The Corporate Finance Shift to Asset- Based Loans PART I

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1 The Corporate Finance Shift to Asset- Based Loans PART I Realistic Business Owners Look Beyond Bank Cash Flow Loans 1 Brian Ballo Corporate Finance Associates The Good News 1 Financing is currently available for your middle market business despite the lingering Credit Crunch. While traditional banks have tightened credit standards on cash flow based business loans, commercial finance lenders are actively lending to fill the operating capital needs of businesses by making asset-based business loans. An asset-based business loan (ABL) is secured by a first priority security interest against a company's accounts receivable, inventory or equipment. On the other hand, traditional commercial banks underwrite primarily based upon the cash flow performance of the business as the source for repayment, and secondarily look to collateral by filing UCC-1 Financing Statements against assets. The key trend is that while "[traditional cash flow] lending disciplines are literally in crisis mode, asset-based lending has remained a strong, steady and viable option for businesses struggling for working capital, states Andrej Suskavcevic, CEO of the Commercial Finance Association. In fact, the Commercial Finance Association reports that the asset-based lending industry, which has grown considerably over the last 15 years, is now funding over $500 billion per year to U.S. businesses. 2 Asset-based loans are flexible, versatile and competitively priced. All kinds of companies big and small, old and new now use them for an array of liquidity needs. Today, asset-based loans are a fundamental financing solution offered by many lenders, including the major moneycenter banks. Therefore, the question is not if financing is available today. Rather, the question is whether your company is looking beyond traditional bank financing to realistically consider the terms involved in an assetbased loan. If you have been turned down for bank financing, you should consider this option. The Reality of Bank Lending in Mid Commercial bank lending to businesses is grounded on a credit fundamental that reoccurring monthly obligations to pay trade creditors and credit grantors are satisfied with monthly cash income, not tangible or intangible assets, nor annual profit. Therefore, banks underwrite senior loans based on EBITDA, 3 and insert financial covenants in loan documents which require that the borrower not exceed a total leverage ratio, have sufficient income to cover fixed charges, and maintain a minimum net worth. The Federal Reserve Bank s reduction in the fed funds rate has caused the prime rate to lower to 3.25%, versus 5% one year ago, down from 8.25% two years ago. However, pricing spreads are as much as 250 to 400 basis points higher for middle market debt as compared to just a year ago. In addition, loan amounts for senior cash flow debt have been reduced to the x EBITDA range. This compares to two years ago when senior debt multiples were in the x EBITDA range and total debt was in the x EBITDA range.

2 The Corporate Finance Shift to Asset-Based Loans Part I: Realistic Business Owners Look Beyond Bank Cash Flow Loans 2 Lower interest rates aside, the traditional banking industry s reaction to the difficult economy has been to impose more loan covenants and tighter cushions for meeting projections. However, this simply creates a greater chance that the borrower will stumble, and return to the bank to negotiate new terms in order to avoid a loan default. So, while reduced interest rates offer limited relief, companies are now struggling to grow and fund operations with far less bank capital. Pros and Cons of Asset-Based Loans One helpful way to appreciate the value of asset-based loans, is to understand how they fit during a wide range of times of a company s life cycle. As depicted below, 4 cash flow loans are generally only made when a company has positive cash flow, whereas an asset-based loan is available to a company during both good times and tough times. If your middle market company is experiencing distress, then being realistic about financing options, means stop hoping in vain to obtain a bank cash flow loan, and start evaluating the loans which are available from asset-based lenders, who have a greater tolerance for borrowers with risk. From the borrower s perspective, the advantages of an asset-based loan (ABL) are: ABL lenders makes loans secured against specific collateral, therefore, if a company has quality collateral, financing is available, despite the fact that the company may have negative cash flow. Underwriting asset-based loans is much faster, often not requiring a review of a business plan or income tax returns. As a result, funding is quicker, sometimes as short as 2-4 days. If a company is growing, the receivables and inventory are likely growing as well. Thus, the company has a greater collateral base and can borrow funds to fuel its growth. ABLs tend to have fewer, more flexible covenants. Cash flow loans, by contrast, often have four or five covenants including total leverage, fixed charge coverage, and minimum net worth. ABL instills discipline. Since the loans are based upon accounts receivable and inventory, the company is motivated to improve collections and timely complete production cycles. ABL loans provide better security to the lenders, which allows them to grant more time to the borrowers to turn around their company in difficult times. Again, from the borrower s perspective, the disadvantages of ABL are: The asset-based lending industry has a negative image, created in large part by traditional banks which previously

