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. relevant asset relative to the amount Asset-based lending is part of the latter, Debt capacity is based on a variety borrowed. The underlying rationale is since it is secured lending in contrast of financial ratios, primarily leverage that certain assets retain their value over to investment grade loans, which are (where debt is calculated as a multiple the business and economic cycle and unsecured. of EBITDA), cash flow cover and can avoid impairment, even if the firm’s In practice, the credit markets adopt interest cover. This approach to lending profits are low or declining. two approaches to a credit decision: a is more appropriate for firms which Where both ABL and cash flow cash flow based approach and an asset- have few hard assets, but high margins lending exist, each is documented based approach. that can support cash flow based loans. separately, with separate collateral pools, different covenants and Quick comparison asymmetric reporting requirements.

Aspect Asset-based lending Cash flow based lending Confidential Invoice Discounting (CID), advances against inventory, Products Revolving Credit Facilities (RCF), term loans, unitranche Plant, Machinery and Equipment (PME) and Real Estate (RE) Based on net debt/EBITDA; ‘leveraged’ transactions Leverage Effectively based on advance rate against assets typically begin at >3.0x Fixed and floating charge determined by guarantor Security Fixed and floating charge on all relevant assets coverage (c. 85% of group EBITDA) Fixed charge coverage ratio (FCCR) or liquidity (based on Leverage, interest cover, cash flow cover, capex limits Financial covenants headroom); can also use cash-flow loan financial covenants (leveraged loans); incurrence covenants for bonds ‘Springing’ covenant usually based on minimum headroom 'Springing' covenant usually based on RCF Cov-lite deals (eg < 80%) utilisation > 25% Cash collection (daily), Sales & CNs (weekly), Financials Information covenants Monthly management accounts, quarterly compliance (monthly), stock & debtor valuations/reconciliations (quarterly), and reporting certificates, annual financials real estate and PME (annual) Permitted investments/ Negative covenants; incurrence-ratio based (bonds) or Typically no restrictions provided forecast covenant compliance M&A/dividends/capex hard-caps (LMA loans), grower baskets (Yankee loans) Wide variation between lenders in respect of both terminology Medium-sized deals based on LMA precedents whilst Documentation and commercial issues but documentation far more lender- large syndicated deals increasingly mimic high yield friendly than Loan Market Association (LMA) precedents bond terms

Liquidity trap? Grant Thornton’s take: ABL is predominantly used to help fund working capital, providing liquidity. This liquidity Asset-based lenders have a different can be very welcome. It is relatively easy to use and instant. But it can become credit focus from cash flow lenders. Given permanent – and troublesome if used for the wrong purpose. ABL facilities are not the availability of both asset-based and designed to invest in long-term capital projects, be used for amortisation of term debt cash flow lending structures, borrowers or to fund losses. But the instant liquidity can make it very tempting for companies to should consider both forms of financing use ABL for non-working capital purposes. techniques to ensure they obtain the most Cash availability under an ABL facility can go down as well as up. The borrowing competitive and optimal funding packages base is constantly changing; it is, after all, a revolving facility. On a frequent basis, the available. It’s common to see both asset- CFO recalculates the borrowing base. If the borrowing base has increased, more can based loans and cash flow based loans in be drawn down from the facility. If the borrowing base has decreased – a low point in a capital structure. the working capital cycle – then the CFO may have to repay some of the facility. The CFO has to make sure the funds are available. If cash receipts have been used for another purpose, this creates a problem. Borrowing short to fund long is the cause of many a corporate crisis.

Grant Thornton’s take:

If the asset-based lending facilities are solely used for working capital purposes then the company will experience the full benefits this form of financing offers. Conversely, if they are used for extraneous purposes, the company can find itself in a liquidity trap and it can become difficult to refinance or replace the facility. Used the right way, ABL is a powerful tool. Not used the right way, then small operational problems can be significantly amplified.

