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Asset-Based Lending Solutions by Both Specialists and Mainstream Banks

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Asset-Based Lending Solutions by Both Specialists and Mainstream Banks Capital Thinking Cheap, flexible and in fashion: CFOs are increasingly being offered asset-based lending solutions by both specialists and mainstream banks. Why wouldn’t you use it? We discuss the positives and negatives of ABL. ISSUE 4 FEBRUARY 2015 Just about every lender now has an asset-based financing product, sometimes labelled as structured finance. Why? Cost of capital. A bank’s cost of capital to be precise. The regulatory framework in 2015 sees ABL products carrying a lower cost of capital for a bank, as the loan is directly collateralised. All good for the banks and lenders. Good for corporates too? It certainly can be. Borrowers benefit from a lender’s lower cost of capital in the form of a cheaper margin. ABL products are very flexible and grow with your business. And they go way beyond basic invoice discounting. For CFOs though, buyer beware. The level of funding available goes down, as well as up, with changes in working capital. If you release a one off cash benefit from a new or uprated ABL facility, will your return on that cash be value creating for shareholders? Could you ever afford to not use ABL once you have started? What exactly is asset-based lending (ABL)? Asset-backed lending ABL is a form of secured lending where In this edition of Capital Thinking, Asset-backed lending usually involves some a loan is advanced against specific we look at five areas: form of securitisation, in which a number of assets of the borrower. In practice, the small, individual illiquid assets are sold by 1 Asset-based lending vs cash flow their originators (usually a financial institution) main focus of asset-based lending is lending to an SPV, which in-turn issues fixed-rate on current assets, primarily accounts securities to investors. These asset-backed 2 Favourable features of asset-based receivable and inventory. securities (ABS) are serviced by the cash lending flow from the assets pooled in the SPV, However, asset-based lending often 3 Use of asset-based lending in which also serve as collateral for the ABS. includes fixed assets, particularly plant transactions The types of assets which lend themselves and equipment and, to a lesser extent, to these structures are very broad but the 4 Types of asset-based lending most common examples are receivables real estate. These latter categories tend to financing from credit cards, motor vehicle leases and be used in addition to, and in support of residential and commercial mortgages. working capital facilities rather than on 5 Asset-based lending and unitranche structures a stand-alone basis, as specialist lenders Asset finance may be able to structure more favourable First though, it is useful to understand financing for fixed assets. the background of asset-based lending. Asset finance often refers to leasing and This type of lending originated in similar structures where the asset is owned Indicative of the new funding by the lessor and leased to the lessee/ landscape in which mid-market CFOs the US in the 1980s and has been a borrower. In many cases, this technique is now operate is the increasing use of well-established part of the financing used for big-ticket items such as aircraft, landscape for many years. In the ships and railway equipment, although ABL, particularly by financial sponsors. leasing is also widely used for a wide range The mid-market and especially non- US, according to Thomson Reuters, of much smaller value assets, with motor sponsor backed firms should understand reported volumes of asset-based lending vehicles being an obvious example. Some asset financed deals may also be structured the power and possibilities offered by were $83 billion in 2013, although this using a more traditional loan structure. ABL, either as an alternative to current was lower than the historic peak of sources of financing or as part of a wider $101 billion in 2011. financing package. ABL has been making steady inroads Much of this growth has been driven ABL is very attractive and can in the UK/Europe and, according to by private equity firms, which have be suitable across a wide number of the Asset Based Finance Association increasingly recognised the benefits situations. It can be an important tool in (ABFA), the supply of asset-based of ABL. In contrast, many corporates your capital structure. At the same time, finance hit a record high in the UK with seem less aware of the benefits. A recent mid-market borrowers must carefully £19.3 billion of funding provided to report from Lloyds Bank noted that navigate ABL, appreciating the approach businesses as at 30 September 2014. UK SMEs have £770 billion of untapped of ABL providers and how ABL differs assets that could be used to fund