Bringing Asset-Based Loans Into Focus

In November 2003, Stelco Inc., one of Canada’s largest steel producers, obtained a new C$350-million asset-based revolving credit facility that replaced its existing senior debt. Over the last three years, many upper-middle-market and large corporate borrowers have made a similar switch to an asset-based loan structure. In this article, we will provide some background on senior debt and an overview of the structure and benefits of the asset-based lending alternative.

Senior debt can be categorized in several ways, including the level of collateralization behind the loan. Some senior lenders require minimal or no collateralization, instead using the borrower’s earnings and/or cash flow as the basis for the loan. However, some senior lenders require full collateralization as defined by the liquidation value of the company’s assets for the loan extended to the company. This distinction makes these types of loans markedly different from each other, and financial executives should consider carefully the merits of each before deciding which option is better for their company. For example, cash flow loans may be preferable for a company posting consistently strong earnings and cash flow in a robust industry. However, for a company with an EBITDA margin under 10%, with high levels of assets or that operates in a cyclical industry, an asset-based loan is generally the better choice.
As Stelco has endured some of the most adverse times in the history of its industry, using its assets to obtain financing gives it the most liquidity and, in turn, the greatest amount of operational flexibility as it works through its industry issues. By contrast, while cash-flow loans have the benefit of not requiring an appraisal and ongoing reporting of assets, they come with comparatively strict – at times restrictive – loan covenants. If a borrower trips its loan covenants in a cash-flow loan because of a dip in earnings, it can be subject to a reduction in available credit and significant fees for covenant waivers and loan amendments. An asset-based loan typically carries looser financial covenants; and, in some cases, may be covenant-light, with no financial covenants, provided the borrower maintains a certain level of excess availability under its revolving credit facility.

Despite such advantages, some still view asset-based loans as the last resort for commercial borrowers or regard them as an expensive financing option that imposes an excessive reporting burden. In fact, asset-based loans provide a borrower with enhanced operational flexibility through all business cycles, and technology has generally made reporting for asset-based loans efficient and non-burdensome.

Many factors have spurred the recent popularity of asset-based loans, but three in particular stand out.

• The first factor is the aggressively structured cash-flow loans completed in the late 1990s. During this period, when many companies were executing leveraged buyouts, acquisitions and roll-ups, banks were routinely delivering highly leveraged cash-flow loans, which were based on a multiple of the borrower’s trailing earnings. The shortcoming of this lending strategy was that many of these loans depended on continued improvement in the cash flows of these companies and a strong capital markets environment to provide an exit for the borrowers as well as the lenders. In general, neither of these conditions held true; and many of these companies have struggled or are now struggling to meet covenants or fulfill maturing debt obligations.
• The second factor driving the demand for asset-based loans is the economic downturn since 2001 and its effect on companies of all types, and, in particular, those that operate in cyclical businesses. As these companies’ earnings have suffered, they have looked to unlock the liquidity inherent in their assets to deliver the operational flexibility and borrowing power their cash flows can no longer command.
• Lastly, the asset-based market remains steady and competitive in spite of large-scale bank consolidation in many loan markets, especially the cash-flow market. This consolidation, along with recent regulatory and shareholder pressures placed on lenders’ portfolios, has caused many lenders to push under-performing loans out the door, an unfortunate trend made more commonplace in difficult economic times. In contrast, the asset-based lending market is more stable. Not only does this make for more competitive pricing, but the large number of lenders in the market also means more institutions are competing for the syndication of larger asset-based loans.

Recently, Fleet Capital was the agent for a C$50-million asset-based credit facility for Ontario-based Anchor Lamina Inc., a manufacturer and distributor of die sets and related components. The company, which is a portfolio company of private equity firm TD Capital, sought an asset-based loan to obtain greater availability over its previous lending arrangement, which, in turn, would give it new strategic options, such as buying back some of its outstanding high-yield bonds. The asset-based credit facility was structured with a $30-million revolver, a $5-million term loan and a $15-million delayed-draw term loan. The delayed-draw feature enabled the company to time its term-loan draws with the funds needed to repurchase high-yield bonds in the market at a discount, a process that Fleet Securities helped facilitate. The asset-based facility also subjected the company to fewer, less restrictive financial covenants.

The common thread among asset-based borrowers of senior debt is leverage. Some companies take on leverage for positive reasons like acquisitions and recapitalizations; others become over-leveraged because of company-specific or industry-wide issues. One hallmark of asset-based loans is versatility. They not only provide an option for refinancing for better terms, more liquidity, etc., but are also often used as a strategic tool for financing acquisitions and leveraged buyouts, as well as helping companies deal with the extreme scenarios of restructuring and bankruptcy. (See Figure One).