CAPITAL THINKING | ISSUE 4 | FEBRUARY 2015 3 2. Favourable features of ABL

1 Lower funding costs and Where firms have a material investment lower cost of capital in core working capital, the pricing “At their best, ABL facilities provide Currently, asset-based lending advantage is much greater if asset-based flexible funding, with relatively facilities attract lower margins and lending is used to finance most of the core low cash outflows for debt service, non-utilisation fees than comparable working capital. which in turn frees up cash for cash-flow based loans. This offers two Since asset-based lenders are often management teams to invest in significant advantages. First, in funding able to advance a high percentage growing the business” the seasonal peaks of the business against working capital, particularly Steve Websdale, Managing Director, (typically funded by a RCF), and debtors, financing a significant ABN Amro Commercial Finance second, in respect of the cost of capital proportion of the core working capital attributable to the core, or normalised, with asset-based lending could reduce working capital (see diagram below). the cost of capital significantly. This 2 Releases cash for investment and dividends Whilst most asset-based lending is a Working capital: reduced cost of capital cost-effective method of funding peaks 1. ABL can reduce the funding cost for seasonal peaks in the working capital cycle, its primary 2. ABL also reduces the cost of the core working capital so lower WACC benefit is in financing core, or normalised, 3. RCFs charge non-utlisation fees on unused commitment working capital. In this respect, ABL

1000 has two significant advantages: first, the 990 ability to release cash for dividends or to 3. Undrawn 1. Seasonal peak 940 Total RCF commitments 930 funded by RCF? fund other activities; and second, lower 920 funding costs. These benefits are best 880 explained through an example.

820 820 820 820 820 820 820 820 820 A target is acquired which has 800 2. Core (normalised) normalised accounts receivable of 760 working £20 million. Post-acquisition, the target capital 700 refinances the accounts receivable with

Jan '15 Feb '15 Mar '15 Apr '15 May '15 Jun '15 Jul '15 Aug '15 Sept '15 Oct '15 Nov '15 Dec '15 an ABL line, which is based on an advance rate of 85% on eligible accounts Note: the average working capital based on monthly figures is 850 receivable of £18 million. This releases a cash sum of With respect to the former, the advantage would be magnified for firms c. £15 million (£18 million x 85%) applicable margin for sub-investment with high levels of core working capital. which the target can use for various grade RCFs range from 300bps to 450 purposes, including funding for further bps compared to 200bps to 250bps for growth or to repay existing (and more asset-based lending facilities although Grant Thornton’s take: expensive) long-term loans used to fund this may vary by 50bps at either end The availability on an ABL facility will the acquisition. We have often seen this of the range. Similarly non-utilisation increase and decrease with changes in technique used following the acquisition fees for RCFs are usually 40% to the borrowing base. This can be useful of a distressed business to fund 50% of the drawn margin compared in businesses with seasonality. However, restructuring costs in a turnaround. with c. 75bps for asset-based facilities. it can create difficulties if the borrowing base suddenly contracts due to an However, these fees are generally 3 Built-in growth, seasonality and charged only where a significant unforeseen event (insolvency of a major continuity of funding portion of the facility is expected to customer) as liquidity would immediately contract. A key advantage of a traditional Businesses which are expected to remain undrawn for lengthy periods RCF, from a borrower’s perspective, is exhibit strong growth in the medium and the fees are often calculated on the that it is not linked to the borrowing base term present particular challenges to difference between the amount drawn and so provides more flexibility in this funding growth in working capital. and either the facility limit or a lower, regard. capped figure.

