Banks at Another Crossroads: Taking a Closer Look at Market Disruption, Evolving Operating Models, and the Impact on Capital Availability

October 1, 2023

By: John J. Whalen, Group Head
Capital Advisory Investment Banking Group

Click here for a print-friendly PDF version

It’s no surprise that we’re still observing a significant tightening in the availability of capital from commercial banks. Bank failures, swings in economic conditions, global crises, political turmoil, and ever-changing consumer sentiment frequently serve as a catalyst for self-reflection and, good or bad, acute reaction from regulators. This time is no different and, as a result of the abrupt contraction in the bank lending market, borrowers are again being forced to find additional and alternative sources of liquidity to support their businesses.

For context, please recall that banks employ a pretty straightforward operating model: take deposits and lend those deposits at interest rates that maximize net interest margin. The nuance is manifest in how to manufacture additional earnings that benefit bank shareholders and each institution operates differently. Most have a tendency to focus on expense control (such as labor arbitrage, capital arbitrage, efficiency ratio, etc.), while others are more forward-thinking by targeting new revenue streams that don’t rely on capital, non-credit growth initiatives, and a general disposition to addressing the client need (not selling the client a product the bank wants their client to buy). At the end of the day, and as some politicians believe, banks are utilities, and their product (liquidity) is a commodity.

Which brings us back to the current situation: many banks are struggling and, as such, are forced to re-evaluate their operating models. Witness the fallout from the failures of Silicon Valley Bank, Signature, and First Republic (disclosure: First Republic was rescued by JPM Chase & Co.). These failures were a direct result of unprecedented Fed tightening, severe balance sheet impairment, and poor liquidity management. Borrowers and consumers compounded the issue by aggressively withdrawing deposits thereby forcing banks, all banks, to shift their priorities away from their core business of lending to stemming outflows and generating additional liquidity by any means possible (such as discounted treasury asset and loan sales, deposit growth, etc.). Layer in troubled real estate and C&I portfolios in a higher interest rate environment, as well as regulatory scrutiny and an expected increase in capital requirement for banks, and the situation is likely to get worse before it gets better.

What does this mean for borrowers? In short, banks are becoming much less reliable credit partners and access/availability through this channel continues to deteriorate. Commercial bank share of total loan market volume has decreased to roughly 10% since the 90’s and, with the proliferation of alternative debt capital providers since the 2008 financial crisis, there’s no sign that this trend will slow. This trend is most evident in middle-market leveraged finance as illustrated below:

The impact on community and regional banks is even more pronounced given their bias to secured lending (loans 100% collateralized by tangible assets) and regulatory limitations on their ability to make leveraged loans. These dynamics limit their ability to lend to service companies, technology businesses, and, in general, companies that are “asset light”, (not to mention private equity-backed portfolio companies that exceed a traditional bank’s leverage tolerances). Another important observation is private credit’s increasing appetite for non-sponsored, privately-held, and family-owned companies – a critically important cohort of borrowers that were once the sole purview of commercial banks. As inflows to private credit continue to increase, these providers have expanded their mandate beyond lending exclusively to private equity firms and are now aggressively targeting non-sponsored operating companies thereby posing another challenge to community, regional, and even money-center banks.

To illustrate further, note the difference in structure/pricing between a traditional commercial bank and a direct lender on a $50MM term loan to a mid-market borrower:

It’s no secret that banks are much more restrictive in terms of credit structures so, when factoring in the flexibility offered in the private markets, the upside of lower all-in cost of capital no longer outweighs the structural latitudes offered by other types of capital providers. Some borrowers will remain hyper-focused on the lowest price but, if the trade for marginally higher pricing is wider leverage tolerance, longer tenors, increased restricted payments and builder baskets, along with more relaxed terms in general, it’s pretty easy to see why banks are losing share.

The Silver Lining: Private Markets
Just as they did following the financial crisis in ’08, banks will acclimate to the new regulatory constraints and capital requirements – especially those that prioritize the development of revenue channels over poorly executed expense control; however, in the meantime, borrowers will face more uncertainty with their primary lenders and, in general, new sources of capital will fill the void.

Private markets include the largely unregulated direct lenders, hedge funds, business development companies, family offices, private equity firms, and SBIC funds. They boast a unique ability to attach at all points of a company’s capital structure and, as a result, this cohort is aggressively taking share from banks. With the ability to move down market to work with companies <$10MM of EBITDA, banks are taking note.

