Has John Paulson smashed his crystal ball on a pile of gold?
Credit Crunch Phase 1
The first phase of the credit crunch is rates and spreads increasing resulting in higher cost of borrowing. Liquidity abounds, but at a decidedly higher cost of capital, especially in the credit markets.
Part 1 of borrowing cost is the relevant index that rates are based on and all of the indices are higher now than a year ago.
A 7,567% increase – from 0.03 to 2.27
One year ago, rates were extremely low - as they had been since 2008, with the overnight SOFR at 0.03%. Today SOFR is 2.27% - a whopping 7,567% increase. All-in pricing for the most creditworthy borrowers is 2% - 4% higher than a year ago, the result of Fed actions to increase short-term rates and cool the economy, spreads widening with the cost of borrowing for lesser credit borrowers widening significantly over last year’s spreads. All interest rate indices have increased.
Part 2 of the borrowing cost is the spread the individual borrower is charged over the index and those spreads have widened – increasing by 25bp to 50bp for the most creditworthy borrowers to 200bp or more for lower quality borrowers. A year ago the most creditworthy borrowers might expect to pay 25bp-75bp over the relevant index with senior non-bank lenders in the 75bp-150bp range and junior lenders in the 150bp-200bp range, meaning there was very little risk premium in the market. Today the lower range of spreads is 50bp-125bp over the index for strong performing $50M EBITDA middle market companies and 300bp-400bp at the higher end for average performing $10M EBITDA middle market companies. The spreads have increased and risk premiums have returned.
Credit Crunch Phase 2
The second phase of a credit crunch is an increase in covenants, terms and conditions.
This takes many forms. Prime among them are higher cash flow to debt ratios and lower debt to equity requirements for new/renewing deals. Lenders want to see more cash flow cushion in monthly budgets simultaneous to the monthly borrowing cost increasing. It is a two-fanged viper. New deals see lower debt to cash flow ratios, higher debt yield covenants and higher equity requirements with lessened reliance on management roll and greater demand for cash equity.
Lenders want to see more cash flow cushion in monthly budgets simultaneous to the monthly borrowing cost increasing… It is a two-fanged viper!
John Paulson has smashed his crystal ball on a pile of gold…
Credit Crunch Phase 3
The third phase of the credit crunch is credit drying up.
We are at the stage where lenders do not yet know if we are heading into a recession-lite, The Great Recession Part Deux (or worse) or a small speed bump. During The Great Recession liquidity dried up seemingly overnight. Companies that had working capital lines drew them down fully if they could. Very quickly lenders started cancelling credit facilities of all types, calling existing loans and not renewing outstanding balances on even performing matured loans. Hard money lenders, the lenders of last resort, affectionately referred to as vultures in the industry, were the only option for many.
Credit will become increasingly less available over time until a clear direction for the economy and that is because markets, lenders in particular, hate uncertainty, and...
Uncertainty reigns. Markets generally abhor VUCA = Volatility Uncertainty Complexity Ambiguity. But that is exactly where we are today. Bankers who can sleep at night wake up fearing the morning financial press headlines. They wilt at the thought of Fed Chair Jerome Powell giving a speech at some college where he might announce MF LRI, many future larger rate increases. They tremble as they scour the markets for any early warning sign of defaults or regional instability or supply chain disruptions or their shadow unexpectedly appearing on the ground beside them, a fresh batch of Ursula’s poor unfortunate souls.
This is where having a really good crystal ball pays off. John Paulson smashed his on a pile of gold after personally making $4B on the 2008 housing market crash, leaving us all in the same predicament: guessing for now and saying with hindsight in a year “I should have known that was going to happen”.
What do I do today? Buckle in, build cash supplies and if you are thinking that you want to sell your business in the next few years, act quickly or plan to wait it out. Vertical Capital Advisors will debut a new valuation tool this month that will enable us to provide anything from a quick snapshot to a comprehensive analysis of your company’s current value. There is still a record amount of debt and equity capital available but multiples have softened this year so don’t wait too long if you are serious about exploring a possible sale.