4 CAPITAL THINKING | ISSUE 4 | FEBRUARY 2015 This is especially acute when they collateral. Typical examples are limits on 5 Level of borrowing are reinvesting surplus cash back into debtor concentration, debtor turnover Typically, asset-based lenders will be the business, leaving little to fund the and stock turnover. If the facilities willing to advance a higher level of funds increased working capital requirement, include term loans, these will often be than a traditional RCF provider. An which typically accompanies growth. supplemented by one or more financial RCF lender will be willing to advance A distinction needs to be made maintenance covenants, the most up to 60% of accounts receivable between three different scenarios. common covenant being the FCCR whilst the asset-based lender can use an i Firms seeking a medium to long- (note that different lenders use different advance rate on up to 90%. However, term RCF, say from four to six years, definitions) although other financial in practice the difference is less marked which is typical of many PE led ratios may also be used including than these percentages suggest since the deals; leverage, interest and cash flow cover. RCF “advance” is based on the headline ii Firms seeking shorter-term RCFs Asset-based facilities have security balance sheet accounts receivable figure with maturities of one to three years and negative pledges in respect of their whilst an asset-based lender applies the and own assets, but do not require these advance rate to the borrowing base of iii Firms where the RCF is provided on controls over other assets in the group eligible accounts receivable. It must also an uncommitted basis as an overdraft which provides borrowers with the be stressed that RCF lenders approach and is repayable on demand, ability to use those assets as security for the credit from a cash-flow perspective typically with a few months’ notice. other forms of financing. This means so will not usually view the funding level borrowers can mix and match their in terms of an “advance rate”. For firms in the first category, the funding requirements using asset-based problem with an RCF is that it would lending in conjunction with other forms need to provide a very high level of of funding - for example, bonds, senior Grant Thornton’s take: headroom at the outset to accommodate and/or junior loan facilities or even the forecast growth over the life of the leasing arrangements. These structures Asset-based lenders have a very different facility and borrowers would be forced are gaining traction and we discuss them view of lending compared to cash flow to pay significant commitment (non- elsewhere in this edition. lenders, even though they may sit utilisation) fees on the undrawn element In general, smaller asset-based alongside their corporate debt colleagues in banks and financial institutions. The in the early years of the facility. Whilst lending facilities tend to be based on borrower needs to make sure they there could also be commitment fees due ‘standard’ documentation, whilst larger appreciate this perspective, focusing on on the undrawn element of an asset- deals require more bespoke drafting. borrowing base, headroom and FCCR, as based lending facility, these costs are One aspect which borrowers seeking opposed to EBITDA, leverage ratios and likely to be lower. asset-based lending must consider from debt service coverage. Borrowers in the second category, the outset is the lack of standardised with shorter-term RCFs, would need documentation in the industry. In our to renegotiate the RCF every few experience, there are significant and years which would entail a significant material variations in the terms and refinancing risk. conditions applicable between different “As more and more companies use Borrowers in the third category, are lenders. Obviously, for smaller deals ABL we see increasing advocacy theoretically at risk from being asked to using simpler ‘standard’ documentation, from our customers too, and this reinforces its growth and progress, repay their facilities at any point in time. set-up costs are lower and, assuming as good news stories spread. At best, asset-based lending facilities the borrower has adequate reporting ABL is a sensible way for banks can prove a cost-effective, flexible systems, deals can be implemented to lend, and a sensible way for solution for seasonal businesses, where relatively swiftly. the right companies to borrow the borrowing base and thus working especially to fund growth, satisfy capital fluctuates during the year in line core working capital needs with seasonality. Moreover, the same Grant Thornton’s take: and as part of the structure in acquisitions.” advantage applies to firms for high- Asset-based lending documentation is growth firms where the borrowing base generally far more lender friendly than Chris Hawes, RBSIF Director, UK Corporate Asset Based Lending, expands to accommodate permanent LMA-style facilities which have become Royal Bank of Scotland increases in the working capital increasingly borrower-friendly in the requirement. face of competition from more lenient, incurrence covenants applicable to high 4 Terms and conditions yield bonds (in larger deals) and the flexible Asset-based loans can include various approach to documentation, in smaller deals, by direct lending funds. Look out for operational-reporting covenants intercreditor provisions and exit fees. which tend to focus on preservation of

