Why Asset-Based Lending is Gaining Traction in Europe
Over the years, a complete spectrum of solutions has developed to meet companies’ diverse funding needs. With it has come an often bewildering range of product descriptors; working capital finance, asset finance, asset-backed finance (ABF), factoring, invoice discounting (ID), asset-based lending (ABL), securitisation and many related solutions to the perennial problem of raising cash for business.
In the current business environment, where banks have often had to shrink their balance sheets and customers have seen their credit ratings challenged, alternative solutions for both provider and user have become ever more important.
Asset-based lending (ABL) can be seen as a hybrid solution to meeting cash demands; like a traditional bank lending facility, it focuses on the balance sheet assets of the business. Unlike a bank lend, it is focused on the here-and-now and linked to the current status of the business assets. Like invoice finance, it looks at the current valuation and liquidity of the assets and monitors their performance. Unlike invoice finance it generally isn’t only focused on receivables.
There are other more subtle issues too. Invoice finance is usually predicated on the transfer of ownership (through purchase or assignment) of the asset, whereas ABL is usually a secured lending product. To the casual observer this might appear to be a purely technical difference, but it means there may be significant legal implications for what can and can’t be done from one market jurisdiction to another. Registration of security interests, third party rights and priorities as well as the situation in insolvency all need to be considered.
In the US, ABL is big business – at the end of 2013 lenders were providing advances of US$80bn, against facilities of US$200bn. Growth in 2014 is estimated by the author to have been around 5% on these figures. Nowhere else in the world yet remotely matches this level. The UK comes in a distant second; in the year to September 2014 its ABL advances market grew by just over 10% to US$6bn advances.
However, just as factoring and ID started in the USA and spread to Europe with early adoption in the UK, ABL is following a similar pattern and also becoming a scale product in the Netherlands.
Although extending to other asset classes, many ABL facilities are effectively debtor led (i.e. receivables are the most important asset class financed). In this context ABL can be seen and compared in the light of the parallel global receivables finance industry, which was estimated to be advancing around US$470bn at the end of 2013.
Process and Calculation
Having established that ABL is big business – related to but different from traditional receivable finance – the next question is how does it work?
ABL considers the whole range of assets held by a business and ranks them in terms of liquidity and potential security. The provider will make an assessment of the subject business and decide which of the asset classes it is prepared to fund and to what level. It will then often consider a further loan based on the client’s cash generation flow.
This process and calculation can be simply expressed by the following descriptive equation:
Effectively, the funding available is the sum of all contributions made by each asset class. So the provider – or its appointed agent – will carefully review and define the current value of the class and what it needs to deduct as not financeable (if it cannot convert the asset to cash, it cannot finance).
It will also decide what level of advance will be offered for each asset class. This will be driven by the relative ease of liquidation of the asset, both in live and in distressed or gone situations – figures which will clearly vary from asset to asset, from case to case. Receivables will ordinarily support the highest percentage advance, followed by raw material inventory and finished goods.
Finally, any additional cash flow element will be based on the projected cash flow being sufficient to provide interest cover and capital repayment.
The deal will be assessed and structured to ensure that it generates adequate cash and headroom for the anticipated needs of the client user. In general terms, such ABL deals are usually likely to be covenant light compared to comparable traditional lends.
Of course, the valuation approach above gives the lender an answer in a moment of time. The art and skill of the provider is to measure and monitor on an ongoing basis to maximise the funding for the client, while at the same time maintaining security in the collateral.
Accordingly, an ABL provider will often utilise the services of third party specialist agents to provide valuation services for one or more of the asset classes. Such a decision to outsource is, of course, moderated by their internal scale capability and risk management policies.
This constant monitoring and control is probably the key differentiator from a traditional balance sheet lend approach. Moreover, it is likely to be relatively labour-intensive and potentially costly – although recent developments in software extraction for client enterprise resource planning (ERP) systems are driving this expense down). However for the lender this inherent additional cost is offset by the greater security and opportunity to lend, and for the user by the greater access to cash than is typically provided by a traditional approach. With ABL, there’s very likely more ‘bang for the buck’.
A Shifting Focus
In recent years, traditional finance providers have been looking for new product markets. The result has been a significant shifting focus in mature markets, from supporting mostly small and medium enterprises (SMEs) to corporate scale business as the providers, users and their advisers have learned to better understand the opportunities in a larger-scale environment.
For the lender, ABL gives a new route to market providing risk diversification, an opportunity for a high return on assets, together with (in Basel-compliant terms) secure lending, a low loss given default (LGD) and accordingly the opportunity for a reduced cost of capital.
For current invoice finance providers ABL is an extension of their existing skills base, which has a focus on asset dynamics and represents a logical progression through asset liquidity.
For the savvy user, there is access to a finance vehicle that provides it with proportionately higher levels of competitively-priced funding, with potential headroom to support, for example, M&A activity.
A rare win-win scenario is therefore available. So is the market effectively limitless?
Of course ABL is no market panacea; it can only work effectively when, for example, receivables are for simple, discrete, identifiable goods and services, when inventory has intrinsic and sustainable value, where plant and machinery is not so specialised that it cannot be easily used in any other environment.
At the lower end of the scale spectrum, ABL competes with invoice finance; at the higher end with securitisation and traditional lending products.
However, with this acknowledged ABL, can potentially make a significant contribution to the funding of real economy businesses through extending the choices and solutions available to users. Not only is it viable in domestic situations, it can also be a highly effective tool in cross-border funding of international businesses, particularly where providers and suppliers work in partnership to share their respective local market expertise.