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15 Oct 2020

Using untapped assets to navigate the COVID-19 crisis

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Asset-based lending is perfectly suited to helping businesses through the COVID-19 pandemic and beyond.

Nobody knows how long the COVID-19 crisis will continue or what the post-crisis landscape will look like.

However, one thing is for certain – in order to survive this difficult period, businesses are going to need the support of their lenders. They will also need their lenders to help them take full advantage of the recovery when it finally comes.

As businesses navigate the uncertain waters of the COVID-19 world and beyond, access to cash is and will remain a primary concern.

The unique characteristics of asset-based lending make it the ideal financing product for these turbulent times.

What is ABL?

ABL is a form of lending in which the lender advances money against the value of specific assets of the borrower.

An ABL lender considers which of a company’s assets are eligible for financing and then sets different ‘advance rates’ in respect of them. These eligible assets will then form the ‘borrowing base’, the value of which from time to time determines the amount of funding available to the borrower.

Typically these assets include the company’s accounts receivable and its inventory but an ABL lender may also lend against a company’s plant and machinery, real estate or intellectual property.

The amount advanced is a function of two elements: (i) the advance rate and (ii) the eligible assets to which the advance rate is applied. In relation to accounts receivable, this can range from 60% to 95% but is usually around 85% or 90%.

Some lenders will even advance against unbilled work in progress (albeit at a lower advance rate than for accounts receivable) and specialist ABL lenders with particular expertise in a certain industry may offer higher advance rates in relation to specific assets. This means that an ABL facility may allow a company to borrow more than a traditional cash flow based loan.

Advances against accounts receivable and inventory are normally structured on a revolving basis, whereas loans against hard assets such as real estate or plant and machinery are usually term loans.

How does ABL differ from cash flow based lending?

As the name suggests, cash flow lenders underwrite lending transactions on the basis of the borrower’s cash flow and its expected profit over the term of the loan.

In this scenario, the amount of lending to be made available is calculated by reference to certain financial ratios - in particular leverage (net debt / EBITDA), cash flow cover and interest cover.

By contrast, an asset-based lender looks primarily to the value of the borrower’s assets and calculates borrowing availability by reference to these assets, rather than to the borrower’s cash flow. This is because certain assets will maintain their value as collateral even when the company is experiencing difficulties with its cash flow or profitability.

Advantages of ABL

Flexibility

ABL is increasingly provided by alternative lenders, such as debt funds or specialist ABL funders. These lenders are often less tightly bound by the regulatory requirements or prescriptive credit criteria affecting traditional (i.e. bank) lenders. As a result, they often have more freedom to design bespoke financing solutions to fit a particular set of circumstances and more scope to exercise discretion when the borrower is facing challenges.

In addition, the lack of banking regulation and multi-layered credit approvals can mean that an alternative lender may be able to reach a decision much faster than a traditional lender.

Costs

The margins on asset-based lending facilities vary widely depending upon where the borrower is on the credit spectrum. However, in most cases, the margin on an ABL facility will be lower than on an equivalent cash flow based RCF. In addition, the costs of non-utilisation on ABL facilities are also usually lower than they are on a traditional RCF.

Fewer financial covenants

Traditional forms of lending may require stringent financial and other covenants as well as rigid facility limits and repayment provisions. For lenders providing such products, it can be harder to adjust their exposure in order to accommodate dramatic fluctuations in performance, such as those caused by the current COVID-19 crisis.

In a downturn, a financial covenant in a leveraged loan can easily be triggered, even though the underlying business could be sound. By contrast, ABL finance documentation often contains no or only very limited financial covenants. This is because, as explained above, ABL lenders underwrite transactions mainly on the basis of the borrower’s assets and not its cash flow.

As a result, ABL lenders will often be more comfortable than cash flow lenders when it comes to lending to businesses facing challenging circumstances.

Recovery

When the recovery finally arrives, some businesses are likely to face a surge of work as a result of pent-up demand. These companies will need to be able to move quickly to meet this demand, which means having access to funding which can scale up very quickly as business activity increases.

This may be a challenge for cash flow lenders, who will find it difficult to fund a company on the basis of its expected EBITDA – however, an ABL lender can provide a facility on which availability increases automatically as trading accelerates. This means that the product is ideally suited to a business which currently has weak EBITDA but for which rapid growth is expected.

A note of caution

Borrowers considering an ABL facility need to be aware of the following:

  1. Because asset-based loans are closely tied to specific assets of the borrower, they typically involve extensive reporting and monitoring of the borrowing base assets. This can make them more onerous to manage than a traditional cash flow based loan.
     
  2. ABL facilities typically afford the lender considerable discretion to adjust its exposure as conditions vary. For example, it is very common for an ABL lender to have the power to implement reserves (i.e. reductions in availability) for specific reasons but also if the ABL, acting in accordance with its “reasonable credit judgement”, deems it necessary to do so. This can sometimes make CFOs nervous that the ABL lender may reduce availability at precisely the point at which it is needed.

    However, in practice, ABL lenders do not, in most cases, implement reserves or otherwise dramatically reduce availability unless there is a clear need to do so e.g. if there is a fraud, a rapid deterioration in the quality of the funded assets or some other unforeseen circumstance. Like all financial services organisations, they have reputations to uphold, which makes it highly unlikely that these discretions would be used arbitrarily or capriciously.

    As with all forms of lending, the key to avoiding problems is to ensure open and early communication with the ABL lender.
     
  3. Receivables and inventory facilities are dynamic, revolving facilities designed primarily to provide working capital. Borrowers should exercise caution if they wish to use these facilities to finance capital projects or repay term debt, as this could create a problem if the borrowing base decreases and the borrower has to repay some of the facility. In such circumstances, if significant cash receipts have been used to repay term debt or to fund capital expenditure, the company could find itself unable to repay the revolving ABL facility. It is therefore very important that borrowers understand the dynamic nature of such facilities and ensure that there is adequate working capital headroom to manage a reduction in availability.

Conclusion

UK businesses have billions of pounds worth of assets which could be unlocked and used to finance growth. However, for various reasons, many corporates are not currently accessing this liquidity.

These reasons may include a lack of familiarity with ABL, a reluctance to move away from traditional forms of borrowing and / or a perception that ABL facilities are too onerous or expensive.

However, for many businesses, ABL could be the financing solution that they need to help them manage this difficult period and then expand into the more prosperous times ahead.

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KEY CONTACT

Don Brown

Don Brown
Partner

T:  +44 20 7809 2042 M:  Email Don | Vcard Office:  London

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