GlobalCapital: the Covid crisis has arguably hit small and medium enterprises the hardest, and I know that’s a market segment where White Oak is very active in lending. How has the last year been for you?
Hakkak: Let’s take a step back first, and look at the state we’re in now. There's a major disconnect between the real economy and the capital markets around the world. You have stock markets reaching record highs, you have companies trading at inflated valuations in the middle of a global pandemic but you also have people and companies which are really suffering.
Governments around the world have been pumping billions if not trillions into the economy, and if it wasn’t for that, businesses would be in an even bigger demise.
Unfortunately some of that money is simply going into the equity and debt capital markets, because when you have new money printed it’s got to go somewhere.
Some of it has indeed gone into the parts of the economy White Oak serves, the real economy — the SME economy.
You have to keep in mind that the SME segment is the primary driver of economic growth. It’s not so much the large companies making headline grabbing decisions to hire or fire hundreds of people, it’s the many small and mid-market companies making individual choices that drives employment and the middle class.
The government schemes, for example CBILS in the UK or the PPP loans in the US, are effectively putting companies on a respirator, to use the Covid terminology. The problem is that’s not sustainable in the long term, and the recovery is probably going to take two or three times longer than people had anticipated. Even once the world is largely vaccinated, maybe 12 or 18 months from now, you will see real, permanent changes in behaviour. Some companies will probably allow permanent working from home, which will cut their bills and make some of their employees happier.
But, to answer your question, White Oak has been busy. We are a facilitator of money transferred from the government into the real economy. Our UK affiliate has given out roughly £250m to around 800 businesses and is the sixth or seventh largest CBILS lender. We’re proud to do our part in getting taxpayer money into the real economy.
Again, though, there’s a disconnect with the capital markets economy. When you’re looking at a 5%-6% downtick in GDP, that’s not just a recession that’s a depression. And yet everything is trading at all time high prices, and to look at markets alone, you’d think life is good.
The people and companies that are really suffering though are the 20%-30% of the economy that we’re trying to support right now.
Is the disconnect between markets and real economy distress also visible in SME lending margins?
Companies like White Oak are paid to find risks, underwrite risks and price the risk. There’s no one fantastic answer to that, it just depends on the credit situation.
There are companies on their last legs, where we may not be able to give them a financial respirator because the situation is too desperate. But there are companies that are surviving, and just need time for people to buy more sandwiches, coffees, widgets, services, whatever. So those are the credits where we’re really trying to identify the risk, and the pricing of that risk varies. We can get higher returns in some of the more challenged credits, but that’s commensurate with the increase in risk.
Firms like us are not trying to gouge anyone, we’re not in gouging business, we’re not trying to take advantage of companies. But we are saying that if the triple-C index is trading at 4%, and those are large and well-established companies, we at least have to charge a liquidity premium over that index.
For other companies, the risk profile is more like double-B or single-B, and again, you can start by looking at the debt capital markets. If the public markets are pricing a loan for a larger company at 3%-5%, a private investor with no liquidity but a similar risk profile is going to want at least 200bp-400bp more for the illiquidity premium.
Assessing risk itself has grown harder, and some of the traditional corporate finance concepts like trailing 12 month (TTM) Ebitda might not be as meaningful, because of the pandemic. What alternative approaches can you use, and to what extent are you simply taking a view on the progress of vaccines and the pandemic?
At White Oak we’ve got more than 20 different lending products across our affiliates which we can use to support companies, and some of them take quite different credit approaches. Cash flow term loans are usually underwritten to a multiple of Ebitda but, for example, we could do an asset-based loan, where we’re looking at the advance rate we offer on a book of receivables.
That puts it on the revenue side of the line, at the top of the profit and loss statement, not the bottom like Ebitda. We can also give them an equipment loan, financing any assets they might have, whether a truck or machinery or other hard assets. Then you’re looking at the particular asset in question, rather than an Ebtida leverage ratio.
