Asset-based lending structures (ABL) can be an excellent source of capital for many companies, especially for non-investment grade businesses and companies in transition who may not otherwise qualify for a cash flow loan. Cash flow loans use EBITDA and some level of multiplier to determine a company’s level of available credit. During negative economic cycles, changes in earnings before interest, taxes, depreciation, and amortization (EBITDA) and the multiplier can mean significant changes in a company’s borrowing capacity at a time when they likely need a lender’s support the most. On the other hand, an ABL structure is based primarily on the value and quality of the pledged collateral and can be a more stable source of available capital through economic cycles. ABL has advantages for both borrowers and lenders and can allow a company to be “bankable” when it might otherwise not be, especially in times of uncertainly and challenging business environments.
Companies that are asset-rich but have lower EBITDA margins are prime candidates for ABL structures. Borrowers who may not otherwise qualify for secured financing can leverage their unencumbered assets, including accounts receivable, inventory, machinery/equipment and real estate, to obtain working-capital lines of credit and term loans. Generally, the amount of financing is dependent on a negotiated advance rate against an appraised value of these assets and supported by a borrowing base.
ABL facilities also help borrowers through improved liquidity and flexibility. Rather than waiting to collect receivables, borrowers receive cash advances on their eligible receivables to support immediate liquidity needs. These cash advances are particularly helpful for companies experiencing rapid growth or having significant seasonality where there can be rapid shifts in working capital requirements. When working capital needs decline, the cash dominion and lockbox feature on many ABL loans ensures that the cash collections go directly to paying down the loan as the assets in the borrowing base decline. The opposite is true as working capital requirements increase. As sales (receivables) and inventory increase to meet demand, the borrowing base expands and provides the needed capital to support the company immediately.
Lenders also benefit under an ABL structure. Under the typical cash-flow lending structure, when a borrower’s EBITDA declines, its leverage ratio increases. The decrease in company performance and increased leverage can lead to covenant violations and can cause risk rating changes within regulated banks. The result in many of these situations is that the borrower would be transferred to the bank’s “special assets” division and then forced out. Banks that have ABL divisions may be able to retain the borrower within the bank by converting it into an ABL structure, assuming the assets are there to support a conversion. An ABL structure is more likely to mitigate a decline in financial performance by corralling the company’s borrowing capacity within a set margin against specific collateral. The structure allows the bank to retain an earning asset and not create further uncertainty and business disruptions that arise from raising new capital. An ABL structure allows the lender more patience with a borrower than a cash-flow structure would.
Lenders also have an advantage in an ABL structure with more control via frequent reporting, cash dominion/lockbox, and the ability to establish borrowing base reserves. While subject to negotiation, the typical ABL structure requires a minimum of quarterly financial reporting and covenant testing, field exams performed by an independent third party, and collateral appraisals. This frequent reporting allows the lender to stay abreast of changing financial conditions and collateral quality in real time. The lender also controls all cash remitted to the borrower. Receivables collections and other payments all flow through controlled bank accounts, and the proceeds are used to pay down the revolver balance. Finally, an important tool for a lender is the ability to institute reserves against available collateral. These reserves could be included for many different reasons, including allowing for a company’s cash burn, inventory obsolescence, or the deterioration of the quality of the receivables or other collateral in the borrowing base.
While it can be more work for the borrower to comply with a lender’s ABL requirements, the benefits of this type of loan structure often outweigh the drawbacks. For companies who must otherwise exit the lender, pivoting to a secured ABL structure versus some other form of financing will generally allow the borrower to incur lower financing costs than it otherwise would in a post-exit scenario. In addition, not having to transition to a new lender means fewer fees the company would otherwise pay to third parties like investment bankers or consultants to source a new lender. Attorney fees would generally be lower when pivoting to an ABL structure within the same lender versus having to completely re-document a new deal.