CAPITAL THINKING | ISSUE 4 | FEBRUARY 2015 5 3. Use of ABL in transactions

A Acquisitions sufficient liquidity, they will be prepared “Increasingly, there is evidence in multi- The nature of asset-based lending, with to recapitalise the business with a higher tiered capital structures of ABL sitting its focus on specific assets, means that level of debt. This includes to refinance alongside a combination of high yield, it can be used to fund working capital mezzanine and/or bifurcated facilities existing, more expensive debt, release alongside other forms of lending, including term loan elements provided equity to pay a dividend, or to reinvest typically senior and junior debt. by institutional debt funds.” in another part of the group. One of the emerging trends, Adam Johnson, Managing Director, particularly in private equity led deals, is Corporate Structured Finance, GE Capital D Restructurings and turnarounds the increasing use of asset-based lending Asset-based lending is well suited to to fund working capital. The main driver turnaround situations. Where a firm has for sponsors is the lower all-in costs of experienced distress accompanied by a asset-based lending although the other B Disposals sharp decline in profits, the contraction advantages discussed earlier are also Asset-based lending can also play a role in EBITDA and the multiple at which a important. in the disposal process. Many mid-to- bank may be willing to lend may leave In some cases the asset-based lender larger auctions use stapled financing (ie the business heavily over-leveraged can provide a composite, one-stop- a pre-negotiated term sheet, arranged on a cash flow basis. This leaves the shop package against all of the target’s by the vendor, which is ‘stapled’ to the borrower exposed either to a financial- eligible current and fixed assets. Whilst Information Memorandum and offered maintenance covenant or, in extremis, a the level of advance against fixed to all potential buyers, especially payment breach either of which could assets may be lower than other lenders private equity). A stapled financing lead to a loss of control by the owners. could provide, the structure offers package, which may be provided on The risk to the borrower will be the advantages of speed of execution a hard (underwritten terms) or soft magnified if all, or even part, of the loan and simplicity, together with the (indicative terms) can offer buyers is acquired in the secondary market by a other benefits described above. This (and thus the seller) important benefits distressed debt fund as they may seek to structure would be well-suited to firms compared to a buyer-originated funding use the default to accelerate and enforce with low margins, but solid balance solution. First, higher leverage, second, their collateral and acquire control of sheets, with a bias towards working more borrower-friendly terms and the business. Nor is this risk purely capital. Many acquisitions experience third, accelerated deal execution. academic (as shown by the recent case of unforeseen problems in the initial period In this context, sellers contemplating Ideal Standard). immediately post completion and using stapled finance for appropriate In contrast, since asset-based lending asset-based lenders’ focus on assets and targets should consider that including is predicated on the value of the assets, headroom means they may be better able asset-based lending as another financing rather than leverage, these lenders’ to accommodate temporary problems. option. In any event, buyers should also problems will not arise provided the One issue which borrowers need to revisit the target’s asset values to ascertain borrower’s assets maintain their value consider is the logistics of using asset- whether asset-based lending may be a through the economic or business based lending to finance the deal. The better option than a cash flow based cycle and provided the business has key issue here is whether the buyer has loan as the former could release cash sufficient cash to avoid any payment sufficient early access to the target to and reduce debt service by eliminating defaults. In addition, since asset-based enable the lender to perform its due amortisation and offering lower margins lending facilities include a significant diligence/valuation of the collateral, on the working capital facilities. portion of working capital, the lender’s conduct its credit process, negotiate the exposure should reduce in line with any legal documentation and, in the case of C Refinancings, recapitalisations contraction in working capital. large deals, arrange syndication. This and dividends Against this background, an asset- could take anything from a month for a Traditional banks are usually based lending package may prove a relatively straightforward deal to as long understandably wary of recapitalising a preferable option for an appropriate as ten weeks for a complex, syndicated business to allow a dividend to be paid. borrower with eligible current and fixed transaction. In contrast, because asset-based lenders assets, as it could support a much higher focus on asset values, provided they level of leverage. are satisfied that they have adequate headroom and the business retains

6 CAPITAL THINKING | ISSUE 4 | FEBRUARY 2015 Who uses ABL? 4. Main types of ABL financing

Preferred sectors A Accounts receivable (trade debtors) Asset-based lending is best suited to The financing of accounts receivable The alternative, debt purchase firms with large asset-rich balance is invariably at the heart of any asset- structure requires an outright sale of sheets where at least half the assets based lending package. It is unusual for the receivables to the funder/lender, and comprise working capital (accounts an asset-based lending package to be can be achieved in the following ways:- receivable and inventory). Many of structured without accounts receivable, i Confidential invoice discounting these firms will have low margins although common exceptions would (CID) where the borrower collects and/or fluctuating EBITDA which is apply to businesses which have high the debts as agent for the lender insufficient to support an appropriate levels of inventory such as retailers. and the debtor is unaware of these level of borrowing, for their working Advances are structured on a arrangements unless there is default capital, on a cash flow basis. Typical revolving basis, which is a function of and subsequent enforcement sectors well suited to asset-based the advance rate based on the eligible lending are shown in the table below. accounts receivable. The frequency with

