As access to capital has become increasingly restricted for middle-market companies, many businesses seeking liquidity have begun to see alternative financing solutions, like those offered by asset-based lenders, as an attractive option.
Asset-based lending (ABL) often comes under fire from critics who claim these loans drive borrowers to default, but it can be a useful tool. ABL provides liquidity to both distressed companies undergoing a turnaround process and growing companies looking to expand. It’s more expensive than traditional borrowing, but generally an ABL arrangement gives the borrower access to the lender’s expertise—which some midmarket businesses find to be worth the steep price tag, even if they have a number of borrowing options.
ABL emerged as a popular solution in the early 1990s, as an alternative for companies that had liquid assets on their balance sheet but could not secure traditional financing based on their earnings. Before long, the market became highly commoditized, and bankers’ decisions about how much liquidity to provide an organization became driven by a standardized borrowing-base formula. The years that followed saw little innovation in ABL; banks continued to offer formulaic, cookie-cutter products that did not accommodate companies with unusual characteristics, seasonal attributes, or atypical business cycles. Asset-based lenders became known as “lenders of last resort,” and the industry was often associated with failing companies and bankruptcy.
Nevertheless, the practice of ABL has never been inherently flawed. It is a misconception to think that all ABL borrowers end up filing for bankruptcy. Reflecting the dichotomy of their client base, most asset-based lenders dedicate one portion of their business to supporting growing, thriving companies and another portion to financing distressed companies.
Asset-based lenders can often provide more liquidity than traditional lenders by using the value of the assets. ABL typically has fewer covenants surrounding financial performance, which can give the borrower more flexibility in operating its business. And asset-based loans can be tailored to meet a company’s specific needs, such as providing increased seasonal advances to help the borrower through a low selling season.
Because asset-based loans require intensive collateral monitoring, borrowers often need to upgrade or adjust their financial reporting practices in order to participate. While this may take some time and energy, the borrower is nearly always better off. Financial reporting improvements sparked by ABL requirements not only provide the lender with insights into the borrowing base, but they often help the borrower’s management team institutionalize better processes for tracking performance and operating metrics.
Communication Is Key
Although ABL lacked innovation in the past, leaders in the sector have begun to evolve in their approach to asset-based loans. Borrowers can distinguish forward-thinking lenders from the old guard by looking at whether prospective lenders value open, two-way communication. Borrowers should look for a lender that truly views the lending relationship as a partnership in which both parties are responsible for maintaining transparency and clarity about their objectives.
To determine a prospective lender’s approach to communication, a borrower’s management team needs to spend as much time as possible with the lender, ideally at its office. They should understand the process by which the lender makes decisions, and should get to know as many of the lender’s decision-makers as they can—not just the underwriters, but also the people who make credit decisions after the loan is executed, as these will be their day-to-day contacts. These relationships will help them better understand the lender’s culture and how it operates.
At the same time, to get a sense of how a prospective lender might react to an unexpected situation, the borrower’s management team should speak with customer references, especially other borrowers that have navigated turbulent situations or faced a significant change in their business. The prospective borrower’s management team should ask questions that provide insights into the prospective lender’s approach to growth and change (e.g., missing financial targets, departure of a key executive) and its responsiveness and flexibility.
An asset-based lender should also be able to provide the borrower with insights into industry and market trends, and should show an interest in maintaining an ongoing dialogue about how to prepare for negative swings in business performance and potentially leverage positive developments. In retail, for example, companies are struggling to get ahead of major shifts in consumer spending patterns driven by technology, social media, and the more frugal nature of the young people who grew up during the recession of 2008 to 2009. Retail companies facing these types of headwinds need to borrow from a lender that understands the landscape as intimately as their management team does.
One topic that a borrower should discuss with the lender before entering into an ABL agreement is the structure of the ABL facility—and the borrower’s management team needs to read all the paperwork. While traditional ABL is rather commoditized, some elements of the loan’s structure may be critical to the success of the partnership. For example, middle-market companies often need to be able to tap into more liquidity if their business dynamics change. They may want the option to increase borrowing substantially, in a term-loan structure. Thus, their loans will need to be structured differently than more traditional or broadly syndicated deals, which often have very low levels of utilization and large unfunded revolvers.
The borrower’s management team must fully understand how the structure of the facility will guide the decision-making process, in a practical sense, throughout the life of the loan. In terms of pricing, no one structure is inherently more expensive than another. Pricing is decided based on the company’s current situation and need for additional liquidity, as well as the timing required to close the facility. Another factor that may affect pricing is the level of specialization required from the lender. If the financing requires highly specialized expertise, fewer lenders may be a good fit, so the loan may be more expensive. But there are not any generic, conclusive rules that determine the pricing for a facility.
Although the structure of an asset-based loan typically ties directly to the specific collateral that is the loan’s borrowing base, the loan agreement needs to be flexible enough that the borrower can manage its business effectively. Management at the borrower should not feel compelled, for example, to store aged inventory just because they need to keep their loan’s collateral on the books. At the end of the day, the borrower and the lender both want the same thing—for the business to succeed.
