The challenges facing small- and medium-sized companies because of current economic volatility can be difficult to navigate. While some companies lack working capital to build inventories, others are growing and need financing to help spur further growth. For many firms, a solution to these challenges is asset-based lending (ABL).
A PROVEN LENDING STRATEGYÂ
ABL has long thrived in both good times and bad as a financing solution for companies with large inventories and working capital needs. Asset-based financing is directly correlated to the value of a company’s assets, which serves as the lender’s collateral for the loan. Once regarded as creative financing for troubled companies, private equity, and investment banks began using ABL to finance larger leveraged deals.
Asset-based loans are well-collateralized, competitively priced vehicles that are effectively used by companies of all sizes for acquisitions, growth, turnarounds or to simply support working capital needs. “Asset-based lending has developed into a well-established financing option for companies with varying needs and is particularly useful for manufacturing, retail, and distribution businesses that make good use of their assets to structure a flexible credit facility,” noted Greg Eck, managing director, Asset Based Lending Group Head for Fifth Third Bank.
A key difference between ABL and cash-flow financing is covenant structures that are typically less restrictive and easier to manage. ABL lenders lean on collateral to support their financing exposure, which allows them to be more flexible and patient in most situations.
A key metric for cash-flow financing, Total Debt to EBITDA, can change rapidly when performance declines, making it a significant issue when the lender has tied much of underwriting to that measure. ABL lenders, on the other hand, design a lending package by first analyzing the liquid aspects of a company’s asset pool and then formulating a credit facility around advances against collateral.
Many cash-flow lenders provide most of their financing in the form of term loans as opposed to revolving lines of credit, often seeking to minimize revolver sizes. While ABL lenders provide term loans, most specialize in providing and administering revolving lines
of credit. Some lenders will provide revolvers in conjunction with a treasury management relationship which makes it efficient for companies to manage various aspects of working capital and cash cycles.
Most loans provided by ABL lenders are collateralized and covered by assets with a perceived lower risk profile, they offer a cheaper alternative to higher-leverage debt packages based purely on cash flow—typically 150 to 200 basis points lower—and come with lower closing fees.
BETTER PREPARED WHEN CHALLENGES ARISE
Many cash flow lenders tend to be more proactive in protecting themselves with a covenant default. ABL lenders are set up to monitor loan exposure on a continuous basis. This allows them to become intimately familiar with working capital cycles of borrowers and are better prepared to react quickly and work with clients when unique challenges arise.
While this may create extra work for a company as they adhere to reporting requirements, stockholders, and management see this heightened level of oversight as a valuable supplement to their own financial tracking.
A TEAM APPROACH
ABL, coupled with a tranche of “last out” or subordinated debt, maybe a safer approach for many middle-market businesses as opposed to large, cash-flow term loans with one lender. It may offer a lower overall risk profile and support for capital preservation. Being able to turn to a team of lenders with deeper resources also may mitigate risk in executing strategies in a company’s future.
The proof of this strategy can be seen in the strong relationships built over the years between ABL lenders and junior debt partners. These relationships offer benefits for all participants:
• Lenders with a history of completing financings together often have legal document templates in place and know each other’s processes and work styles. This lowers the risk of lengthy or failed loan execution.
• Junior debt providers gain comfort in knowing an ABL lender is closely monitoring a borrower’s business trends and is more likely to act pragmatically in a crisis.
• Senior lenders appreciate that the junior lender is often proactive with management and ownership and may even hold a board seat or observation rights.
• Lenders with existing relationships provide effective lines of communication, a lack of confusion, and rapport with the management team that benefits all.
M&A CONSIDERATIONS
Middle-market companies across most industries are solely focused on managing through a possible downturn, as are their advisors and lenders, with most growth strategies being reassessed given the uncertain environment. In fact, global M&A was 30% lower
in 2022 compared with 2021, according to Bloomberg.
While there are many hard-to-estimate factors that could affect the timing of the economic recovery, the Conference Board said in its March 2023 Global Economic Outlook that it expects growth to slow to 2.3% in 2023. In an environment roiled by uncertainty, ABL structures may be a more prudent way to finance acquisitions. The equity gap to be filled may not be materially different than a cash flow structure as purchase price and leverage lending multiples pull back in response to volatility created by inflation and the Fed’s interest rate hikes.
The distressed buyout market will eventually heat up. Here, there is a role for ABL structures, which always lead with a revolving line of credit. Draws against revolving lines of credit have several under-appreciated features in the absence of scheduled principal amortization and the borrowing base expansion that accompanies growth in sales, which provides added liquidity without a term loan. These features can lower fixed charges, making it easier to meet covenants and free up cash flow to reinvest in a recovering or growing business.
As businesses and their advisors look to the future, ABL may be the answer to solid execution for sound and strategic planning. ABL can be a powerful tool, particularly in capital-intensive industries. The capital structure can be diversified, borrowing capacity can be freed up for other purposes and businesses gain a source of working capital.
