The Growing Allure of Asset-Based Financing
By Greg Miller-Jones
Managing Director and Head of Originations
If your company needs liquidity, an increasingly popular way to obtain it from a bank is through an asset-based loan (ABL) structure.
An ABL is a specialized loan product in which financing is predicated on not only the creditworthiness of the borrower and strength of its balance sheet, but also on the quality and value of the collateral provided to support the extension of credit. Once considered the financing method of last resort for distressed companies, the ABL has emerged as the structure of choice in good times for companies of all sizes across a wide range of industries and is an especially attractive alternative in challenging times when cash flow is strained.
Addressing a range of liquidity needs
Companies may turn to asset-based finance to obtain the liquidity they need for purposes such as effectuating buyouts, funding dividends, developing new product lines (capital expenditures) or providing for general seasonal working capital needs. Here’s a sampling of ABL transactions the bank has recently completed:
Our advice to prospective borrowers, regardless of the specific liquidity need, continues to be: Before you raise additional equity or seek to raise various expensive forms of junior capital, consider whether you are taking full advantage of what’s on the left side of the balance sheet.
Features that make ABLs attractive
ABL structures are primarily revolving lines of credit, though some include a term loan component. Various types of collateral can be used to back ABL financing, including unrestricted cash, accounts receivable, inventory, machinery and equipment, real estate and in some instances intangible assets, typically intellectual property.
ABL financing is formula-driven against these assets. For example, a company may have an ABL credit facility that allows it to borrow up to 60% of the value of its inventory and 85% of the value of its accounts receivable.
What makes an ABL appealing to many companies is its flexibility: The availability of financing grows and shrinks with the corresponding availability of a company’s assets. ABL financing can be customized to fit a company’s business cycle and is easily adjusted.
This flexibility is particularly attractive to companies in business cycle and in many cases is easily adjusted. For example, a company in the seafood industry may need greater flexibility to support its inventory growth during peak fishing seasons. An ABL can give the company access to credit precisely when it is needed.
Covenants, cash dominion and other benefits
Another major advantage: ABLs have fewer covenants than traditional cash flow loans. An ABL is typically governed by a single covenant, fixed-charge coverage. Lower middle-market asset-based borrowers typically are subject to this covenant and it is normally tested monthly or quarterly. For upper middle-market and large borrowers, the fixed-charge coverage test is typically “springing,” meaning it’s not tested until the borrower’s borrowing base availability falls below a minimum excess threshold.
In exchange for this flexibility, the lender will require that the concept of cash dominion be put in place prior to funding or that a predetermined spring be established at some minimum level of excess borrowing base availability. Cash dominion refers to controlling the flow of receipts as accounts receivable (A/R) is converted to cash. In its simplest form, cash dominion simply means as cash receipts are collected, the proceeds go to directly pay down the outstanding revolving loan balance. As the borrower requires cash to pay for goods and services or fund payroll, etc., it borrows against its line of credit.
A common feature built into ABLs is “springing dominion.” With this feature, as long as the borrower exceeds a certain level of borrowing base availability, say 15%, as its A/R is converted to cash, the borrower retains control over its A/R conversion. It’s only when availability drops below, in my example 15%, that the proceeds are governed by “full dominion” and are automatically swept to pay down the outstanding revolving loan balance.
ABLs also offer:
Outdated administrative concerns
Some borrowers hesitate to dive into the ABL waters because they fear the amount of administrative work needed to properly report availability to lenders — i.e., the ongoing tasks of monitoring collateral value. However, thanks to current technology, when the right lender takes the time to explain what’s needed from the outset, there’s nothing arduous about the process.
The biggest hurdle is an upfront one — constructing your borrowing base. This requires collaboration with the lender as it closely examines your prospective collateral to determine which assets are eligible to support and maximize availability.
Once the company’s borrowing base is established, however, ongoing reporting — typically a monthly requirement — can be easily and rather quickly accomplished by importing the relevant data into a customized borrowing base certificate that is mutually agreed upon and designed prior to funding.
A market that’s open for business
Many retailers migrated to asset-based financing (ABF) at the onset of the pandemic when their cash flows contracted. They structured borrowing bases predominately supported by inventory values which provided quick and efficient access to capital. With the improvement in earnings, we’ve seen some revert back to cash flow-based structures, yet ABF remains an effective financing method for those who wish to fully monetize current assets, such as accounts receivable and inventory.
Asset-based finance is an especially valuable funding source for middle-market companies. While large corporations tend to have greater access to established capital market channels — including both traditional and institutional bank loans, junior capital, high-yield bonds and equity markets — their middle-market counterparts tend to have more limited options. This is especially true for smaller middle-market firms.
When it comes to meeting the needs of middle-market companies, the ABL market tends to be much more open for business. Add to that the fact that ABLs typically represent the least expensive source of funding, and middle-market financial executives would be wise to consider an asset-based structure to address their liquidity needs and reduce their overall weighted average cost of capital.
If you need more liquidity and flexibility and you can’t get it from your current cash flow structure, an asset-based loan may very well be the answer.
Shopping for an Asset-Based Lender
Here are several criteria to consider before choosing an asset-based lender:
How long have they been in the business? Lenders have tended to come and go in the ABL business. Does the candidate have an extensive track record, one that illustrates an ability to provide this type of financing throughout multiple stages of the economic cycle?
Do they listen? Anyone can calculate an advance rate. But does the lender exhibit a willingness to dig in to understand your business, think creatively and tailor a solution to meet your specific needs?
Do they have experience in your industry? A major determinant of a lender’s ability to add value to an asset-based structure is its understanding of your business. MUFG Union Bank recently worked with a winery on a $75 million asset-based facility necessitated by some performance issues. Our understanding of the wine business — most notably how, unlike most consumer products, the value of wine inventory can actually increase over time — enabled us to do the deal and provide the client with the most favorable terms.
Do they want a relationship — or just a transaction? It’s always best to work with a lender that wants a relationship with your company. In tough times, conducting business is always so much smoother when the borrower and the lender know each other well and have built a level of trust.