Provisions regarding disposition of collateral are standard in ABL loan documents. As expected, this is a very important clause for the lender, which is relying significantly on the borrower’s collateral. While almost all loan agreements have this type of provision, it is important to understand how the lender will react if and when disposition of collateral becomes necessary. The borrower needs to ensure that the lender understands why disposition of collateral may be important and how it may help the company succeed in the long run. The types of provisions that are included will reflect the lender’s relationship with the borrower and how well the companies work together, as collaboration is key to ensuring that each party’s interests are represented.
Collateral, Not Covenants
Along the same lines, the borrower’s management team must understand, before entering an agreement, the degree to which the lender is willing to work with them through the ebbs and flows of their business cycle. The purpose of any covenant should be to act as a trigger so that when the borrower reaches a certain point, management must take a “time out” for a dialogue in which the lender can ask key questions and determine next steps. Does more analysis need to be done? Do other parties need to be brought in to assist with the situation?
Alternative lenders often have a different approach toward covenants than do traditional lenders, whose covenants are primarily focused on the balance sheet and financial performance. While asset-based lenders may also consider performance-based metrics, they are much more concerned with collateral and liquidity covenants. Borrowers should seek as much flexibility as possible within each covenant, as well as a maximum of two to three covenants for any facility. Rolling or trailing measurements can help borrowers avoid a situation where one underperforming month causes a covenant breach.
Covenants are useful for driving dialogue between borrower and lender, but they shouldn’t be the only driver. Discussions about the borrower’s performance and strategy should be happening continuously, enabling the borrower’s management team to concentrate on executing that strategy and, if necessary, actively reforecasting the business, rather than focusing inordinate energy on living up to loan covenants. Often, covenants reflect only lagging indicators, so they typically provide an alert of declining value too late for the lender to respond effectively. At the end of the day, an asset-based lender should focus on the borrower’s collateral and leading performance indicators rather than on financial covenants that may be too rigid or restrictive.
It’s very important for borrowers to find time, well in advance of their need for additional liquidity, to conduct comprehensive research on lenders, because when they actually need the capital they likely won’t have enough time to do proper due diligence. Borrowers should leverage their network and financial advisers to meet with as many lenders as possible. Once a company has identified a lender and the loan document is drafted, the company’s management team must understand who is managing the loan document from the lender’s team and who is driving the decision-making. Getting to know this person will help the borrower understand whether a breached covenant will lead to a conversation or to punitive action.
Value and Service
A good asset-based lender should provide borrowers with real, tangible assistance in running the business. This may involve connecting the borrower with change agents or helping the borrower find necessary expertise to round out its management team. Circumstances vary, but the value the lender brings to the table should extend well beyond the capital. Gaining access to a lender’s expertise is a key reason why some borrowers that have other funding options choose to pay a premium to work with an asset-based lender.
Thus, when selecting a lender, the borrower needs to pay close attention to the service, flexibility, and responsiveness of its prospective partners, as well as the access borrowers have to decision-makers within the lending organization. An innovative, forward-thinking approach to the lender-borrower relationship can complete the value equation and make ABL’s price worth paying. Often, the relevant comparison for the borrower is not ABL lender versus traditional bank, but rather ABL lender versus equity investor.
Access to capital is one of the biggest barriers to success for midmarket companies today, so ABL is getting a good deal of attention, both from businesses seeking liquidity to pursue new avenues of growth and those looking to execute a turnaround. At the same time, new asset-based lenders are creating a more competitive environment and driving innovation in the marketplace. The landscape is evolving, and the regulatory environment continues its focus on “de-risking” the system.
Today, the lending industry landscape is broad, with providers ranging from traditional lenders—i.e., banks—to non-traditional lenders, including boutique finance companies and alternative lenders. And demand for non-traditional lenders continues to increase. Although a bank may be a company’s first choice in terms of rapport and comfort level, the increased regulations that traditional lenders are now subject to might mean a bank is not the right fit for a borrower’s financing needs. Change in the sector is happening fast, and sophisticated, savvy companies are increasingly seeking out new lending partners that can help them navigate the challenges facing their businesses.
Although it will take time to fully move past the 1990s’ “one-size-fits-all” approach to ABL, a new mind-set is gaining traction each day: Asset-based loans are no longer a funding mechanism of last resort, but rather a first step toward the next phase of a borrower’s business strategy.
Andrew H. Moser is co-founder, president, and CEO of asset-based lender Salus Capital Partners of Needham, Mass., where he is responsible for providing guidance and perspective in structuring transactions, and for the safety and soundness of the Salus loan portfolio. Moser is a commercial finance and retail industry veteran, recognized for his contributions and creativity in asset-based lending over the past 20 years. He has previously held senior executive positions with First Niagara Bank, GMAC Commercial Finance, Capital Source Retail Finance, and Wells Fargo Retail Finance, among other institutions.