Asset-Based Lending

Asset-Based Lending

Adds Fetch and More to Its Repertoire

Asset-based lending has lost many of its mongrel characteristics and now fetches healthy companies that want to use this additional source of fund- ing. However, there is a fair degree of complexity to the due diligence required: valuing the , monitoring the performance of the company and the state of the asset values, and liquidating, if necessary. This article discusses the basics to help less experienced ABL lenders feel they are successfully taking these loans through obedience school.

by Salvatore Settineri sset-based lending (ABL), a specialized area of clude that, for their institution, the likelihood of secured lending, has its origins in factoring and repayment on these loans is low. In fact, experi- has been around for years. Historically consid- enced asset-based lenders analyze assets very closely Aered relatively high risk because of its frequent use to determine the likelihood of paying back the loan with troubled companies, this old “dog” of a product principal through the sale of assets in the event the has learned some new tricks. Today’s ABL has business fails. In 2004, Standard & Poor’s introduced become a mainstream product used by companies a new rating to the market, known as a “recovery across the credit spectrum. rating.” While S&P’s traditional ratings predict the The concept behind asset-based lending is sim- likelihood of default, the recovery rating supple- ple: Asset-intensive companies in need of to ments it by predicting the likelihood of recovering run their businesses can use their noncash assets as an outstanding loan in the event the company does collateral. In return, the asset-based lender makes a default. This concept has been very well received loan to the company based primarily on the value of by asset-based lenders. those assets, rather than relying on the more restric- tive financial ratios and other covenants used to pro- Determining What Assets Qualify tect lenders in traditional, cash-flow-based loans. If The crux of ABL is in qualifying the assets. In the company is not able to pay back the asset-based determining which assets qualify, asset-based loan, the lender liquidates the assets. lenders look at both the value of the assets as well as Traditional cash flow lenders not familiar with their ease of liquidation. Typically, asset-based the inner workings of the ABL product might con- lenders prefer to lend against current assets, because

