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Asset-Based Loans: The Solution for Volatile Times

06/03/2020 Ron Kerdasha, SVP, Fifth Third Business Capital

Asset-based lending thrives in challenging situations. Learn how asset based loans may be a successful solution for businesses during COVID-19.

When 2020 dawned, every indicator pointed to a year of solid performance across the business landscape. Then came the COVID-19 pandemic, bringing challenges that no one—neither business leaders nor their advisors—had ever faced. The whiplash from an economy that was humming to record unemployment took just over a month.

Principal among the challenges in the coming months for many small and medium-sized companies: how to recalibrate finance strategies and structures to support the need for working capital, investment in capital equipment, along with funding both organic growth and acquisitions. For many of those companies and virtually all of those needs, the answer can be Asset-Based Lending (ABL).

A Proven Strategy for the Economic Downturn

Asset-based lending has long thrived as a solution in challenging situations. “Asset-based lending is a flexible financial solution that is able to provide credit through the credit cycle and the life cycle of a company, and I think we will see that … more and more… as this situation unfolds,” predicts Richard D. Gumbrecht, CEO of the Secured Finance Network.

Overall, ABL parameters rarely deviate—no matter the market conditions—and can be structured to accommodate companies with lower operating margins or who may be working through a distress situation. A key difference between ABL and cash flow financing is covenant structures that are typically less restrictive and easier to manage through in the event of a default.

A key covenant for cash flow financing, Total Debt to EBITDA, can change rapidly when performance declines, making it a significant issue when the lender has tied much of underwriting to that measure. ABL lenders, on the other hand, design a lending package by first analyzing the liquid aspects of a company’s asset pool, then formulating a credit facility around advances against accounts receivable, inventory, equipment or real estate. ABL financing packages may also include lines for capital acquisitions, thereby preserving liquidity for other financial goals.

Another attractive feature for companies considering ABL is cost. Because most of the loans provided by ABL lenders are collateralized and covered by assets with a perceived lower risk profile, they can offer a cheaper alternative to higher leverage debt packages based purely on cash flow—typically 150 to 200 basis points lower—and come with lower closing fees.

A Key ABL Benefit for Now: No “Financial Distancing”

Many cash flow lenders, having pushed the limits on leverage, tend to be more proactive in protecting themselves with a covenant default. Not so for ABL lenders; they are set up to monitor loan exposure on a continuous basis, often monthly. This allows them to become intimately familiar with working capital cycles of borrowers.

While this may create extra work for a company as they adhere to reporting requirements, stockholders and management see this heightened level of oversight as a valuable supplement to their own financial tracking, particularly in volatile times. The same can be said for junior lending partners who know the ABL lender is paying close attention to liquidity dynamics.

A Team Approach

ABL, coupled with a tranche of “last out” or subordinated debt, may be a safer approach for many middle-market businesses. It may offer a lower overall risk profile and support for capital preservation. Being able to turn to a team of lenders with deeper resources, as opposed to one lender, also may mitigate risk in executing strategies in a company’s future—whether that’s navigating through a crisis or even executing a growth plan.

The proof of this strategy can be seen in the strong relationships built over the years between ABL lenders and junior debt partners. These relationships offer benefits for all participants:

  • For borrowers, this two-tiered debt approach can be a benefit. Lenders with a history of completing financings together often have legal document templates in place and know each other’s processes and work styles. This lowers the risk of lengthy or failed loan execution.
  • Junior debt providers gain comfort in knowing an ABL lender is closely monitoring a borrower’s business trends and is more likely to act pragmatically in a crisis.
  • Senior lenders appreciate that the junior lender is often proactive with management and ownership, and may even hold a board seat or have observation rights.
  • And lenders with existing relationships provide for effective lines of communication, a lack of confusion and rapport with the management team that benefits all.

Looking to the Future of M&A

Today, middle-market companies across most industries are solely focused on managing through the pandemic crisis, as are their advisors and lenders, with most growth strategies—organic, merger or acquisition—on hold.

As Forbes painted the picture: “Among other things, executives of companies that would typically have been strategic buyers have been forced to redirect the focus and energy of their teams toward the immediate health of their own companies and away from longer term goals that include pursuing growth through acquisition strategies. Similarly, private equity sponsors have spent an increasing amount of time on efforts to strengthen or save their existing portfolio companies, at the expense of new deal activity.”

When the curtain does begin to lift on recovery, the M&A sector and the business economy in general, likely will not see a hasty return to business-as-usual. The Wall Street Journal forecasts “… a painfully slow recovery, with many Western economies, including the U.S. and Europe, not back to 2019 levels of output until late next year—or beyond.”

In an environment roiled by uncertainty—now and moving forward—ABL structures may be a more prudent way to finance acquisitions, particularly for manufacturing and distribution companies. The equity gap to be filled may not be materially different than a cash flow structure as purchase price and leverage lending multiples pull back in response to volatility created by the pandemic.

The distressed buyout market will eventually heat up. Here, too, there is a role for ABL structures, which always lead with a revolving line of credit. Draws against revolving lines of credit have several under-appreciated features in the absence of scheduled principal amortization and the borrowing base expansion that accompanies growth in sales, which provides added liquidity without a term loan. These features can lower fixed charges, making it easier to meet covenants and free up cash flow to reinvest in a recovering or growing business.

Preparing for Recovery

As businesses look to the future, ABL may be the answer to solid execution for sound and strategic planning—for both companies and their advisors. As organizations begin to consider their first steps back to financial stability, ABL can be a powerful tool, particularly in capital intensive industries. The capital structure can be diversified, borrowing capacity can be freed up for other purposes and businesses gain a source of working capital.

When the time comes, contact an ABL specialist to discuss your unique financing needs and options. Find out more about Fifth Third Business Capital's ABL expertise and financing options here.

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