Driving the Trading Value of Assets
summary-date february 2015
Featured in ABF Journal
“Risk management” has always been a fundamental part of the ABL industry—and rightly so. Interestingly, though, the term has also become synonymous with financial conservatism. When ABLs don’t know an asset’s worth, their inclination is to assume the worst so they won’t be surprised on the downside. But ABLs needn’t be “conservative.” Financial models shouldn’t be populated with assumptions deemed either aggressive or conservative; they should instead contain accurate assessments based on the advanced art and science of predicting asset values.
At Gordon Brothers Group, we believe that when you have the deepest expertise and information on your side, fewer “worst case” assumptions are needed to render accurate predictive values, which often leads to higher NOLVs. In other words, higher NOLVs can be achieved in one of two ways: through deep understanding of the asset values or through aggressive assumptions. We squarely believe prudence dictates the former.
So where does this “deep expertise” come from that’s so crucial for accurate assumptions? This question is especially important in an industry where only one in thousands of appraisals is actually ‘tested’ in a subsequent disposition. First and foremost, it’s not all science. If it were, there would be a computer program that would simply spit out values based on readily available quantitative inputs. The reality, of course, is that those models are just a tool. A good appraisal “process” must have access to and gather reliable data; run the models; and most importantly, include checks and balances with experienced appraisers and disposition experts to ensure accuracy.
Once the right process and people are in place, it comes down to the data. The primary consideration should not be how many appraisals a firm has issued, but rather how many dispositions that firm has managed. Nothing trumps real world data in driving accurate appraisals. This includes both the recent asset trading values as well as changes in the market relative to those assets. It is important to have knowledge of the intrinsic value of the assets, the buying behavior of those who would purchase the assets in disposition, as well as the sector trends and macroeconomic factors. Below we examine a few of these considerations in key sectors:
Volatility in oil prices coupled with the Fracking Revolution
Despite all the political chatter, those in the energy industry know the price of oil reflects worldwide markets, not local or regional supply and demand. That said, moving oil, gas and other energy around is anything but efficient. Following the midterm elections, the debate over the Keystone XL pipeline will likely heat up. It is not just infrastructure, however, that affects energy assets – so do technical innovations (e.g. horizontal drilling and hydraulic fracking), crude grade trends, and regulatory limitations.
The price of a barrel of oil serves as the industry benchmark for drilling activity. While Saudi oil reaches a breakeven point of approximately $12/barrel; most domestic oil falls somewhere north of $50/barrel. Commodity price volatility tends to expose those with weaker business models (e.g., wildcats) or those that simply picked the wrong fields, or even the wrong locations in the right fields.
One such example is Greenfield Energy Services, a company whose nine-figure fracking-related asset pool is currently being disposed of by Gordon Brothers Group – representing the largest fracking asset disposition in the world. For every seller, there is a buyer at a certain price (albeit sometimes at a negative premium). Our recoveries on these assets are in line with our expectations despite recent oil price volatility. Why? Because most of the buyers are fielding spreads based on long-term contracts that insulate them from short-term price dips.
Longer-term, the price of oil and gas will impact the value of all types of energy assets, so it’s important to reassess the underlying asset values on a regular basis. We suggest this be done annually or semi-annually for most assets. Due to geopolitical factors, the pace of technical innovation and unpredictable regulatory measures as a result of growing environmental concerns, it appears as though price volatility is the new normal. This will likely be further exacerbated by the financialization of commodity futures, which promotes speculation by traders and undermines economic fundamentals such as supply and demand. Given this reality, it would be wise to reassess asset values more frequently than once a year.
Consumers embrace digital shopping; retailers rewrite their business models
In recent years, “omni-channel” retailing has been the industry buzzword. The goal for retailers was to integrate all available shopping channels—from brick-and-mortar stores, to e-commerce, mobile and social channels, to direct mailings and catalogs—into one seamless customer experience. Now, however, digital commerce is at a “tipping point.” There is simply too much retail square footage in the mix and not all digital investments are paying off. The rate of change in retailing has never been greater and the gaps between first, second and third tier retailers in every sector are widening. Very few retailing concepts will be able to remain competitive without adapting to the changing dynamics of the marketplace.