growth. from traditional cash-flow lending. CAPITAL THINKING | ISSUE 4 | FEBRUARY 2015 1 Three factors may explain this For true ABL, advances against conundrum: first, a lack of familiarity, if working capital are structured on a Grant Thornton’s take: not confusion, with the ABL offering; revolving basis, whilst loans against ABL is very much a mainstream funding second, reluctance on the part of hard assets are frequently provided as option in today’s market place. Borrowers and borrowers to abandon their traditional term loans (usually as a ‘top-up’ loan). financial sponsors are becoming increasingly bank lenders; and last, an outdated In general, where asset-based lenders aware of ABL as a straightforward way to perception on terms such as price. are providing a one-stop-shop financing unlock monetary value and boost liquidity Although ABL is unregulated in package for working capital and other from the balance sheet that is suitable in a the UK, it is regulated in some EU fixed assets, the working capital portion wide range of scenarios. countries, notably Germany and France. should comprise at least 60% of the In addition, in an effort to promote total funding, and other assets usually 2 the ‘advance rate’: the maximum best practice, ABFA introduced a self- 30% to 40%. percentage of the current borrowing regulatory framework in the UK and Asset-based lending rests on three, base that the lender is prepared to Republic of Ireland on 1 July 2013. inter-connected pillars: advance to the borrower. Whilst the Asset-based lending is often confused 1 the ‘borrowing base’: comprises the advance rate generally remains fixed, with other forms of finance, particularly eligible assets, which are available the size of the loan will fluctuate asset-backed lending and asset finance. to the lender as collateral and in line with underlying changes in However, as we discuss, these are excludes ineligible assets such as the current assets included in the significantly different from true asset- inter-company receivables and aged borrowing base based lending, which focuses on working receivables 3 ‘headroom’: the difference between capital items on balance sheet. the maximum amount of the advance (or the facility limit, if lower) and the actual amount drawn. Borrowing base, the advance The borrowing base, the advance and headroom and headroom Balance Eligible Maximum £’000 Advance rate Set out in the table opposite is a simplified sheet amount advance calculation of the eligible assets, the advance Accounts receivable 50,000 45,000 90% 40,500 rate, the borrowing base and the headroom. Inventory 35,000 20,000 55% 11,000 Borrowers should be aware that the maximum Plant and equipment 20,000 20,000 60% 12,000 advance may not always be available for Real estate 25,000 25,000 50% 12,500 drawing as lenders may sometimes place an Borrowing base 110,000 76,000 availability block (suppressed availability) Amount drawn 60,000 of 10% to possibly 15% on the facility, particularly in the absence of a Fixed Charge Headroom 16,000 Coverage Ratio (FCCR). Some lenders use the borrowing base to describe the maximum Many ABL providers would expect working capital to comprise the amount the lender is willing to advance. majority of the facilities, with 60% being a good rule of thumb. Calculating the advance: the effective rate The amount advanced is a function of One rule of thumb used in the more correct view is that the former two factors: the advance (or headline) industry to gauge the advance rate is refer to credits arising against the rate, and the eligible assets to which based on the following formula: receivables ledger (eg credit notes, that headline rate is applied to arrive at damaged or wrong goods delivered) 1-[2D + 5%] where ‘D’ is dilution the effective rate. and therefore take place over a period In the example of accounts To arrive at the eligible accounts of time. In contrast, ineligibles are receivable, the advance rate is the receivable, the balance sheet figure is immediate deductions made to the maximum percentage the lender adjusted by deducting excluded debts gross balance sheet receivables to is prepared to advance against the and ineligible debts. arrive at the eligible amount against eligible accounts receivable and The terms ‘dilution’ and which the advance rate is applied; typically ranges from as low as 60% ‘ineligible amounts’ are often used these typically include exports or to as much as 95%. interchangeably however, perhaps a amounts invoiced in advance. 2 CAPITAL THINKING | ISSUE 4 | FEBRUARY 2015 1. Asset-based lending vs. cash flow based lending The corporate lending market falls Typically, the former is based on the Conversely, asset-based lending is into two distinct groups: investment borrower’s expected (forecast) profits based on the value and quality of the grade and sub-investment grade. and cash flow over the life of the loan.
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