You’re right though that it is very hard to do something on that TTM basis, but we offer [debtor-in-possession] loans for companies with debt on their balance sheet already. We can come in and provide a super senior loan on a conservative leverage ratio, based on those trailing figures.
If a company went from four times levered to eight times because their earnings collapsed during the pandemic, we can come in senior to existing debt and do a secured loan at 3.5 times on a current TTM basis, for example — just to give them survival capital at the top of the structure.
In your asset-based lending activities, have you seen SMEs trying to make greater use of their working capital to raise finance?
For a SME looking at funding options, perhaps box number one is closed, box number two is closed, but box number three, asset-based finance, is open. That, therefore, becomes the option borrowers gravitate towards.
A lot of the larger banks have also had problems in their trade finance portfolios, which were asset-based lending, thanks in part to the defaults and fraudulent borrowing from some commodity trading firms last year.
That’s led to large banks trying to re-evaluate their exposures and pull back, creating another opportunity for firms like ours. So we’ve been very active in that kind of lending.
Avoiding trouble in those portfolios requires verification — if you are not checking the authenticity of receivables or inventories, that creates the possibility for fraud. Today’s world of technology and cleverness gives all kinds of opportunities for the unscrupulous to get cute.
But if you have someone that does a field examination or a spot check on inventories, every month, that helps mitigate the risk. If someone says they have 20,000 cellphones at a warehouse, send someone down there to check they don’t just have 1,000. It doesn’t eliminate it entirely, but it helps to mitigate it.
Similarly in receivables, you call the counterparties and check. Not every day or every month on every counterparty, but pull out a random list and make sure every counterparty on the list comes up once or twice a year.
A lot of the banks now struggling with their trade finance portfolios simply didn’t have those robust mitigation procedures in place in the past.
Clearly physical due diligence is very important, but the ability to visit assets or companies in person has been reduced quite a lot this year. How has your firm dealt with those challenges?
You’re absolutely correct that there's no substitute for in-person meetings, and there's no substitute for office visits. So, within the US, we actually are allowed to travel on approved basis for due diligence.
We also utilise third party verification. So for example, in my cellphone example, I don’t have experts in my company right now that have the time to go count cellphones in a warehouse. But there are firms that perform that service for us. Validating receivables is a desktop job for the most part — you make a phone call to the treasury desk of the purchasing firm, check that they bought them, check they received them, and check that they’re going to make payment in 60 days.
Maybe it’s not perfect, and more in-person [meetings] would be preferable, but you make do with what you have in an imperfect world, come up with creative ways to gain comfort on the due diligence side.
Desktop and phone and internet can get you quite a long way, though of course you’re still missing that human sense you get in person. But we’re doing our best to carry on.
Have you been fundraising during the pandemic period?
We have, and it’s quite a mixed picture in terms of how different potential [lending partners] have coped with the new environment.
Some of our investors are equipped and feel comfortable to move forward with their due diligence online, just as we do with our investments, but some potential investors are interested and ready to commit reasonable tickets but still require some on-site work.
One large account needed an office visit to get approval to invest, and I said, “Look, you’re very welcome to visit us in New York or San Francisco, but I promise you, there’s no one there right now. If you need us to come in and put a suit and a tie on, we can do that but there’s not a lot of point.”
This account would have also had to fly people over, meaning two weeks’ quarantine just to see some empty office space.
We’re also seeing a segment of investors no longer interested in the sort of risk we give exposure to. They’re looking for returns of 12% in ‘private debt’, but when you drill into what they’re actually investing in, it’s opportunistic, special situations, distressed debt. We don’t have that product, we’re more involved in the more conservative side, performing illiquid credit. Double B-type risk at 7%-8% versus triple-C or unrated for 12% we think is a more attractive risk-adjusted return — you never know if defaults are going to bring that 12% down to 8% anyway.
