Asset Based Lending, P.33 (See References for OCC Publication

BASICS OF ASSET-BASED LENDING FOR BANKERS

1 Dev Strischek, Principal Devon Risk Advisory Group, LLC [email protected] or 404.394.6294

ABL 2020 2 Agenda

 Definition of Asset-Based Lending (ABL)  Characteristics of ABL Clients  Evaluation of and Lending on Accounts Receivable  Evaluation of and Lending on Inventory  Structuring a Working Capital Line of Credit  Administration of Lines of Credit  Closing and Summary

ABL 2020 3 Agenda

ABL 2020 4 Primary Collateral

 Seasonal lending’s primary collateral is the borrower’s own working capital assets  Cash  Inventory  receivables  Securing the loan with the assets being financed ties the purpose (seasonal working capital financing) to the use (seasonal working capital expansion) and repayment source (seasonal working capital contraction)  Cash conversion cycle efficiency is key to operating cash flow—how long cash is converted into and tied up in inventory and receivables before it returns to its cash state as well as its quality in each state:

Working capital asset Turnover ratio or days outstanding Quality of working capital asset analysis measure cash 12 or 30 days Cash in escrow inventory 4 or 90 days Unsaleable inventory receivables 6 or 60 days Uncollectible receivables

ABL 2020 2020 Collateral Underwriting Principles

 The Bank’s right to repayment from collateral requires borrower to default first  So Bank’s reliance on repayment from collateral requires valuation at time of default  Risk factors to consider:  liquidity  Present value of cash received at time of liquidation  Value at default  Marketability  Perishability  Control  Physical  Legal  So what is collateral value shrinkage or Loss Given Default (LGD)  Conversely, what LTV protects us against LGD?

5 ABL 2020 Collateral Analysis

 Assets in existence at loan’s inception  Cash  Investments  Receivables  Inventory  Fixed assets  Intangibles  Assets subsequent to loan’s inception  New or replacement assets  Rents, leases, and other pledged cash flows Contracts to validate and support certainty of cash flows Secure receipt of flows via lockbox

6 ABL 2020 Collateral Analysis  Analysis  liquidity  Now is better than later  Marketablity  Commodity vs. one-of-a-kind asset, e.g., red #2 wheat vs. DaVinci’s Mona Lisa  Publicly traded market vs. no ready and willing buyers,  Perishability  Crops and livestock vs. equipment and buildings  Expiration of licenses, copyrights, patents  Control  Physical possession  Perfect lien on asset supported by lockbox, physical audit, lockbox  Perfected lien on asset  Blanket lien  Abundance of caution  Springing lien  Negative pledge  Unsecured  Claims of other lenders and creditors?  Typical LTV’s  Current value at loan’s inception is not always value at point of loan’s default  So maximum LTV should reflect loss given default, 75% LTV means value can decline 25% and 7 remaining value is enough to repay the loan ABL Collateral Valuation Summary 2020

Factors to Consider in Collateral Value Analysis

Collateral Asset Options (See liquidity Marketability Perishability Control Typical LTV’s App F)

Cash

Investments

Receivables

Inventory

Fixed Assets

Intangibles

8 ABL Collateral Valuation Summary 2020 Factors to Consider in Collateral Value Analysis Collateral Asset Options liquidity Marketability Perishability Control Typical LTV’s

Cash -Immediate -face value Not applicable Physical Cash- 90 to 100% -restrictions on Possession liquidation Investments -margin call -market value -not applicable --physical -50-75% -SEC 144 possession or tri- -closely held stock party agreement

Receivables Collection -quality of customers Not applicable Perfection 50-80% period w/UCC Inventory Production -raw materials (RM) Foodstuffs Perfection RM- 50 to 75% period -Work-in-progress WIP) w/UCC WIP- 20 to 50% -Finished goods (FG) FG- 50 to 75% Fixed Assets Depends on -Depreciated value Maintenance Perfection Land- 50 to 60% type of FA -mobility w/mortgage Bldgs-50 to 89% Equip-50 to 75% F&F- 10 to 50% Intangibles Depends on -depends on demand Expiration of Perfection Depends . . . type of for item patent, w/UCC intangible copyright

