Credit crunch?

17 March 2008

“We're not really in a ‘credit crunch.' I think we're in a ‘confidence crunch,'” according to Samuel Zell, the US real estate billionaire. He argues that the large amounts of liquidity in the financial markets that existed eight weeks ago still exists today, although with a different risk premium.

For manufacturers of equipment and rental companies, the events of the last two months in world financial markets are causing great concern. It all started with a crisis among US sub-prime mortgage lenders, then spread to the banks and hedge funds that provide them with cash. Then, fear quickly spread to the UK and other multinational banks, sending a chill down bankers' spines all over the world.

‘If your company is owned by a venture capitalist, expect that they may postpone selling you, but expect also that they will demand ever more vigilance on cash management and restrict investment.’

US effects

For those of you in the US, perhaps the already existing slowdown in domestic new housing starts is most important. According to the US Department of Commerce, construction starts for new houses in August 2007 were the slowest for twelve years.

It's easy to imagine US rental companies soon beginning to postpone fleet additions for perhaps a year. Today, however, they are mostly still taking equipment from a long pipeline caused by manufacturers' lead times which were over six months. Access manufacturers, for example, will need to exercise great care to avoid being hit by a slowdown in orders at the same time as banks may be tightening up on credit. Rental companies can maintain flat financial performance from one year to the next without adding their fleets, but this can cause a catastrophe for their suppliers.

Market transformation

This may not be all bad news for rental companies outside the US, who are in economies unaffected by the US situation. In fact, overcapacity by the US manufacturers would transform the world market for self propelled access equipment into a buyer's market for the first time since the early 2000s.

Rental companies who are building their fleets, and therefore raising money, should expect the banks to continue lending, although probably very selectively. This would certainly represent an opportunity for banks to raise interest rates, although they would probably see more defaults as well. A warning bell should be ringing for the most highly leveraged rental companies, who could well see their overdrafts of invoice discount lines reduced in size, or cost of borrowing rise.

The pressures are similar for publicly traded companies and those owned by venture capitalists or other private investors. The banks are saying they will still lend, although perhaps not at the same cash flow multiples as earlier in the year, and the venture capitalists still have money to invest. All things being equal, however, the more timid the banks, the less a venture capitalist can pay for a company they acquire, and still make the same return. So the first thing that happens is that company values go down. As a result, investors who already own companies postpone selling; effectively waiting until things turn around, if they can.

Syndication difficult

Larger deals will tend to suffer more, as the banks are having particular trouble syndicating large debt, a process by which larger loans are effectively sold in slices to banks and investors with specific risk and return criteria. The current crisis started in syndicated loans which re-financed sub-prime US home mortgages. The US markets for syndicated loans are down a full 36% from the second quarter to the third quarter of 2007; leveraged loans with lower credit ratings are down 46%.

If your company is owned by a venture capitalist, expect that they may postpone selling you, but expect also that they will demand ever more vigilance on cash management and restrict investment. This is equally true for manufacturers and rental companies. However, looking back towards the beginning of the decade, a downturn provides some very interesting opportunities for cheap acquisitions of good companies in temporary difficulties. Remember, Linamar bought 48.5% of Skyjack for €15m in 2001, a company which made a €41m profit in 2006 on sales of almost €260m.

Perhaps the most frustrating thing about the current moment for much of the industry is the uncertainty. Will things get worse due to some other shock to the financial system? This uncertainty makes it easy to postpone decisions, especially decisions made by investors. The risk-averse personality of a typical banker often makes delaying a decision even easier than saying no.

Conversely, it is often a prudent decision for an investor to wait rather than invest at the wrong moment, even if it means keeping many accountants and expensive analysts on the payroll waiting for the right moment.

Tighter credit

In conclusion, today's perceived credit crisis could get worse or better, depending on any new shocks to the financial system. I expect things to be quiet for a month or so, particularly regarding new money available for building rental fleet or acquisitions.

However, the most likely outcome is that credit will become a bit tighter than a few months ago, but available at a higher price as supply and demand reach balance. This means that investors will still invest, but they will negotiate hard on price and be very careful with their money.

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