Figure One

When GSW Inc., an Ontario manufacturer of water heaters, wanted to make a cross-border acquisition of a company called American Water Heater, it obtained the funds through the value of the assets of the acquired company. Fleet Capital provided a US$30-million credit facility based on American Water Heater’s receivables and inventory, which financed the acquisition as well as ongoing working-capital requirements.

In another example, Toronto investment banking firm NewPoint Capital recently approached Fleet Capital to provide asset-based financing for the purchase of certain divisions of motor coach carrier Coach USA by a private equity group. Fleet Capital determined that the assets of the acquired divisions – accounts receivable, certain real estate holdings and the buses themselves – were valuable enough to help fund the transaction, which closed at US$140 million. The asset-based financing gives the new entity both the liquidity and flexibility to take a leadership role in the regions it operates.

Defining assets: Unlike a cash flow loan, the borrowing capacity of a company seeking for an asset-based loan is based on the amount, quality and liquidity of the company’s accounts receivable, inventory and fixed assets. Generally, the current assets of accounts receivable and inventory serve as the borrowing base for a revolving credit facility that can be drawn down and repaid. This structure can accelerate a company’s cash flow by allowing it to borrow against the liquidation value of its current assets, in turn using the borrowed funds to finance the company’s working capital needs. The revolver is analogous to a credit card, which can be used to borrow and re-borrow up to a specified limit.

In addition, fixed assets (machinery, equipment, real estate) can also be used to collateralize an asset-based loan. In contrast to its current assets, a company’s fixed assets frequently serve as the basis for a term loan, under which the amount is fixed and then repaid through either monthly or quarterly installments over a five- to ten-year period. Similar to a real-estate mortgage, repayments of the loan cannot be re-borrowed. In some cases, the fixed-asset advance can be structured as a component of a revolver. But availability of funds against the fixed assets would reduce over time to mirror a typical term-loan amortization schedule. There are also occasions when certain non-traditional assets (e.g., trade names and intellectual property) are eligible as collateral, but these assets are considered on a case-by-case basis.

Availability against assets is determined initially by a collateral examination and appraisal. This determines the borrowing base and specifies the assets that may not be included in the borrowing base. For example, eligible accounts receivable typically include receivables from completed sales, whereas items like older receivables (over 90 days from invoice) and foreign receivables are usually considered ineligible. Eligible inventory regularly includes all finished goods and marketable raw materials and most often does not include works-in-process (WIP), slow-moving or obsolete inventory or inventory on consignment with customers, to cite a few examples.

The frequency of asset-based loan monitoring and reporting reflects the strength of the borrowing company. Monitoring and reporting for asset-based loans has been facilitated greatly by new technology. For example, at Fleet Capital, customers can monitor their accounts and gain access to real-time information on-line, a capability that eases the manpower burden on the asset-based borrower. Additionally, report generators and other software are constantly being developed to simplify processes like reporting and determining eligible collateral for borrowing-base purposes.

It is important to note that asset-based lending is not necessarily an all-or-nothing proposition. In addition to asset-based loans that are predicated solely on the value of a company’s assets, an overadvance or senior stretch loan can be arranged. In this scenario, a lender will structure a loan that offers elements of both asset-based and cash-flow by offering availability beyond the lendable value of current and fixed assets, if the company can demonstrate sufficient cash flows. In combination with funds lent on assets, the senior-stretch product rewards companies with stronger historical and projected cash flows by providing a highly versatile structure that is generally priced lower than a pure cash-flow loan.

Time-tested and versatile, asset-based loans are delivering strategic financing at competitive terms, allowing companies in all types of industries to achieve operational flexibility through the value of their assets.

Sidebar:

The Case for Asset-Based Loans

• Dependable – Asset-based lenders tend to take a long-term view of their loans, especially in difficult economic periods or in cyclical businesses.
• Leverage – Asset-based lenders have a greater tolerance for leverage.
• Flexible – Fewer covenants are attached to the facility.
• Cost – Asset-based loans are currently competitive with cash-flow loans.
• Industry Stability – Bank consolidation is tightening credit standards.Ira Kreft is Executive Vice President and Group Manager (Central North America) with Fleet Capital Corporation.

Michael Scolaro is currently Senior Vice President, Business Development Officer, with Fleet Capital, responsible for sourcing and funding credit facilities in Canada.

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