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Credit Crunch: Tightening Markets Could Spell Trouble

Accessibility to credit will determine which companies—upstream and downstream—sink or swim in 2023.

The tightening of credit markets was well-underway before the banking debacle that saw the collapse of Silicon Valley Bank (SVB) and Signature Bank, the bailout of First Republic and the takeover of Credit Suisse.

Wells Fargo chief economist Jay Bryson said last month that he expects lasting economic consequences following the banking crisis. Lingering uncertainty means that banks are expected to tighten lending standards—at least for the near term. Businesses are also expected to rein in hiring plans. That’s the recipe for a vicious circle starting with stringent financial conditions leading to slower growth, only to result in further tightening and even slower growth. In the U.S., the Wells Fargo economic team expects real GDP to contract 1.2 percent later this year and into early 2024.

U.S. companies might have already started to pull back on hiring. On Friday, the U.S. Bureau of Labor Statistics said that nonfarm payrolls rose 236,000 in March, versus the average monthly gain of 334,000 over the prior six months. In a report from payroll firm ADP Inc. on Wednesday, private sector employment rose by 145,000 jobs in March, representing a 40 percent drop from the 242,000 added in February.

One factor (a funding source that agrees to pay the company the value of an invoice less a discount for commission and fees) servicing the fashion and retail industry who requested anonymity said “there’s going to be headwinds for [some] unless they are very strong borrowers and are operating well within their bank facility.” For those that go “outside of their loan formula into over-advances, leverage, then it’s going to be a challenge for these borrowers to get funding,” this financier said.

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The factor said that in a post-SVB world, “Even some of the more aggressive lenders are not going to be as aggressive as they once were. I think they’re now more concerned about credit quality, and they’ll be more reluctant to fund inventory at very high levels.”

Investment banking viewpoint

Geoffrey Frankel—CEO and senior managing director of Hilco Corporate Finance, the investment banking arm of financial services firm Hilco Global—believes that recent banking events could accelerate further tightening in the credit markets.

He expects that as capital moves out of second tier banks—those below the group dubbed “too big to fail,” which in the U.S. are JPMorgan Chase, Bank of America, Wells Fargo and Citibank—”underwriting standards will be enhanced and pricing will increase. This likely will further stimulate a migration from bank sources of financing to more expensive non-bank capital sources.”

Frankel said signs of distress among fashion firms and retailers became evident as early as the second quarter of 2022. “At that point and since, inflation has been persistent, supply chains in certain industries remain disrupted, and cost of capital has continued to rise,” he said.

But that doesn’t mean that it’s currently all gloom and doom for fashion firms and retailers—including those considered distressed.

“There is and will continue to be significant liquidity provided by special situations [financing and] non-bank credit funds,” Frankel said. “We are at a transition stage in the market where pricing expectations of distressed borrowers has not yet caught up with the reality of what special situations funds demand.” That gap is expected to narrow, and eventually diminish, as financing moves away from the low-cost environment through mid-2022 towards an increasingly distressed backdrop.

As an investment banker, Frankel said that the mergers and acquisitions boom of 2021 and 2022 is now in the rearview mirror. It’s no surprise that high-performing businesses are still able to command premium valuations, but getting a transaction done has become more difficult as the “availability and price of financing those acquisitions has increased,” he said. This could get worse as the world seems to be heading into a distressed M&A environment, although that would be a boon to buyers who have capital to put to work.

What about the supply chain?

RapidRatings CEO James Gellert said one silver lining to the SVB debacle is that more people are now aware of critical supply chain risk management issues, such as “concentration risk.” His firm uses credit analytics to help clients evaluate supply chain and third-party vendor risks.

“Supply chain risk managers need to understand suppliers’ financial health, ability to access capital, and with what and how many institutions their suppliers deposit their capital,” Gellert said. And in evaluating the health of upstream or downstream partners, he said companies should check on a vendor’s ability to scale and use analytics to evaluate and predict what are the challenges that are upcoming in the marketplace.