UK Borrowers by sector Q3 Q2014* which invoices are presented depends Recourse vs. Non-recourse on the nature of the business, but is Borrowers may prefer to structure their 7.2% Services either daily or weekly (with monthly 4.6% receivables financing on a non-recourse 29% Retail being usually too infrequent). Advance basis as the cash from sale of the Distribution rates vary, but the headline advance accounts receivable will reduce debt 29.5% 1.1% Other rate can be as high as 95%. However, either by being used to actually repay Manufacturing borrowers should focus on the effective any loans or will reduce ‘Total Net Debt’ Construction 24.6% (as defined in the loan) by being netted 4% rate, after taking account of ineligible Transport and aged invoices. off against any outstanding debts. To Source: ABFA, October 2014 Two main structures have evolved qualify as a true sale the company must ensure strict compliance with for funding trade receivables; a loan The position in the more developed GAAP or IFRS, but must also be mindful structure or a debt purchase structure. US market indicates that services, that the transaction is not in breach of Under the loan structure, to state leasing and the retail sector account any other existing loan obligations. the obvious, the asset-based lender for roughly half of asset-based Non-recourse structures typically advances a loan to the borrower (who lending deal-flow, although oil and take two forms; non-recourse backed has originated the receivables) which by credit insurance paid for by the gas together with metals and mining is secured against present and future borrower and non-recourse where together account for more than 20%. receivables. The loan is structured on a the receivables are purchased at revolving basis which fluctuates daily as a discount with no recourse to the Deal size new invoices are raised and as payments borrower or credit insurance. The latter ABL can accommodate a very wide are collected from the borrowers’ is usually reserved for larger firms with range of deal sizes. Traditionally, customers. Market practice is for the well-established customers. smaller corporates were more likely proceeds to be paid into a ‘blocked’ to make use of asset-based lending, account under the control of the lender. with providers more comfortable This is vital as it ensures the lender knowing their loans to smaller, will benefit from a fixed, rather than a riskier firms had full collateral floating, charge over the receivables. backing. Under English law, the holder of However, in today’s market a fixed charge gets paid out of the asset-based lending is being widely proceeds of the sale of their collateral used by varying sizes of firms in a before all other creditors including range of circumstances. Very large preferential creditors if the originator is deals are syndicated, whilst small declared insolvent. deals are provided on a bilateral basis. Deals falling in the middle are usually clubbed between a small number of providers.

CAPITAL THINKING | ISSUE 4 | FEBRUARY 2015 7 ii Disclosed invoice discounting where vagaries of fashion (e.g. ladies’ or the borrower collects the debts as gentlemens’ clothing). Specific issues in calculating agent for the lender, but the debtor One further potential problem the advance for inventory is aware of these arrangements for asset-based lenders arises from The effective advance rate for iii Full service factoring where the Retention of Title (‘ROT’) issues. inventory is based on the Net Orderly Liquidation Value (‘NOLV’). The lender agrees to pay a percentage This affects both goods sold by the calculation starts with the balance of eligible debts as soon as they borrower to its clients and stock ‘sold’ to the borrower by suppliers. sheet value of inventory, but usually are presented, with the balance excludes work in progress, raw This affects goods on consignment or (less fees and charges) paid when materials and inventory subject to provided on the basis of sale or return/ the debtor pays. The borrower retention of title by suppliers, to arrive approval. For goods supplied by the will also outsource part or all of at the eligible inventory. its credit control. The level of borrower to clients, their contract This is then adjusted for three service provided can vary from must preserve both legal and beneficial items; the sales margin, a discount debt collection only, through to title to the goods until payment has for a forced sale and the costs of the lender providing a full service been made, coupled with requirements liquidation (eg salaries and sales from raising the invoices, debtor to ensure the goods are both commission, insurance and rent) management and collection. properly insured and are separately to arrive at the NOLV. The headline advance rate is applied to the book Asset-based lenders are able to identifiable to preserve the lender’s value of eligible inventory but the structure facilities on a recourse or security. Equally, goods supplied to the borrower which are also subject actual advance is reduced further even a non-recourse basis. In both by certain preferential creditors (eg to ROT will also be ineligible for an cases they will often require the the prescribed part and employee advance. originator to arrange or procure credit preferences) to derive the actual Branded merchandise can also insurance to mitigate the risk of non- advance amount. payment. prove problematic for lenders, if The “prescribed part” is the the supplier’s terms require the amount set aside for unsecured B Inventory borrower to return inventory post creditors from the assets covered by Many of the advantages which apply default to avoid flooding the market a floating charge and enjoys priority to financing accounts receivable apply and damaging the brand. In these vis-à-vis the floating charge holder. equally to inventory. However, there circumstances, lenders will be keen to Employees enjoy a preference in respect of wages and salaries. are some major differences, which ensure they have sufficient access to warrant explanation. the intellectual property rights (IPR) First, since the borrower usually to enable them to realise the inventory. C Plant, Machinery and Equipment requires complete flexibility in In evaluating their security, lenders (PME) and Real Estate (RE) managing its inventory, the loan is may also focus on the inventory mix invariably secured by a floating charge to ensure that there is no unduly high Asset-based lenders are willing to on the inventory held by the borrower concentration on a few line items consider funding for both PME and from time to time. that may be difficult to realise; the RE to complement the working capital Second, certain types of inventory classic example being a supplier of golf facilities. The advance is based on the are not suited to ABL. Eligible clubs where it transpired that a high estimated value that could be achieved inventory is restricted to finished proportion of inventory value comprised assuming a disposal within a three to goods and marketable raw materials (slow-moving) left-handed golf clubs. six month period. The value of the (e.g. commodities) whilst WIP (work- assets is supported by independent in-progress) is usually excluded Grant Thornton’s take: valuations conducted at the beginning unless it has some resale value and and at regular intervals during the life Presenting invoices on a weekly or even can be incorporated into another of the loan. a daily basis promotes a culture of strong In both cases the advance is manufacturing process. Lenders will financial discipline, with CFOs monitoring structured as a term loan in favour of also seek to exclude inventory which liquidity on a daily basis, allowing greater is difficult to sell because it is slow visibility and understanding of the the lender; PME is usually ‘plated’ to moving, obsolete or subject to the company’s cash cycle. enshrine the lender’s rights vis-à-vis