Many pension funds or insurers, however, are so behind on their targets that they’re trying to catch up by taking excess risk, and if a brand name fund comes offering them 12% on distressed, they’re tempted to take it. Everyone is reaching for yield now, but we see a shift in views coming this year, and there is already more interest in products that White Oak offers.
Given the volume of fundraising in that sector, it seems like it might be a struggle to deploy it
I think there are a lot of shenanigans going on. There are certain businesses that are distressed right now, and in sectors which might see a fundamental, structural shift in demand. You might want to go and lend money to a gym company, but maybe during the pandemic their customers bought Peloton bikes, or decided they prefer walking their dogs or running outside to pumping iron in the gym.
So it’s very hard to do a discounted cash flow analysis on the next five years of a distressed gym company. There are too many variables. But nonetheless some funds are claiming they can do it, and there’s a sex appeal to the higher returning distressed opportunities for some investors.
In some cases, too, the investment thesis has a social cruelty that we just don’t have the stomach for. If the idea is to buy a struggling business and then cut staff even more, we’re not interested. We don’t feel taking advantage of companies in a global pandemic is the right business to be in.
Are there particular sectors that stand out as being attractive opportunities for the kinds of lending you do?
We’re looking for essential services across the board. Whether you’re in a global pandemic or not, if you walk out on the street and twist your ankle, what’s your first call? It’s not going to be buying a new pair of Gucci shoes, it’s going to be calling your doctor or going to hospital.
You’ll be doing that as an absolute priority. It primes getting a haircut, it primes entertainment, it primes clothing, it primes everything.
Legal services are similar. If you get sued, you need a lawyer, and you need it more than almost anything else you buy. So for example legal receivables make sense to us, because for those that need legal services, they’re essential.
How do you look at energy credit? It’s certainly essential, but it has its own challenges both from an ESG and oil price perspective.
We’ve been consciously avoiding investing in bad energy over the last few years. Candidly, some of our worst performing credits have been energy. So not only from a social standpoint but also a performance standpoint, we’re going to be avoiding that sector.
But we do have a big program of investments in ‘good energy’. White Oak was one of the first lenders which created a power purchase agreement with solar energy. So we do a lot of solar deals, and have been doing these for years. When we started, 14 years ago, their credit profile was very risky, but instead of taking the risk on the solar company, we could take the risk of the utility company buying the power instead.
What do you think the endgame for the government SME support schemes in the countries where you’re active will be?
It’s a situation that’s very politically charged, at least in the US. I think the UK has done a tremendous job of providing liquidity to SMEs, though some of the facilitators, including the banks, could have done a better job getting this cash from government to companies. In the US, the situation has been more charged because of the presidential election [in November 2020].
But the overall endgame is hard to answer because it depends on the progress and success of the vaccination programs. So we’ll see; the jury is still out.
What happens when these government-backed loans start to go wrong? Clearly it’s not going to be politically palatable to start taking the keys from small business owners.
There's no simple or straightforward answer, because every company has its own unique challenges. Companies may need additional support, other than Paycheck Protection Program capital. So assuming our underwriting thesis was correct, we may have to be more patient, and look for situations where these companies can get more time.
In some cases, we may have to put in additional capital, and in some cases we’ll have to let them know we can’t support them any more. If that happens, we’ll collect those receivables or liquidate inventories.
But we’re also pricing in some of that risk. If we’re taking an additional 200bp of spread, we can weather an increase in loan losses and still be up versus public market credit investing.
That’s something that works better across a granular portfolio — with our affiliates, we’re lending to 800 SMEs, so if we see eight, 10 or 20 go down, that yield increase overall covers some of the credit risk.
Time for a crystal ball: what’s the world going to look like a year from now?
People have to realise we’re in uncharted territory, both from an economic standpoint, and in terms of corporate policies. Companies will give people more flexibility about their approach to working from home, or anywhere else. Nobody wants to have 50 or 200 satellite offices in future but clearly the norms of office work are not going back to what they were pre-pandemic. That means different ways of working, different asset valuations, and adapting to a new environment.