The key data points that seized our attention this week have to do with the odd divergence between fundamental economic performance, which appears to be trending down, and C&I lending, in which approval rates appear to be trending up. There is nothing more certain to impose losses on capital providers than allowing greed to trump fear, but we believe that is exactly what we are seeing in the market.
Fundamentals Moving in the Wrong Direction
The U.S. economy continues to muddle along, with mixed economic signals at best. Conversations with business owners and capital providers active in the middle market continue to paint a picture of a lack of organic growth opportunities. A look at the U.S. PMI index from May 2011 through April 2013 shows a trend line moving in the wrong direction (see link).
Small Bank Lending Points to Trouble Ahead
Absent growth opportunities, there are fewer places to put capital to work, and as a result capital providers are finding themselves at the mercy of supply/demand dynamics that they have never before been on the wrong side of. We have paid particular attention to the lending activities of small banks (here defined as banks with less than $10 billion in assets). Prior to the recession many of these banks were content to focus on real estate lending. Those banks that have survived the fallout from that concentration of risk have jumped into C&I lending aggressively.
Increasing approval loan approval rates during a period of weak to declining macroeconomic fundamentals suggests to us that Small Banks are placing themselves at risk of considerable losses as they go further out along the risk spectrum to close deals (see link).
Risk Factors
The downside risks in the market continue to multiply, but it seems that many participants are wedded to the idea that we will see a more robust economic recovery before we see another recession. From our standpoint in the lower middle market, we view this as wishful thinking.
- Global finance is facing the twin headwinds of a push for more stringent regulation as well as the massive risk inherent in anything other than a perfectly choreographed unwinding of monetary easing by central banks across the globe alone should give all market actors pause (see articles here and here).
- Geopolitical unrest continues to multiply (see an insightful piece on the jingoism of China here).
- Holders of municipal bonds are learning that these investments were far more complicated, and far less “safe” than advertised (see article here).
The challenge of uncharted waters we find ourselves in is to be confident in the lessons of history while remaining versatile enough to adjust to the true and lasting changes in the economy. Opportunities abound in all markets, but the most sizeable opportunities appear during periods of uncertainty.
About the Author
David Johnson (@TurnaroundDavid) is a partner with ACM Partners, a boutique financial advisory firm providing due diligence, performance improvement, restructuring and turnaround services. He can be reached at 312-505-7238 or at david@acm-partners.com.
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