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8 CAPITAL THINKING | ISSUE 4 | FEBRUARY 2015 other parties (eg landlords) and also to For RE, terms can vary widely prevent double-charging. with some lenders requiring full Grant Thornton’s take: Advances against PME will amortisation over a comparatively Funding for PME and RE tends to be in the generally amortise fully over the short period (5 – 7 years) whilst form of a ‘top-up’ loan where such assets expected economic life of the asset, other lenders may be willing to allow represent a small part of the overall asset- although it may be possible to longer periods (15 years) with a bullet based lend. It enables borrowers to access structure a balloon payment if the asset structure. a ‘one-stop shop’ financing package. Where has some residual value at the end of such assets represent a more significant the term. Some plant and equipment part of the borrower’s assets, borrowers can be funded on a revolving basis, car will be able to obtain higher leverage over hire firms for example. PME and RE from specialist providers.

5. Bi-furcated structures with asset-based lending in tandem with unitranche and high-yield bonds

Financing structures in the US have default) with the cash flow lenders’ This is an irrevocable call, given long used asset-based lending in concerns that this would also cross to a cash flow lender, to acquire all conjunction with other forms of cash default into their loans which invariably of the asset-based loans in the event flow based lending including high yield comprise the majority of total of distress; typically either cross- bonds and, more recently, unitranche. borrowings. acceleration or possibly cross-default. In Europe, whilst asset-based lending is Market participants are considering frequently used with term loans, hybrid a raft of solutions to reconcile these Grant Thornton’s take: US-style asset-based lending/high yield competing interests across a broad bond structures have yet to fully take range of inter-creditor issues, in It seems likely that these bi-furcated off. Thus far, the adoption of these bi- particular; the duration of both structures will become more common- furcated structures has been inhibited standstill and enforcement periods, the place as both sides reconcile their interests. We are aware of one or two by inter-creditor issues which play out sharing of residual collateral and finally, solutions that are already in operation. differently in Europe and the US. by giving cash-flow based lenders an The key issue taxing the market is option to purchase the asset-based loans how to reconcile asset-based lenders’ in distress. desire to preserve the value of their collateral (which typically requires enforcement within 60-90 days post

