scarcity. In some cases, change is so violent that it can permanently alter the institutions and market structures we rely on to do business, creating long-lasting opportunities for deploying capital. These far-from-equilibrium storm systems lead to extraordinary investment opportunities. The Safanad Regulatory Fallout Storm System represents such an opportunity.
Regulatory Fallout Storm System
The sub-prime mortgage crisis that began in 2007 turned into a global financial crisis when the interbank loan, or Fed funds, market collapsed in the fall of 2008 (Figure 1a). The Federal Reserve responded by injecting massive amounts of reserves into the banking system (Figure 1b) through purchasing bonds and mortgage securities, a policy that came to be known as Quantitative Easing (QE). QE effectively replaced interbank loans with direct government finance.
(a) Interbank Loans
(b) Bank Reserves
To date, the interbank loan market has shown no signs of life and although the Fed has slowed purchases of securities they have shown no desire to shrink their balance sheet back to pre-crisis levels. Reserves remain at $2.9 trillion, more than 34x $85 billion pre-crisis level, posing a serious inflation threat when the reserves are ultimately used to support loans and deposits. For all practical purposes, the Fed funds rate no longer has meaning as an indicator of liquidity; its role has been replaced by the interest rate paid on bank reserves, currently 0.25%. Like the Great Depression of the 1930’s, the financial crisis has produced massive changes in the economy and financial markets. Some of the changes were temporary. For example, the S&P 500 (Figure 2a) fell from its October 2007 peak of 1965.2 to a low of 676.5 in March 2009. After five years of gains, the S&P now stands at 1996.7, 195% above its low and 27.6% above its pre-crisis peak.
(a) S&P 500
(b) GDP vs. Potential GDP
Changes in the real economy have proved longer lasting. The most recent (August, 2014) employment report showed 139.2 million total nonfarm jobs, 9.5 million above the 129.7 million February 2010 low and just above the 138.4 million pre-crisis peak in December 2007. But the population is bigger today than it was in 2007 and workers have become discouraged during the long recession. Many people may have permanently left the workforce. The employment/population ratio (59%) today is 4.4% (10.9 million jobs) below its pre-crisis level of 63.4% in December. Similarly, Q2/2014 real GDP ($16.0 trillion) was 11.1% above its $14.4 trillion Q2/2009 trough and 6.7% above its $15.0 trillion Q4/2007 pre-crisis peak. But the 4.7% gap between GDP and potential GDP (Figure 2b) has not closed appreciably during the recovery, an annual shortfall of output and income amounting to $748 billion, more than $3000 per person per year for the entire country. The financial crisis has also forced permanent changes in institutions, especially in healthcare and financial services. ObamaCare is forcing changes in the way health care is delivered, pushing patients out of high cost hospitals and emergency rooms into lower-cost skilled nursing facilities, urgent-care centers, and home care. Dodd-Frank has increased compliance costs, driven small banks out of business, and restricted capacity to make and securitize business and mortgage loans. The severity of the financial crisis created a hostile political climate for the banks that were widely blamed for the collapse. As a result, in July 2010, during the worst of the financial crisis, Congress passed and President Obama signed into law the Dodd–Frank Wall Street Reform and Consumer Protection Act, a hastily thrown together package of financial reforms that promised “to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail”, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.” Dodd-Frank differs from other legislation in that it is essentially organic. Dodd-Frank does not define the new regulations; it creates a host of new agencies that, themselves, have the authority to create new regulations. As was the case with health care reform, it will be years before the full set of new regulations is known. One thing is clear, however. Every financial institution will have to bear the costs of complying with all of them. Many smaller institutions will be crippled in the process. This has created a vacuum in the market for loans to small businesses. This Regulatory Fallout Storm System will create huge and long-lasting investment opportunities. The fixed nature of Dodd Frank’s compliance costs means they fall harder, as a percentage of assets, on small banks than on big ones. This is important because, historically, they have played different roles in the economy. Small, community banks are the traditional lenders to small businesses, the source of most new jobs. Burdensome compliance costs have made it largely uneconomic for small banks to make business loans. As a result, 48% of banks have closed their doors since 2007, most of them small.
The demise of small bank lending
At first sight, business lending appears to be back on track. Business loans collapsed by one-third during the financial crisis, from a peak of $1600 billion in October 2008 to $1200 billion in July 2010 (Figure 3). In the four years since then, total business loans have more than recovered their losses and now stand at $1742 billion, 8.9% above pre-crisis levels.
C&I Loans–All Banks
But the entire increase came from the 100 banks with the largest assets. Business loans made by the largest 100 banks, measured by asset size, have increased by $464 billion, or 52% (Figure 4(a)) from the July 2010 low of $885.3 billion. Small banks–below the top 100 in asset size—have only increased loans by $26 billion (12.9%) from the trough and outstanding loans are still $39 billion below their 2008 peak (Figure 4b).
(a) C&I Loans Large Banks
(b) C&I Loans Small Banks
This may explain at least some of the sluggish job growth and weak inflation performance in the recovery and why the Fed has kept interest rates so low for so long. If small bank business loans had recovered as much as top 100 banks (52%), loans would be $80 billion (39%) higher and there would be 6.4 million more jobs today, enough to erase the gap between GDP and potential GDP. In addition to sharply reducing small bank business lending, Dodd-Frank has also changed the types of loans that big banks will do. Increased compliance, due diligence, and oversight costs are forcing banks to increase their minimum effective loan size in order to earn sufficient fees and interest margin to meet return on asset requirements. One implication of this two-tiered banking system is that traditional customers of big banks—large companies, hedge funds, and private equity firms—are enjoying a generous supply of credit at low cost while traditional customers of small banks—small and medium-sized businesses, homeowners, and commercial property—are left with no available source of capital. This is good for Wall Street firms but is tough on Main Street. Small bank customers have been orphaned with no source of working capital. This has created a vacuum in business lending that can and will be filled by private equity and mezzanine debt investors at attractive returns. The same is true for residential and commercial mortgage lending. Both opportunities should persist for as long as regulatory compliance costs remain a burden, which should be for a very long time.