“With higher interest rates, you have a dampening of credit availability and a higher cost of capital for companies. That plays into whether the weaker companies that have been surviving on cheap capital will be able to continue to operate their businesses as they have been over the last few years,” Gellert said. “Most of them are going to be influenced by whether the counterparties that they’re working with can maintain and sustain their businesses and credit, their ability to borrow, their ability to invest, and their ability to survive a longer period of time if their operations have been disrupted. It all comes down to capital and credit.”

He noted that smaller companies are the ones that tend to only have one funding source and that would often be a bank. And banks usually lend in the short term on a floating rate basis. In a rising interest rate environment, the bank debt not only costs more for smaller companies, but they’re also getting squeezed from both higher labor costs and the cost of goods from their suppliers, he said.

One fallout could be that fashion firms and retailers may find that their suppliers will become more conservative over what they will or won’t sell, or produce, or may even limit the ability to pre-purchase orders.

“These are the kinds of things that larger businesses looking at their suppliers need to assess really carefully,” Gellert said.

And suppliers, who need to be just as careful about their own businesses, are heading into a period of credit contraction where they need to decide who they want—or don’t want—to work with.

In a volatile credit world, symbiotic relationships have a better shot at ensuring the survival of both partners. It’s one reason why Gellert believes that communication—and therefore transparency—is becoming a vital component of the discourse between upstream and downstream business partners as they more willingly share plans and intelligence to provide forward guidance on purchasing expectations.

“We’re seeing more suppliers that we rate for companies [now] wanting to understand how strong those companies are themselves,” Gellert said, adding that more firms are also trying to have a better understanding of their own supply chains. “That’s good over time as it will lead to a more transparent supply chain.”

Will bankruptcies increase?

At the start of 2023, retail CFOs were already looking at more than just the balance sheet. And with the COVID-19 pandemic largely in the past, they’ve moved from reactive mode into a strategic, proactive position as they analyze how to future-proof operations. A BDO 2023 Retail CFO Outlook survey indicates they’ve identified three must-do future proofing retail strategies: maintain leaner inventory levels, invest in supply chain technology and raise prices to maintain fiscal health in an inflationary environment.

As always, financially-sound companies with the foresight to plan ahead aren’t the ones to worry about. For companies teetering on the edge, it’s a whole different ballgame.

BDO’s Bi-Annual Bankruptcy report noted that six retailers have filed Chapter 11 petitions just three months into the calendar year, versus five retail collapses for all of 2022. The newly bankrupt include off-price home goods retailer Tuesday Morning, footwear store Shoe City, and party supplies chain Party City. The operationally- and financially-challenged home goods retailer Bed Bath & Beyond has managed to find ways to dodge the bankruptcy bullet, but it is expected to file at some point this year—and it’s luck could run out sooner than later.

David Berliner, restructuring and turnaround services partner at BDO, said fashion firms on the hunt for debtor-in-possession financing will see the costs of debt increasing due to rising interest rates and fees.

“Looking at the list of retailers that have filed over the past three years, the candidates that filed and those that may file are primarily retailers that have operational issues, [such as] falling sales and losing money. With the cost of debt rising, financial issues may become an added burden to companies already struggling operationally,” Berliner said.

As the ability to obtain affordable financing diminishes, that too will make restructuring more difficult. Since 2020, there were few reorganizations as most bankrupt firms either sold their assets or ended up in liquidation mode. Citing to Debtwire, Berliner said David’s Bridal, Gap and Totes Isotoner are among the apparel and accessories firms to keep an eye on. Others to watch include At Home, Bed Bath & Beyond, Qurate, Belk and Kohl’s.

While much of the market focus is centered on smaller banks such as regional institutions, those working with larger banks aren’t necessarily out of the woods. That means even fashion firms in relatively decent financial shape could face pressures, too.

“A big bank says look elsewhere, or they say you had an $80 million facility and we’re only going to give you $50 million and you need to find a junior to supplement. It could happen,” Michael Appel, former CEO and chairman of Rue21 who is managing director at Getzler Henrich & Assocs., said. “You’ve got plenty of people who have build their businesses in alternative lending, but if you can’t get money at 4 percent, and they say pay 10 percent or 14 percent, then it’s a matter of survival.”