When Inflation Strikes Back

article

An inflationary scenario in the future is largely a question of “when” versus “if”

Date april 2012

Featured in The Secured Lender

With the effects of the 2008 financial crisis still lingering and unemployment continuing at elevated levels, one bright spot for the U.S. economy is that inflation has remained largely dormant.  Annual inflation as measured by the Consumer Price Index was just 2.7% in 2009 and 1.5% in 2010.  Equally important, inflation is likely to stay at benign levels throughout 2012, since high unemployment means labor costs – historically the primary driver of inflation – will likely remain constrained.

Even so, an inflationary scenario at some point in the years to come is very much a question of “when” rather than “if.”  Several extraordinary factors at work in today’s economy mean that inflation can never be far from borrowers’ and lenders’ minds:

  • The Federal Reserve’s extraordinary responses to the financial crisis have increased the US monetary base.
  • Ongoing political unrest in the Middle East poses persistent risks for oil prices.
  • Surging demand for commodities in emerging market countries and elsewhere creates an ever-present risk of food and raw materials shortages.

In fact, it is worth noting that these very factors led to an unexpected, albeit brief, uptick in inflation in the first quarter of 2011, despite fairly anemic domestic GDP growth.

What’s the bottom line for asset-based lenders (ABLs)?  Even in an era of seemingly persistent unemployment and low interest rates, ABLs should be aware of the potential impacts of inflation on loan portfolios and think through the potential pitfalls – and opportunities – they may face during an inflationary cycle.  They should also be aware of the protective measures that may be available to them when inflation makes a comeback.

Heightened Risks for Borrowers and Lenders

Inflationary pressures can significantly alter the risk / return equation behind an ABL’s business model.  Once-stable borrowers may find themselves suddenly scrambling to keep up with unexpected hikes in labor and raw material costs, resulting in a spike in debt levels overall. For ABLs, this may mean a sudden jump in utilization rates on revolving facilities across the existing portfolio.  Higher interest rates, which typically accompany inflation, can make these problems even more acute.

Adding to the heightened level of risk in this scenario is the likelihood that many borrowers will not be able to pass higher costs on to their end customers in the near term.  This “lag time” in passing through costs can present serious working capital issues for numerous borrowers, especially those with direct exposure to highly volatile raw material input prices and relatively short product turnaround cycles. Plastics manufacturers, food processors, and metal components manufacturers, to name a few, can quickly find themselves overextended and facing serious financing challenges.

Further, rising inflation makes it more difficult for ABLs to accurately predict real returns on deployed capital.  When borrowers repay their loans in a rising-price environment, the amount repaid may be worth significantly less in real terms than the amount of the initial funding, making forecasting much more challenging for lenders. At the same time, borrowers may have added incentive to take out more loans in the short term, since they know the funds will buy more raw inputs and labor today than they will six months or a year down the road.  

The end result for the ABL may be a flood of requests for new funding at exactly the point in the cycle when its visibility on returns is most impaired.

New Opportunities for ABLs in an Inflationary Environment

Despite this gloomy outlook, the return of inflation – whenever it happens – may not be all bad for ABLs.  Surging debt levels among borrowers may cause larger banks to pull back on new loans simply because borrowers’ higher debt-to-equity ratios no longer meet the banks’ risk criteria. 

As a result, many attractive borrowers can find themselves shut out of consideration for traditional bank financing when inflation sets in, creating openings for opportunistic ABLs to step in and fill the funding gap. 

In particular, this can create strong opportunities for ABLs with companies that operate with lower levels of capitalization, such as distributors and service providers.  As with nearly every company, distributors and service providers will also face challenges from rising labor costs in an inflationary cycle.  At the same time, however, distributors and service companies’ input costs are typically far less volatile than those for manufacturers.  Moreover, an increase in debt-to-equity ratios may not signal that the business’ receivables or inventory have lost value.

Take, for instance, a distributor of consumer electronics products that imports goods from Asia for resale in the United States to retail outlets:

  • Such a distributor would typically incur incremental sales, packaging and shipping costs in order to bring these products to market.
  • As such, the bulk of the distributor’s regular operating costs are known and quantifiable.
  • In periods of rising inflation, the company’s products should become more expensive, once the initial “time lag” for passing costs to customers elapses, giving the lender more cushion to work with in the event that the borrower defaults and the ABL is forced to liquidate the assets.
  • Importantly, ABLs can put themselves in an even stronger position by collateralizing both accounts receivable and retail inventory.
  • As always, ABLs should take care to secure appropriate advance rates for lending against a distributor’s products.

Borrowers in the service sector – such as temporary employee placement agencies – may possess similarly compelling combinations of strong receivables that can collateralize loans, as well as fairly predictable input costs.  However, these borrowers will obviously lack physical inventory for use as collateral.

Steering Clear of the Largest Pitfalls

In an inflationary environment, borrowers with direct exposure to volatile commodities prices will run the greatest risk of a working capital squeeze, and therefore pose the most extreme risks for ABLs.

Makers of plastics products like polystyrene and rubber, for example, are only a few short processing steps up the supply chain from crude oil; thus, unexpected spikes in fuel costs severely affect these manufacturers. Food processors and makers of metal components, among others, may also pose risks to lenders.

Larger companies in these sectors typically have strong hedging and risk management practices in place to protect margins and cash flows from unforeseen swings in input costs.  ABLs, however, should not assume that their own portfolio companies are aware of the best practices for hedging, nor that they have the capabilities to implement these practices effectively.