We believe we have moved into the next phase where optimization of each channel and the overall integration is paramount. In other words, “omni-channel” has now been superseded by “opti-channel” strategies. Opti-channel strategies include major efforts to transition customers from under-performing channels, such as a closing store, to ongoing channels, including higher performing stores nearby or online. Migrating consumers to adjacent stores or to a retailer’s e-commerce site combines conventional old-school techniques like promotions with cutting edge mobile technologies such as QR codes, mobile beacons and receipt matching.
Retailers are re-assessing the size and number of stores required in an omni-channel environment. While it is very difficult to downsize an existing store, especially big box stores, underperforming stores can be pruned. While this process is difficult for retailers to execute without deleveraging their operating model, any transferred sales from the closed stores become highly profitable contributors to earnings. As we partner with some of our healthy retail clients to develop and measure these transition programs, we’re helping retailers maximize the ROI in the optimization stage of the retail cycle.
For ABLs, it’s important not to mistake these programs for distress. We fully expect monetization of the underlying non-performing assets (unwanted inventory and excess fixtures) to hold up. The real trick for retailers is to make sure their stores remain an asset, not a liability.
RETAIL REAL ESTATE
Too many square feet and few retailers to lease it
Mall traffic is down, way down. There are now plenty of digital alternatives to what was once a nearly singular retail channel and the social magnetism of the mall rat.
But that doesn’t tell the whole story in retail mall real estate. Similar to retailers themselves, the gap between the A malls and the B and C malls is widening. Luxury, high-end and newer malls are faring well, while B malls are struggling and C malls are being turned into data centers (Baltimore), fish farms (Thailand) and parks (Columbus). As anchor tenants close stores, the domino effect creates a downward spiral that is hard to recover from. It’s no surprise that only one new indoor mall has been built in the U.S. since 2006.
The strip center and big box story is similar. The two bright spots are strong factory outlet centers and the major downtown areas in New York, Boston and other major coastal cities.
A series of systematic, rather than cyclical events have reshaped the market for retail leases. First, back in 2005, there were changes to the bankruptcy code effectively eliminating most of the value in lease designation rights. Then, in the midst of the financial crisis in 2008, retailers squeezed landlords for rent reductions and retail real estate values dropped. More recently, landlords have been hamstrung by their own lenders when negotiating lease concessions to support tenant restructurings. The net result has been record vacancies, retailers that are much more thorough on site selection and more flexible lease terms.
For ABLs, portfolios that include retailers with at, or above-market, long lease terms should be carefully assessed. The longer the lease terms and the more over-market, the less nimble a retailer can be in adjusting to this new “opti-channel” paradigm.
Brand acquisition market frothy, but less DTR
The competition for proven brands—those with high consumer recognition, wide distribution, lifestyle expansion opportunities, and existing licensing programs —has never been greater. While the number of pure-play brand acquisition platforms is still quite small, their success has created additional competition among them for add-on brands.
With the license-only model now over 10 years old, lenders can safely lend against brand collateral, but must respect the inherent difference in predictability for intellectual property assets. The graphic below demonstrates the typical standard deviation for different asset types. With brands at the right end of the spectrum, a lower loan-to-value ratio (LTV) should be used, even on a rock-solid appraisal.
Our advice to ABLs trying to manage risk: stay up-to-date on macroeconomic and sector trends, but more importantly, stay close to your borrowers. Not surprisingly, the ability to both underwrite new loans and recover on those in distress is principally based on a strong understanding of the collateral and careful monitoring processes. Getting it right out of the gate requires as deep an understanding of the trading value of the assets as possible. In these cases, there is no substitute for disposition experience.