3 The Corporate Finance Shift to Asset-Based Loans Part I: Realistic Business Owners Look Beyond Bank Cash Flow Loans 3 extended many unsecured loans. But, times have changed, and because few bank loans today are unsecured, many of the common perceptions about asset-based loans are, in fact, misconceptions. The amount of an ABL is determined by the assets on the balance sheet, which have sufficient liquidity. Only companies with assets that are readily liquid would likely benefit by an ABL, while many service companies would not. Asset based lending tends to be more expensive than other types of financing, often three to five percentage points above traditional bank financing; however, particularly for manufacturers and distributors, asset-based loans are more in line with traditional bank pricing. ABL runs counter to the thinking of a lot of CFOs, who believe that short term assets should not be tied to long term financing. Forms of Asset-Based Loans Asset-based loans are structured in the following forms: (1) an asset-based line of credit, (2) a term loan, or (3) a collateralized by a pledge of specific assets. An asset-based business line of credit is usually designed for the same purpose as a bank business line of credit - to allow the company to bridge itself between the timing of income receipts and expense payments. This critical timing issue explains why accounts receivable are the focus for underwriting both cash-flow and asset-based business lines of credit. The credit limit of a cash-flow based line of credit has a pre-set credit limit which bears a direct relationship to the amount of the accounts receivable at the time of loan application. 5 On the other hand, an asset-based line of credit will generally have a revolving credit limit (aka revolver ) that fluctuates based on the actual accounts receivable balances that the company has on an ongoing basis. This requires the lender to monitor and audit the company to evaluate the accounts receivable size. However, the advantage to a company with a revolving credit facility is the ability to obtain a larger line of credit, since asset-based lenders underwrite the value of eligible receivables, and do not require the borrower to wait (as cash-flow lenders do) until the collateral has been converted to cash. A revolving line of credit typically has a term of one to three years. An asset-based term loan is based on a certain percentage of the orderly liquidation value of the machinery and equipment, and the appraised fair market value of the land and buildings. Asset-based term loans collateralized against equipment and real estate include regular periodic payments of both principal and interest in order to retire the debt at a fixed maturity date, typically five to seven years. Yet another category of asset-based loans involves pledging or assigning specific accounts receivable as collateral for the debt. This form of financing is contrasted with factoring, which involves the sale of accounts receivable at a discount. These two asset-based methods are discussed in depth in Part II of this Article: Factoring and Financing Accounts Receivable, A Comparative Analysis, by Brian Ballo. Asset-Based Lender Monitoring Common to all forms of asset-based loans are certain controls and monitoring imposed by lender, which are directly related to the credit-worthiness of the

4 The Corporate Finance Shift to Asset-Based Loans Part I: Realistic Business Owners Look Beyond Bank Cash Flow Loans 4 borrower. Typical controls include: (1) a Borrowing Base Formula monitors the ongoing relationship between the value of the collateral available to secure the outstanding loan and the actual balance of the loan, (2) Collateral reporting or funding controls may be required on a daily, weekly, or monthly basis, and range from submission of sales invoices/shipping documents to accounts receivable aging and listings/inventory listings, (3) Collection controls include the use of a blocked account or lock box, whereby the lender maintains control over how accounts receivable collections are deposited, and (4) Lender make periodic audits of the borrower's books and records to substantiate collateral values as represented by the borrower. Conclusion If your bank has reduced, or denied, the amount of credit that your middle market company requires to conduct its operations and grow, then considering all available financing options means realistically evaluating asset-based loans. While the interest rates on asset-based loans tend to be more expensive, the overall terms are actually more flexible. The practical use of asset-based loans, and methods such as factoring, can be useful short-term tools that provide necessary capital, giving a company more time to eventually qualify for lower cost cash-flow loans. Contact Your Investment Banker CFA s investment bankers can help you evaluate your financing options. No matter what stage your company may be in its life cycle, if your company has eligible assets, then there is a good chance that an assetbased loan can be arranged. About the Author: Brian Ballo is a Managing Director in the Los Angeles office of Corporate Finance Associates. For more information on how your company can obtain asset-based financing, contact Brian Ballo, at or send to brianb@cfaw.com Brian has 13 years of experience as an investment banker arranging corporate finance solutions. He has strong relationships with factors and accounts receivable financing sources, which enable a Company to obtain cash quickly and, thereby, improve corporate working capital. He has a corporate attorney background, and is familiar with the issues and laws involved in secured transactions under the Uniform Commercial Code. About CFA: For 52 years, Corporate Finance Associates (CFA) has been one of North America s largest investment banking firms serving middle market companies. CFA has more than 30 offices in the United States, Canada and India, as well as investment banking alliance partners in Europe and Asia. CFA focuses on transactions in the $10 million to $250 million range. 12/01/09

5 The Corporate Finance Shift to Asset-Based Loans Part I: Realistic Business Owners Look Beyond Bank Cash Flow Loans 5 1 See also: Part II: Factoring and Financing Accounts Receivables, A Comparative Analysis, by Brian Ballo, and Part III: Cooperating with a Factor Helps Banks Retain Customers, by Brian Ballo 2 The Commercial Finance Association publishes a Quarterly Asset-Based Lending Index. After the asset-based industry showed unprecedented growth in total credit commitments during Q2 and Q3 2008, volumes in Q and Q held steady, demonstrating the stability of asset-based lending. 3 Wells Fargo explains: That means we look at the cash flow of your business as the primary repayment source for the money we lend you. How do we compute cash flow? A company's cash flow is its net profit, plus its non-cash expenses - depreciation and amortization. Our rule of thumb is that for every $1 in total loan payments, your business must generate $1.50 in cash flow. 4 Bank of America chart 5 Nevertheless, bank lenders typically require a Security Agreement collateralizing all accounts receivables and file a blanket UCC-1 Financing Statement against all assets, including inventory and equipment. Such over-collateralization puts a chokehold on a company s ability to leverage its accounts receivables. Reasonable bankers, particularly if they are reducing the amount of available credit, will cooperate by subordinating their lien rights to factors who acquire the company's accounts receivables for cash. This topic is discussed in detail in Part II I of this Article: Cooperating with a Factor Helps Banks Retain Customers, by Brian Ballo.