9 ABL Reaper Corporation Assets 2020 The company’s assets available for collateral:

Cash $25,000 Receivables. Net 275,000 Inventory:  Caskets $250,000  Embalming supplies 100,000  Burial wardrobes 50,000  Total 400,000 Net Fixed assets:  Land $100,000  Building 50,000  Equipment 35,000  Vehicles 15,000  Total 200,000 Trademark 100,000 Total Assets $1,000,000

10 ABL Reaper Collateral Valuation Summary 2020 Corporation Assets Current liquidity marketability perishability control LTV % Collateral Available for Value ($) Value ($) Collateral Cash 25,000

Receivables, net 275,000

Inv-caskets 250,000

Inv-embalming 100,000 supplies Inv-burial 50,000 wardrobes NFA-land 100,000

NFA-bldg 50,000

NFA-equipment 35,000

NFA-vehicles 15,000

Trademark 100,000

Total 1,000,000 11 ABL Reaper Collateral Valuation Summary 2020 Corporation Assets Current liquidity marketability perishability control LTV % Collateral Available for Value ($) Value Collateral ($M) Cash 25,000 90 22.5

Receivables, net 275,000 80 220.0

Inv-caskets 250,000 50 125.0

Inv-embalming 100,000 50 50.0 supplies Inv-burial 50,000 50 25.0 wardrobes NFA-land 100,000 80 80.0

NFA-bldg 50,000 80 40.0

NFA-equipment 35,000 50 17.5

NFA-vehicles 15,000 50 7.5

Trademark 100,000 0 0

Total 1,000,000 59 587.5 12 ABL 13 OCC Expectations for Borrower Analysis  What distinguishes ABL from operating cash flow lending is the reliance on funds provided by the conversion of working capital assets to cash. Key criteria that must be met in assessing an ABL facility on a “liquidity” basis include  a properly structured, controlled, and monitored credit facility.  a facility that is self-liquidating in nature, with minimal reliance on illiquid collateral or over-advances.  reasonable liquidity and excess availability trends (or in line with plan) with no extraordinary liquidity needs.  a facility that is stand-alone with a senior lien position and not subordinate or pari passu with respect to other debt.  reliable projections of future liquidity and borrowing needs.  a viable turnaround plan, if applicable, with actual performance reasonably in line with plans.  If these criteria are not met, the facility should be evaluated on a cash flow basis.

ABL 2020 14 Regulatory Ratings Red Flags on ABL Transactions

 The following list provides some characteristics that deserve an examiner’s attention and may warrant an adverse risk rating:  Failure to meet earnings or liquidity projections.  A significant unplanned increase in cash burn or a decline in revolver availability.  Excessive leverage.  Unexpected debt needs outside of the ABL revolver.  Significant recurring losses.  Frequent over-advances with unreasonable repayment structures.  Failure to perform on a related debt.  Failure to provide timely financial information, including collateral monitoring information.  An adverse rating may also be appropriate if the bank must liberalize advance rates or definitions of eligibility, including the addition of fixed assets to the borrowing base, to keep the loan within formula.  If liquidation of collateral (e.g., a forced sale by the bank or borrower) is an ABL loan’s most likely source of repayment, the loan would likely be classified as substandard Source: OCC Handbook on Asset Based Lending, p.33 (See References for OCC publication

ABL 2020 15 ABL Borrower Trends to Watch Out For  Trends in borrower’s operating cycle and overall financial performance can signify credit or collateral quality deterioration that could lead to an adverse risk rating.  The following are examples of factors the lender and the examiner should investigate as the factors occur:  Slowing inventory turnover or accounts receivable collection.  Recurring inventory write-downs.  Prime inventory sell-offs that adversely alter the mix of inventory.  Extended payables.  An inventory buildup not supported by sales.  An out of formula borrowing base.  Adverse field examination or appraisal results.  Increases in monthly cash burn and liquidity needs.  An unstable or rapid decline in excess availability.  An operating performance that deviates materially from planned performance.  Borrower inability to provide reliable projections of liquidity and borrowing needs

ABL 2020 16 What is Asset Based Lending (ABL)?