Next time: effective working capital management

In the next edition of Capital Thinking, backed up with effective working capital driving consistent processes based we will be taking an in-depth look at management to ensure cash flow is around best practices can deliver material working capital management. managed properly. A well-structured cash flow improvements, adding value For CFOs of any size of company, ABL facility is not a substitute for for all stakeholders. improved working capital management effective working capital management. When evaluating the ‘self-help’ that is a key source of creating finance From a CFO’s perspective, a strong may be available, companies, sponsors internally. This complements, and often organisational focus on the importance and lenders need an understanding of the reduces the requirement for, raising of working capital management is various complex and interacting levers finance externally. fundamental to optimising the efficiency that can be used to drive a sustainable In the context of ABL facilities for of operations to support the delivery release of cash from working capital, working capital purposes and providing of strategic objectives. This approach which will be explored in our next liquidity, well-structured facilities can is frequently seen in financial sponsor edition. only take you so far. They need to be backed companies, where a focus on

CAPITAL THINKING | ISSUE 4 | FEBRUARY 2014 9 Appendix: illustrations of asset-based lending vs cash flow based lending

The following financial sponsor based examples illustrate how However, typical market practice at present can include a an ABL approach can result in a similar amount of leverage combination of ABL and cash flow facilities, as in Structure 4. as a cash flow based structure (Structure 1 and Structure 2 A similar level of leverage can be achieved as an all ABL respectively), though under the ABL structure, cash cover approach (Structure 3), although in this case, cash flow cover is headroom is greater given there is less or no fixed amortisation. greater in Structure 4 as more of the financing is in bullet form Structure 3 illustrates that when all assets on a balance (the TLB and mezzanine loans). sheet are utilised, a higher level of leverage can be achieved, It’s important to note that an asset-based lender will not look yet maintaining the same debt service coverage ratio as a cash at leverage multiples in the same way a cash flow lender will; we flow based structure. show the below multiples for comparison purposes only.

Structure 1: ABL financing Year 1 debt service

Gross Debt Eligible Advance Availability Margin Interest Amortisation Comments value Service

Accounts receivable 22,000 18,000 95% 17,100 2.25% 445 0 445 May be in form of CID; 80% average utilisation pa Stock 18,000 9,000 80% 7,200 2.25% 187 0 187 80% average utilisation pa Plant, machinery 10,000 6,000 60% 3,600 2.50% 109 960 1,069 Amortising over 3 years with 20% bullet and equipment Total 27,900 741 960 1,701

Structure 2: cash flow based financing Loan Facility size Leverage Margin Interest Amortisation Debt Service Comments RCF 2,000 0.3x 4.00% 80 0 80 80% average utilisation pa TLA 8,500 1.3x 4.00% 383 1,700 2,083 Fully amortising over 5 years TLB 14,000 2.1x 4.50% 770 0 770 5 year bullet Mezzanine 3,500 0.5x 6.00% 245 0 245 6 year bullet; will also include PIK interest Total 28,000 4.1x 1,478 1,700 3,178

Structure 3: ABL financing (as Structure 1, but including real estate assets) Gross value Eligible Advance Availability Margin Interest Amortisation Debt Service Comments Accounts May be in form of CID facility; 80% 22,000 18,000 95% 17,100 2.25% 445 0 445 receivable average utilisation pa Stock 18,000 9,000 80% 7,200 2.25% 187 0 187 80% average utilisation pa Plant, machinery 10,000 6,000 60% 3,600 2.50% 109 960 1,069 Amortising over 3 years with 20% bullet (a) and equipment Real estate 10,000 8,000 60% 4,800 3.25% 177 1,280 1,457 Amortising over 3 years with 20% bullet (b) Total 32,700 918 2,240 3,158

Structure 4: ABL and cash flow based financing Gross Debt Eligible Advance Availability Margin Interest Amortisation Comments value Service Accounts receivable 22,000 18,000 95% 17,100 2.25% 445 0 445 May be in form of CID; 80% average utilisation pa TLA 4,500 4.50% 223 900 1,123 Fully amortising over 5 years TLB 7,000 5.00% 420 0 420 5 year bullet Mezzanine 4,000 7.00% 320 0 320 6 year bullet; will also include PIK interest Total 32,600 1,408 900 2,307

Assumptions Structure EBITDA 6,800 Credit statistics 1 2 3 4 (a) Typical loan tenure for PME is between 3-5 years CFADS 3,840 Leverage (c) 4.1x 4.1x 4.8x 4.8x (b) RE loans would generally be over a longer period and with regular revaluations to minimise amortisation LIBOR 1% DSCR 2.3x 1.2x 1.2x 1.7x (c) Based on 100% utilisation at test date Non-utilisation fees ignored

