Asset Based Lending: Smart Leverage in a Volatile Market
By Ron Kerdasha and Greg Walker, MB Business Capital
October 27, 2015
Despite the continuation of a modest economic upsurge, demand for loans from middle-market companies remains short of expectations. The result is a supply and demand imbalance as lenders anxiously put their cheap capital to work, driving borrowing costs down and overall availability up. Companies are often surprised by the loan terms and availability offered, and frequently they are caught off-guard in making decisions on how much debt leverage they should maintain on their balance sheets.
The key for any company sourcing new financing today is to seek a credit facility that meets its needs while at the same time paying heed to the long-term ramifications of leverage. Management – especially those with more cyclical business models – must be prepared for changes in market conditions over which they have no control, which can tangibly impact a business plan. Changing market forces might include swings in the overall economy, rising interest rates, the impact of regulatory issues or other government mandated changes, and the volatility of commodity prices and currencies.
The volatility challenge
Volatility has recently been heightened by a nearly 17% increase in the value of the US Dollar and a 47% decline in the price of crude oil over the past 12 months ending August, which is creating massive ripples for companies worldwide.1 footnote Changes in costs related to healthcare and other forms of insurance are also real issues for many companies. These are all potential challenges for management teams to work through, particularly smaller privately-held companies which typically have a lower threshold for pain. Regardless of what the overheated lending market may be offering, stepping down debt levels to more reasonable levels as a defensive strategy should be strongly considered.
So what to do? Companies should carefully match themselves up with a lending structure and lending partners, and review the impact of varying debt levels. It may be perilous to view loans simply as a “commodity”. The provider of a loan is as important as how much you can get, and at what price. All too often, today’s senior lending market pushes lenders to uncomfortable levels of leverage. Since that strategy offers little or no margin for error, it may not be the best alternative for both lenders and borrowers.
Asset based lending: A team approach
A safer asset based lending (ABL) approach sourced from a commercial bank provides less initial funding but may offer a lower overall risk profile for a borrower. An ABL product coupled with junior debt – such as “last-out” or mezzanine debt -- may provide a price advantage on a blended basis, and the capital preservation feature should not be overlooked. The ability to turn to a team of lenders with deeper resources instead of one cash flow lender in a leveraged transaction may further mitigate risk in executing future strategies whether you’re battling through a crisis or implementing a growth plan.
During the last ten years asset based lenders have forged deep relationships with many providers of junior debt. Borrowers can benefit from this two-party approach as they enter into relationships with groups that have completed financings together in the past. Legal documentation templates are often already negotiated and in place, thereby minimizing execution risk and lowering closing costs. The two groups may have also previously worked together as partners post-closing and be familiar with each other’s credit cultures.
Many junior debt providers gain comfort in knowing an asset based lender is closely monitoring a company’s business trends, and are increasingly likely to act more pragmatically in a crisis as a result. Conversely, senior lenders appreciate that a junior lender is typically more proactive with management and ownership, and at times can hold a seat on the board of directors. Senior and junior lenders with existing relationships lead to open lines of communication among all parties and more transparent messaging.
Consistency and cost savings
Overall lending parameters proposed by asset based lenders are also more predictable and rarely deviate based on market conditions. There is a very good chance that an asset based borrowing structure provided in 2009 on the heels of the Great Recession included an 85% advance rate against accounts receivable just as it does today. Because most of the loans provided by asset based lenders are collateralized and covered by assets with a perceived lower risk profile, bank-backed ABL remains a cheaper alternative to the higher leverage debt packages based purely on cash flow. In fact, asset based loans provided by banks are typically 150-200 basis points lower than cash flow financing and often have lower closing fees. As noted, such rates can be blended with junior debt, typically in the 12% range, to provide competitive overall pricing versus one-stop cash flow lending.
An asset based loan for a corporate buyout may initially provide less funding than a cash flow loan but may represent a more thoughtful, long-term approach. Structuring the deal with less senior leverage can preserve capital over the long run, especially when managing through unforeseen events, which can impact short-run performance. With shortfalls in projected financial performance and declining operating cash flow, asset based lenders look to the value of the assets as a secondary source of repayment behind operating cash flow. As a result, they are more inclined to provide a longer time frame and further liquidity so that management can prepare and execute a turnaround plan.
Asset based lending can also prove valuable in supporting a growth strategy or add-on acquisitions by leveraging off an expanding or acquired asset pool. Asset based lenders often provide more aggressive advance rates against accounts receivable and inventory justified by their higher level of due diligence and overall experience. Draws against revolving lines of credit have an often underappreciated feature: its lack of scheduled principal amortization throughout the term of the financing. This can lead to lower fixed charges, make it easier to meet covenants, and free up cash flow to reinvest back in the business. Linking a revolver directly to a company’s main operating account at the lending bank can also minimize borrowing levels and reduce interest expense.
Managing through difficult times
Lending during challenging situations has long been one of the key areas for ABL to thrive as a financing solution. The adverse effects of poor performance can trigger many alarms and result in covenant violations or liquidity issues. Covenant structures in ABL deals are typically limited relative to those included in a cash flow financing, and are easier to manage in an event of default. A key covenant for cash flow lenders – Total Debt to EBITDA – can change very rapidly with a decline in performance and become a major issue for a lender that initially provided the loan based on that measure. Having pushed the limits on leverage, cash flow lenders may react more proactively to protect themselves with a covenant default.
Many ABL lenders are set up to monitor their loan exposure on a continuous basis and become intimately familiar with working capital cycles of their borrowers, resulting in a more patient approach that yields fewer surprises. While adhering to reporting requirements of an ABL deal may create extra work, stockholders, management and other lenders often find this oversight extremely valuable as a supplement to their own financial tracking. This dynamic may favorably impact the strategy of stakeholders during a difficult situation.
ABL: The multipurpose solution
Asset based lending is clearly not suitable for every company on the lower end of the market, but over many years it has become a readily available financing option for manufacturing and distribution businesses, and to a lesser extent, service businesses. Companies in these sectors would clearly benefit by utilizing flexible ABL debt structures for acquisitions, recapitalizations, growth strategies and turnarounds.
About the Authors
Article authored by Ron Kerdasha, Group President and Region Executive, and Greg Walker, Senior Vice President, who together lead MB Business Capital’s business development efforts in the Northeast and Mid-Atlantic.
1 WSJ Dollar Index Symbol: BUXX, 9/4/14 $75.49, 9/2/15 $88.56, 16% increase YoY. During the last week the BUXX traded down slightly so 16% today vs. 17% last week (17% quoted in the article)
Oil: Crude oil NYMEX: WSJ, 9/4/14 $91.29, 8/27/15 $38.06, over a 47% decline. During the last week oil strengthened to $46.00 today or 50% off last year. Back to top