When comparing/contrasting, private markets offer the following:

• Flexibility: Unlike banks, the capital providers listed above have the ability to play in any part of a company’s capital structure and, in most cases, at multiple points in the same company’s cap stack. This includes senior secured debt (cash flow loans, controlled asset-based loans, last-out term loans, second lien debt, subordinated/mezzanine facilities, preferred equity, and minority common equity);

• Agility: Private markets are just that – “private” and, in large part, unregulated. While these providers most certainly have dedicated investment committees, they’re also professionals with deep experience/knowledge that possess the skillset to move quickly in support of a borrower without the obstacles many clients face when undergoing the credit approval process at a bank. Approvals, feedback, and recommendations commonly take days, as opposed to weeks and months that can sometimes be required when working with a bank;

• Value Add: Private market participants frequently offer a higher level of sector expertise and skillsets derived from existing portfolio companies in like industries, as well as experienced operating executives that work directly with borrowers on everything from business development (revenue growth) to corporate development (identification of acquisition targets), asset integration, cost efficiencies, manufacturing processes, IT platforms, and workforce.

One particular area of focus of our Capital Advisory Group is “right structuring” balance sheets following the steep increase in interest rates and the corollary impact on operating cash flows. Following years of near zero interest rates and aggressive leverage tolerances, many borrowers are burdened with debt capital structures that aren’t sustainable at double-digit rates. Private capital providers, notably family offices and structured equity providers, are committing more flexible forms of equity capital that serve as a relief valve for companies that became over-leveraged with “free money” during 2018 – 2022. The exclusive goal in these situations is finding bespoke capital that right-sizes the debt profile of a company and frees up management to focus on the core business. Preferred equity, mezzanine debt, and the use of PIK structures (Payment In Kind that allows interest to accrue) constitute viable options in today’s market when companies need relief from onerous debt burdens and, given their inherent flexibility, private market providers are serving as the relief valve.

It is important to initiate a forensic review of a company’s capital structure and credit agreement followed by the development of recommendations based on a modeling of different structural options. Once a feasible path is determined, a formal, competitive process to solicit providers and negotiate the most issuer-friendly terms should take place followed by a diligence period and selection of the best capital partner to meet your needs. Invariably, this type of introspective assignment yields benefits beyond the new capital as a “right-structuring” of the credit agreement creates additional goodwill with the senior secured lender and, more often than not, provides an opportunity to negotiate more favorable terms.

As is always the case with cycles, access to capital trumps the price of capital. This cycle is negatively affecting banks and as such, borrowers will be forced to evaluate other liquidity options to facilitate growth, redeem shareholders, and/or manage balance sheets. Sounds intuitive but given the number of exogenous risks companies face today, it is important to understand what options are available in today’s capital markets environment and what areas are experiencing wholesale change.

About Matrix Capital Markets Group, Inc.
Founded in 1988, Matrix Capital Markets Group, Inc. is an independent, advisory focused, privately-held investment bank headquartered in Richmond, VA, with additional offices in Baltimore, MD and New York, NY. Matrix provides merger & acquisition and financial advisory services for privately-held, private-equity owned, not-for-profit and publicly traded companies. Matrix’s advisory services include company sales, recapitalizations, capital raises of debt & equity, corporate carve outs, special situations, management buyouts, corporate valuations, and fairness opinions. Matrix serves clients in a wide range of industries, including automotive aftermarket, building products, car washes, consumer products, convenience retail, downstream energy, healthcare and industrial products. For additional information or to contact our team members, please visit www.matrixcmg.com.

Disclaimer
The contents of this publication are presented for informational purposes only by Matrix Capital Markets Group, Inc. and MCMG Capital Advisors, Inc. (“Matrix”), and nothing contained herein is an offer to sell or a solicitation to purchase any of the securities discussed. While Matrix believes the information presented in this publication is accurate, this publication is provided “AS IS” and without warranty of any kind, either expressed or implied, including, but not limited to, the implied warranty of merchantability, fitness for a particular purpose, or non‐infringement. Matrix assumes no responsibility for errors or omissions in this presentation or other documents which may be contained in, referenced, or linked to this publication. Any recipient of this publication is expressly responsible to seek out its own professional advice with respect to the information contained herein.