For both existing borrowers and new applicants that depend heavily on raw materials, consider taking a close look at each company’s risk management practices. The following diligence items may shed light on a borrower’s potential risk profile when inflation picks up:

  • Does the company have a risk management policy in place for hedging input costs, with buy-in from senior leadership?
  • Does it adhere to the policy consistently?
  • Does it have dedicated risk management personnel in place who understand the relevant futures markets?
  • Does it have the leverage to incorporate price changes into its inputs contracts based on changes in relevant commodities indices?

Of course, not all borrowers will be able to answer “yes” to each of these questions, but having the discussion may help you understand whether existing borrowers will continue to meet your risk criteria when inflation returns, and whether loan requests from new borrowers constitute an appropriate use of your firm’s balance sheet.

In short, without extremely strong risk controls in place, it will be wise to avoid or minimize new lending in these sectors.

Additional Key Points for Consideration

Most borrowers will fall somewhere in the middle of the inflationary risk spectrum, with varying degrees of exposure to, and protection from, swings in commodity input prices. However, inflation will affect almost every borrower in some way.

In a rising-price environment, ABLs should reexamine their general criteria for the timing of new loans, as well as how to collateralize and price risks, bearing in mind the following key general considerations:

  • Pricing “Lags” and Timing for New Loans

When inflation picks up, most borrowers face the same basic question: How long will it take to recoup our increased business costs by securing higher prices from our end customers? Companies with dominant competitive positions in consolidated industries generally have the ability to negotiate higher sale prices with their end customers quickly, before working capital comes under pressure.

Most companies, however, do not have that luxury.  ABL borrowers typically compete in highly fragmented industries with large numbers of local and national competitors, and therefore may not have significant discretion over final pricing to their end customers. ABLs should, thus look for signs on a case-by-case basis that might indicate that a borrower has the ability to raise prices should the need arise. These may include:

-  Niche manufacturing or service capabilities or service capabilities that would make a borrower’s products difficult to replace or replicate.

-  Customer perceptions that the borrower provides a premium product or service.

-  Integrated service offerings that would make a borrower’s products “stickier” for customers (for example, bundled after-market support).

Assessing whether a particular borrower meets these criteria is a subjective process, and will depend on the lender and its partners’ due diligence capabilities and judgment. Even when a borrower does satisfy these standards, predicting the potential time lag between cost increases for the borrower and pricing increases to the end customer can prove tricky.  For instance, as Netflix recently discovered, broad attempts to raise pricing do not always go according to plan.

In the absence of clear signs that a borrower has significant pricing discretion on its own, ABLs should take a cautious approach to the timing of new loans. Lenders should wait for uniform signs of end-customer price increases across an entire industry sector before extending credit. This may help ABLs to ensure that their portfolio companies’ financial forecasts are attainable, and that their own balance sheets remain on stable footing during an inflationary cycle.

  • Re-Examining Collateral Standards

Inflationary pressures should also prompt ABLs to re-examine their collateral standards. Specifically, capital equipment may no longer constitute appropriate protection for new loans due to the potential gap between inflated nominal valuations and the equipment’s actual market value in a liquidation scenario. A borrower that requests a loan against a piece of equipment valued at $1 million, for example, probably has unrealistic expectations if it paid $800,000 for the equipment only six months ago.

ABLs that do not have a solid perspective on the resale market for machinery and other capital goods may be putting themselves at additional risk by continuing to accept inflated equipment values as collateral under inflationary conditions. Working with a strong appraisal partner can help in navigating this challenge.

  • Need for a Tougher Stance on Risk Premiums and Loan Structures

For all of the reasons mentioned above, a spike in inflation clearly introduces new risks for ABLs. Lenders should be sensitive to the indicators that may signal rising inflation, and make every effort to account for these heightened risks as they structure and price new loans.

Smaller ABLs may be hesitant to seek higher risk premiums and tighter loan covenants at the onset of inflation for fear of losing deals to larger competitors. Overextending the balance sheet on new loans without having a clear picture of the potential impact of inflation, however, may pose an even larger risk to the ABL’s long-term financial strength.

The best approach is to take a cautious stance toward new lending at the beginning of the cycle. ABLs should seek opportunities to finance borrowers with fundamentally healthy business models, and should not hesitate to negotiate terms that will compensate the lender appropriately for extending capital in light of heightened risk levels and enable the lender to step in early and protect itself if the borrower goes into decline.

Conclusion

While there is no shortage of uncertainty in the current economic environment, one thing is abundantly clear:  inflation will eventually make a comeback.

ABLs and borrowers alike should keep a close watch on the macro indicators that may signal a return of inflation. In addition to the most obvious factors – falling unemployment and strong GDP growth – watch for rising prices for goods and materials from developing economies in Asia and elsewhere. They could signal that the large labor surpluses in those countries are shrinking. Continued strong demand growth for commodities in emerging markets also poses risks of shortages for global manufacturers and consumers.  Further, if U.S. policymakers are unable to reach a consensus on paying down federal debt, the Federal Reserve may have to “inflate away” the debt.

ABLs and borrowers can prepare themselves for inflation’s inevitable return by establishing a game plan early.  ABLs should:

  • Review their portfolios to make sure they understand borrowers’ exposure to commodity price risks.
  • Check with borrowers that have exposure to sensitive raw materials inputs to ensure that effective risk management strategies are in place and encourage borrowers to lock in favorable supply contracts wherever possible
  • Keep in mind that inflation may present new opportunities along with new risks
  • Hold firm in negotiating appropriate risk premiums and structures for new loans when an inflationary cycle has begun.

As always, ABLs can best protect themselves by working in partnership with strong advisors who understand the macro indicators that may signal rising inflation, and can help them plan and execute accordingly.