Asset Based Lending as a Financial Tool

Many Chief Financial Officers and other finance executives view asset based loans as a financing outlet of last resort. While that may sometimes be the case, such a view is a one-dimensional perspective. But as companies confront a tight credit market coupled with lower than expected results, many CFO's are viewing asset based lending as a viable option in the financing tool kit. Even successful companies with strong banking relationships can quickly fall out of favor with lenders and lose access to unsecured financing, especially if they've shown recent losses.

A few bad quarterly results doesn't necessarily mean that a company is in bad shape. But stringent bank underwriting parameters can cause existing loans to be called and prevent the firm from qualifying for new financing. A company facing such a scenario can use asset based lending (ABL) arrangements as bridge loans to pay off banks and provide liquidity until bank financing is achievable.

What is asset based lending?

An asset-based loan is secured by a company's accounts receivable, inventory, equipment, and/or real estate, whereby the lender takes a first priority security interest in those assets financed. Asset-based loans are an alternative to traditional bank lending because they serve borrowers with risk characteristics typically outside a bank's comfort level. These assets typically have an easily determined value. The financing can take the form of loans to revolving credit lines to equipment leases and can range from $100,000 to $1 billion, depending on needs and circumstances.

How can ABL be a beneficial financing option?

Acquisitions
To grow a business, a company may look to acquire a strategic partner or even a competitor. Asset-based financing is often an efficient means to obtain funding for business acquisitions.

Turnaround Financing
Turnaround financing is often used by under-performing businesses that are not achieving their full potential. In some cases, it is used for businesses that are either insolvent or on their way to becoming insolvent. Asset-based lenders are accustomed to the bankruptcy process and asset-based financing is ideal for turnarounds because of its flexibility.

Capital Expenditures
Capital expenditure is the money spent to acquire and/or upgrade physical assets such as buildings and machinery. Capital expenditure is also commonly referred to as capital spending or capital expense.

Debtor-in-Possession (DIP) Financing
Debtor-in-possession (DIP) refers to a company that has filed for protection under Chapter XI of the Federal Bankruptcy Code and has been permitted by the bankruptcy court to continue its operations to effect a formal reorganization. A DIP company can still obtain loans--but only with bankruptcy court approval. DIP financing, which is new debt obtained by a firm during the Chapter XI bankruptcy process, allows the company to continue to operate during a reorganization process. Asset-based lenders also provide exit financing or confirmation financing to companies coming out of bankruptcy.

Growth
Typically, as a company grows so does its need for financing. Also, as a company's collateral grows, its assets can strengthen its ability to borrow. An experienced and creative asset-based lender can assemble a credit facility that can scale to grow with a company.

Recapitalization
Recapitalization is the process of fundamentally revising a company's capital structure. A company might recapitalize due to bankruptcy or replacing debt securities with equity in order to reduce the company's ongoing interest obligation. A leveraged recapitalization typically achieves just the opposite--by taking on a material amount of debt, the company increases its ongoing interest obligation but is able to pay its shareholders a special dividend.

Refinancing/Restructuring
When a company enters or exits a growth stage, refinancing or restructured financing may be key to creating a capital structure that better meets the needs of the company. This type of financing is often used for market expansion, completing an acquisition, restructuring operations, or following a successful corporate turnaround.

Buyout
A buyout is the purchase of a controlling percentage of a company's stock. In a leveraged buyout (LBO), the acquiring company uses the minimum amount of equity to purchase the target company. The target company's assets are used as collateral for debt, and its cash flow is used to retire debt accrued by the buyer to acquire the company. A management buyout (MBO) is an LBO led by the existing management of a company.



What are the advantages to ABL?

* Tends to feature fewer covenants than other types of financing and those it does include tend to be more flexible. Cash flow loans, by contrast, often have four or five covenants including total leverage, fixed charge coverage, and minimum net worth.

* If a company is growing, the receivables and inventory it uses to secure the asset based loan is likely growing as well. Thus, the company has a greater collateral base and can borrow funds to fuel its growth.

* ABL instills discipline. Since the loans are based upon accounts receivable and inventory, the company is motivated to improve collections and complete the production cycle in a timely manner.

* As mentioned earlier, ABL imposes less stringent covenants compared to cash flow loans. These type of loans also provide better security to the lenders, which in turn allows them to grant more time to the borrowers to turn their company around in difficult times.

What are the disadvantages of ABL?

* Since the level of funding is contingent upon the asset values on the balance sheet, there may not be sufficient liquidity. Only asset rich companies would likely benefit, while many service companies would not.

* Such a requirement can be difficult for the company.

* Asset based lending tends to be more expensive than other types of financing, often three to five percentage points above traditional bank financing.

* ABL runs counter to the thinking of a lot of CFOs who believe it is dangerous to tie short term assets to long term financing.

Although asset based lending is now a common financing tool, it is not for everyone. It makes sense to explore all types of financing before deciding if asset based lending is the right choice. The CFO must review the state of the company's credit, analyze the firm's asset structure, and its current debt load. Asset based lending can provide the liquidity needed for the company to grow until less expensive bank financing is available.