Marketable Securities Strategy
Investors who do not have ready access to opportunities to deploy capital in private companies in the lower middle market must look for an indirect way to profit from the Regulatory Fallout storm system by taking positions in marketable securities. There are a number of ways to do so. The first way to benefit from the Regulatory Fallout storm system is to simply overweight U.S. equities and underweight long-term bonds. Restricted lending to the lower middle market companies that would, in normal times, be the economy’s primary engine for job creation means an extended period of sub-normal job growth and sub-normal GDP growth. Disappointing growth convinces the Fed to keep interest rates lower, longer and to leave the massive stock of bank reserves in place, rather than shrink reserves back to pre-crisis levels. Low interest rates and plentiful bank reserves both support higher stock valuations. Meanwhile, the hedge funds, private equity sponsors, and big companies that are traditional customers of large banks are taking advantage of their access to cheap credit by purchase equities and acquiring smaller companies, pushing stock prices and private equity valuations higher. Eventually, of course, banks will convert enough bank reserves into loans and deposits to push inflation higher, pushing interest rates up and bond prices down. Within the stock market, investors can overweight sectors that benefit from these conditions. Rising profits at large banks and other financial firms and slow job and income growth means it makes sense to overweight financials and underweight consumer goods. The stocks of leveraged finance firms, e.g., Blackstone, Carlyle, KKR, Apollo, Oaktree—are especially attractive because easy credit terms for large borrowers make this an attractive time to harvest profits by selling portfolio companies. That triggers large carried interest payments, positive earnings surprises, and big dividends for investors.
Private Equity Strategy
Investors who have direct access to private equity can do even better. Private equity investors can provide working capital and growth capital directly to lower middle market companies that have been abandoned by their traditional bank lenders and have need of a reliable source of working capital and growth capital. According to the National Center for the Middle Market at Ohio State University, there are more than 200,000 middle market companies in the U.S. with annual revenues between $10M-$1B. Added together, middle market companies would be the fifth largest economy in the world—roughly the size of Germany or Japan—with GDP of $4.3 trillion, $10 trillion in annual sales, and 46 million jobs. Within the middle market, there are significant differences in investment opportunities due to the differing availability of bank loans to large and small companies. Upper middle market companies, with revenues of $100M – $1B, sometimes have access to public markets and are profitable customers for large banks. Lower and core middle market companies, with $10M – $100M in revenues have less access to bank financing and represent the most interesting investment opportunity today.
Middle Market Valuation
Based upon the most recent reports from GF Data on valuations of middle market companies by size, shown in Figure 5, lower middle market companies are selling at significantly lower valuations than larger companies. Pricing at the upper end of the middle market has increased significantly in the past year, reflecting the greater availability and lower cost of loans from large banks. Small companies with $3-5 million of annual cash flow (EBITDA) are still selling at low post-crisis valuations of 4.8 x EBITDA, a 42% discount to the 8.3 x EBITDA paid for companies with at least $10M of EBITDA. As an example, in ‘normal’ times, before the financial crisis and before Dodd-Frank, a high quality middle market company with $50 million in revenues and $10 million in EBITDA might expect to borrow 3.5x cash flow, or $35 million from their bank for working capital and to finance growth. The loans would be secured with the company’s operating assets of, say, $50 million as collateral. If the business were sold, a financial buyer might expect to pay 6x cash flow, or $60 million for the company, financed by $35 million in secured loans from the bank, $10 million as an unsecured loan from a mezzanine, or subordinated debt, lender and $15 million in equity. Now assume a post financial crisis, Dodd-Frank world in which the company becomes an orphan with no access to bank financing either because the loan size is now too small to be profitable for a big bank or because its small bank lender goes out of business. Without bank loans to finance working capital needs the business owner must look for alternative sources of capital. This is an attractive opportunity for an investor. With no bank in place, a private equity investor can step into the bank’s shoes and structure an investment as a senior bank loan collateralized by the company’s operating assets. This enables the investor to pay out a significant portion of the company’s $10 million of annual cash flow as interest or dividends, while reinvesting the rest to grow the company and to participate in the increase in the value of the company as profits grow over time. In the above example, the investor might invest $40 million in the company, secured by the assets of the business, collect $5 million (12.5%) per year in current income while re-investing half the company’s profits to grow the business, and to own enough equity to bring the overall expected IRR to 20-25% over a 3-5 year period assuming modest growth in company profits and the same exit multiple. If there is significant improvement in credit availability in the next 3-5 years returns would be significantly higher, reflecting both higher company profits and higher exit multiples. Recent conversations with trusted partners active in the lower middle market confirm the opportunity. Deals are currently being done at 10-12% current income and 15-25% total expected returns (IRR’s). Before engaging in this strategy, however, there are some things investors should keep in mind. The timing of exits is uncertain and refinancing risk is high. Small companies are inherently more risky than big ones so diversification is very important. It is important to have flexible, patient capital structure and to control the assets of the company. Finally, it is important to invest directly into the operating company, rather than buy loans from brokers, hedge funds, or other intermediaries. Financial firms like these have ample access to capital, so excess returns would be priced away before the loan makes it to the Bloomberg screen.