© 2006 by RMA. Salvatore Settineri is a senior vice president at GE Capital Markets Inc., New York, New York, where he is responsible for the distribution of GE’s asset-based lending transactions. The author wishes to acknowledge Karen Van de Castle and Ned Reynolds at GE Commercial Finance for their help in creating this article. 26 The RMA Journal May 2006 Asset-Based Lending Adds “Fetch” to Its Repertoire they are more easily converted to cash, over a shorter time frame. However, fixed assets, such as In determining eligible receivables, a lender may also look at factors machinery/equipment and real such as receivables turnover, concentration of receivables, and the estate, may also be included as collateral, either to support a overall quality of the borrower’s receivables management systems. term loan or, in some cases, to support a revolving credit facility. In either case, the component of , and specialized prod- When considering inventory, the the borrowing base derived from ucts that have limited resale type of inventory (for example, fixed assets is capped at a per- potential are typically excluded raw materials, work-in-process, centage of total availability that from the borrowing base. finished goods), age, turnover, typically ranges from 15% to As mentioned earlier, and inventory management sys- 30%. This cap percentage is usu- machinery/equipment and real tems are all important. For ally a function of the type of estate can also be eligible as col- machinery/equipment, the type equipment involved, but is also lateral if the overall collateral mix (for example, specialized versus influenced by the competitive is more heavily weighted toward basic manufacturing), age, ease to environment and so may vary current assets. The determination dismantle and transport, and effi- considerably from deal to deal. to include fixed assets will be ciency...critical considerations. Typically, most of a compa- made on a case-by-case basis and ny’s are eligi- will be influenced by the financial Tools Used by ABL lenders ble collateral to secure an ABL condition of the borrower. To measure collateral value, facility. However, receivables that the ABL market uses certain fall into certain specific categories Determining Advance Rates tools, including asset or field may be excluded. Common Once the pool of eligible ; initial and ongoing examples of ineligible receivables assets has been identified, the appraisals; ongoing borrowing base would include receivables 90 or advance rates against each type of reporting as well as close monitor- more days past due, any intra- asset need to be determined. ing of assets through ABL-specific company receivables, and possi- The advance rate is the maximum loan reporting systems; and tradi- bly certain government receiv- percentage that can be borrowed tional covenant compliance ables and foreign source receiv- against the eligible assets. requirements. These tools are ables. In determining eligible Deriving the appropriate advance used to evaluate the values of col- receivables, a lender may also rate is critical because it deter- lateral and monitor those values so look at factors such as receivables mines how much exposure the that credit exposure can be man- turnover, concentration of receiv- lender will have to the different aged to achieve the highest level ables, and the overall quality of pools of assets. Most lenders seek of recovery in the event a compa- the borrower’s receivables man- advice regarding the appropriate ny’s cash-flow-generating ability agement systems. advance rate from outside from operations ceases and assets The nature of inventory col- appraisal firms that specialize in need to be liquidated. lateral varies by company and assessing the value of specific Field exam. Generally, a industry. Eligible inventory typi- types of assets. field exam involves a review of cally includes all finished goods When determining advance systems and procedures in addi- and marketable raw materials. rates, various factors must be tion to verification that the assets Depending on the manufacturing taken into consideration, depend- the company says it has are in process and the time necessary to ing on the type of assets under fact the assets presented as collat- complete production, it may be consideration. For example, eral. The primary focus of this possible, although less common, when considering accounts is to verify accounts receiv- to include work-in-process. receivable, the rate of dilution in able and inventory, and to identi- Damaged goods, slow-moving the receivables is very important. 27 debt write-offs, and incor- tion most of the liquidation Figure 1 Borrowing Base (as of a certain date, in millions) rect invoices. . This methodology can In addition to examin- be used for both retail and whole- Gross A/R $128.7 ing books and records, field sale inventory. Real estate is typi- examiners evaluate invento- cally appraised using a fair market Less: Ineligible (11.4) ry. They may visit locations value (FMV) approach. Net Eligible A/R $117.3 where inventory is ware- The borrowing base. The housed to verify that the Multiply: Advance Rate 85% borrowing base is the amount that locations actually exist and a lender is willing to lend against Net A/R Availability $99.7 that inventory is, in fact, specific assets. Once the field located at those premises. exam and appraisals are complete, Field examiners perform an advance rate against these Gross Inventory $34.1 other distinct tasks, for assets is established and the bor- Less: Ineligible (1.9) example, conducting test rowing base is set. The borrowing counts to verify that the Net Eligible Inventory $32.2 base is a dynamic document. It inventory systems are accu- can be provided as often as daily Multiply: Advance Rate (NOLV 76%*85%) 65% rate, testing the systems to or as infrequently as monthly. ensure that returned inven- Net Inventory Availability $20.9 Regardless of how often it is pro- tory is handled appropriately, vided, it must be updated to and confirming that dated reflect the changing levels of inventory is identified prop- Total Availability at Closing $120.6 receivables and inventory. erly and that the aging of Fundamentally, the borrowing Less: Drawn at Closing 110.6 inventory is being correctly base provides two critical pieces maintained. Less: Outstanding L/Cs of information: the level of eligi- Excess Availability $10.0 Appraisal. Demand for ble assets (typically receivables appraisals has grown in and inventory) and the advance fy any potential red flags that recent years. Lenders’ use of inde- rates against these assets. might lead to problems in the pendent valuations is now the Consider the following examples: future, such as customer concen- accepted practice because lenders • Gross receivables of $110,000 trations, pre-billings, excess value the independence and less $10,000 of ineligible inventory, dated or expired inven- knowledge of third-party reviews as receivables equal $100,000 of tory, and delinquent taxes. In well as the time savings involved. eligible receivables. The eli- gible receivables multiplied addition, field examiners test the Inventory, machinery/equipment, by the advance rate, in this quality of the accounts receivable and real estate are the primary case 85%, determine borrow- and verify that they are genuine. appraised assets, but trademarks ing base availability of Another top priority for an audit is and other intellectual property can $85,000 ($110,000- to identify the dilution of the also be appraised. $10,000)*85%=$85,000. receivables. Dilution is a measure- There are several ways to • An example for inventory fol- ment expressed as a percentage of determine the liquidation value of lows: $200,000 gross inventory total uncollected receivables. For assets, depending on the type of less $25,000 of ineligible example, 5% dilution means that asset being appraised. The most inventory equals $175,000 of for every dollar of receivables a common basis for inventory and eligible inventory. Assuming company bills, it will collect 95 for machinery/equipment valua- an NOLV of 72% and an cents (100%-5%=95% collection). tion is net orderly liquidation advance rate of 85% yields an inventory borrowing base of There are numerous possible value (NOLV). NOLV is the value $107,100 ($200,000- causes for dilution. Typically, that can be reasonably expected $25,000)*72%*85%=$107,100. companies have some form of following the liquidation of inven- The borrowing base primarily dilution for warranty returns, bad- tory after taking into considera- consists of current assets includ-

28 The RMA Journal May 2006 Asset-Based Lending Adds “Fetch” to Its Repertoire ing accounts receivable and inven- the size of the company, the with these loans, the investor base tory. At times machinery/equip- nature of the business, and the has grown significantly. In addi- ment and real estate can be number of locations, lenders are tion, the entrance of new included and monitored in a simi- often faced with a very complex participants has created a more lar fashion. Below is an example of task. As a result, the ABL market competitive, robust, and liquid a complete borrowing base using was historically an informal mar- market-place. This growth is current assets only. Note that, in ket where a relatively few, experi- expected to continue as more this example, the NOLV of inven- enced investors joined together to investors gain a better understand- tory is assumed to be 76.5%, provide a loan to a borrower. ing of the ABL debt product. ❐ which is multiplied by an advance As the ABL product has rate of 85% to derive the effective evolved in recent years, it has Contact Salvatore Settineri by e-mail inventory advance rate of 65%. begun to be used as an alternative at [email protected]. financing option for healthy com- Investors and the Development of the panies looking for “covenant- Capital Markets for ABL light” deals. The size of these While the concepts behind transactions has grown, bringing Share your comments or questions asset-based lending are relatively with it the need for professional about articles appearing in The straightforward, the due diligence syndication. Today, all of the RMA Journal with Beverly Foster at required to value the assets, mon- major market originators have itor the performance of the com- dedicated capital markets teams [email protected]. If contacting pany plus the asset values, and to for structuring and selling ABL the author directly, please "cc" liquidate, if necessary, is not sim- transactions. By syndicating ABL [email protected]. Thanks. ple. Depending on factors such as loans to banks that are less familiar

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