10 CAPITAL THINKING | ISSUE 4 | FEBRUARY 2015 Debt Advisory

Midlands South and London and North South-West

David Ascott Tarun Mistry Matthew Bryden-Smith Nigel Morrison Partner Partner Director Partner T +44 (0)20 7728 2315 T +44 (0)20 7728 2404 Manchester Bristol M +44 (0)7966 165 585 M +44 (0)7966 432 299 T +44(0)161 953 6333 T +44 (0)117 305 7811 E [email protected] E [email protected] M +44 (0)7760 174 499 M +44 (0)7976 854 440 E [email protected] E [email protected] Ven Balakrishnan Jonathan Mitra Partner Associate Director James Bulloss Jon Nash T +44 (0)20 7865 2695 T +44 (0)20 7865 2407 Associate Director Manager M +44 (0)7771 837 809 M +44 (0)7815 144 280 Leeds/Newcastle Southampton E [email protected] E [email protected] T +44 (0)113 200 1516 T +44 (0)23 8038 1184 M +44 (0)7866 360 241 M +44 (0)7969 651 108 Catherine Barnett Shaun O’Callaghan E [email protected] E [email protected] Manager Partner, Head of T +44 (0)20 7728 3278 Debt Advisory Claire Davis Alistair Wardell M +44 (0)7980 870 523 T +44 (0)20 7865 2887 Associate Director Partner E [email protected] M +44 (0)7545 301 486 Sheffield Cardiff E [email protected] T +44 (0)114 262 9728 T +44 (0)29 2034 7520 Michael Dance M +44 (0)7789 076 601 M +44 (0)781 506 2698 Senior Consultant Mark O’Sullivan E [email protected] E [email protected] T +44 (0)20 7865 2583 Partner M +44 (0)7525 352 760 T +44 (0)20 7728 3014 Joe Dyke E [email protected] M +44 (0)7795 491 094 Associate Director E [email protected] Birmingham South-East David Dunckley T +44 (0)121 232 5210 Partner Christian Roelofs M +44 (0)7557 012 636 Richard Lewis T +44 (0)20 7728 2408 Director E [email protected] Director M +44 (0)7977 586 324 T +44 (0)20 7865 2193 Reading E [email protected] M +44 (0)7890 743 786 Richard Goldsack T +44 ((0)118 983 9651 E [email protected] Director M +44 (0)7538 551 468 Kathryn Hiddelston Leeds E [email protected] Partner, Head of Catherine Saunderson T +44 (0)113 200 2653 Tax Restructuring Associate Director M +44 (0)7736 329 722 Phil Sharpe T +44 (0)20 7728 2618 T +44 (0)20 7728 3065 E [email protected] Director M +44 (0)7976 994 321 M +44 (0)7827 872 461 Cambridge E [email protected] E [email protected] Raj Mittal T +44 (0)1223 225 609 Director M +44 (0)7798 662 609 Jeremy Toone William Jeens Birmingham E [email protected] Partner Associate Director T +44 (0)121 232 5177 T +44 (0)20 7865 2314 T +44 (0)20 7865 2546 M +44 (0)7974 026 177 Simon Woodcock M +44 (0)7808 478 783 M +44 (0)7970 982 999 E [email protected] Associate Director E [email protected] E [email protected] Gatwick Philip Stephenson T +44 (0)1293 554 092 Christopher McLean Associate Director M +44 (0)7912 888 669 Associate Director Leeds/Newcastle E [email protected] T +44 (0)20 7865 2133 T +44 (0)191 203 7791 M +44 (0)7825 865 811 M +44 (0)7974 379 719 E [email protected] E [email protected] Scotland

Rob Caven Ali Sharifi Partner Partner, Head of Corporate Finance Advisory Glasgow Manchester T +44 (0)141 223 0629 T +44 (0)161 953 6350 M +44 (0)7774 191 272 M +44 (0)7967 484 182 E [email protected] E [email protected] John Montague Director Edinburgh T +44 (0)131 659 8530 M +44 (0)7711 137 263 E [email protected]

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