 Asset-based lending (ABL) is a type of commercial lending designed to finance the working capital needs of a borrower whose cash flow may not support debt repayment but liquidation of the borrower’s collateral can repay the debt  Cash flow is the primary repayment source for an asset-based loan but with stronger reliance on the company's assets as collateral.  Collateral typically available to secure the asset-based loan includes accounts receivable, inventory, machinery and equipment, general and specific intangibles, real estate, and other assets.  Because working capital support is the primary use of most asset-based loan facilities, accounts receivable and inventory generally are the bank's core collateral.  Personal guaranties, often secured, provide additional support

ABL 2020 17 What is ABL?  Monitoring and controlling collateral is critical to the asset-based lender’s ability to mitigate credit risk.  Collateral evaluation begins with a comprehensive field examination to determine value, followed by a continuing program of periodic examinations.  The collateral and loan values are monitored continuously (daily/weekly/monthly) to ensure that the realizable value of the collateral is always sufficient to repay outstandings.  The bank generally exercises control over the borrower's cash and the proceeds of the collateral. Receivables are collected by the bank through lockbox arrangements, with collections applied by the bank directly to the outstanding loan balance. Subsequent loan advances are made only on written evidence of the existence of additional collateral.  3 pillars of ABL  Cash dominion—lockboxes controlled by bank to receive payments from borrowers’ customers  External audit—random audits of borrower’s collateral conducted by bank’s auditors  Borrowing base—calculation of lendable value of collateral

ABL 2020 18 Keys to Successful ABL Transactions

 Appropriate credit policy and underwriting  Accurate evaluation of underlying collateral (A/R and Inventory)  Appropriate transaction structure (Advance Rates)  Appropriate secure transaction (Loan Documentation)  Effective and successfully executed monitoring plan

ABL 2020 19 OCC Expectations for ABL Policy

 ABL policies should be in writing and initially and periodically reviewed and approved by a bank’s board of directors. At a minimum, the policies should address:  ABL goals, objectives, and risk limits and expectations.  loan approval requirements that mandate sufficient senior-level oversight.  staff responsibilities for establishing and maintaining sound underwriting standards and prudent credit risk management controls.  standards for liquidity and collateral monitoring, advance rates, field audits, and loan covenants.  standards for liquidity and collateral monitoring, advance rates, field audits, and loan covenants.  pricing policies that ensure a prudent trade-off between risk and reward.  management’s requirements for action plans to use when conversion cycles, collateral values (quality of the borrowing base), or operating cash flow decline significantly from projections. Action plans should include remedial initiatives and triggers for risk-rating changes, changes to accrual status, and loss recognition.

ABL 2020 20 Agenda

ABL 2020 21 Characteristics of Prospective ABL Borrowers

Characteristics Prospective Customers

 High sales growth.  Customers  Larger, longer-term financing gap  Manufacturing  Seasonality.  Distribution  Larger, longer short-term gap in  Wholesaling peak season  Importing  Long-term capital commitments.  Service  Financing gap never goes away  Any companies which deal in  Acquisition financing. business to business transactions where goods and services are  Larger inventory/accounts present and receivables and receivable inventory are present.  Weakened creditworthiness due to heavy borrowing.

ABL 2020 22 Agenda

ABL 2020 23 Evaluation of and Lending on Accounts Receivable

 Tools for General Evaluation of Accounts Receivable

ABL 2020 24 Key Elements in General Evaluation of Accounts Receivable:

 Key Elements in General Evaluation of Accounts Receivable:  Who is the receivable from?  What are the terms?  Is the sale complete?  Is there the possibility of dispute of the receivable?  How long is the collection cycle (A/R turnover)?

ABL 2020 25 Application of Tools:

 Who is the Receivable from?  Large, Well Capitalized Company- Most Desirable  Publicly traded Companies, Larger Private Companies (Coca Cola, WalMart, etc.)  Company in Financial Distress or Less Credit Worthy- Least Desirable  Small Independent Businesses, Individuals, etc. (Contractors, restaurants, etc.  •What are the terms?  –Standard Terms or Less - Most Desirable  –Extended or Unusual Terms - Least Desirable  •Dated Receivables (Seasonal)  •Consignment / Guaranteed Sale

ABL 2020 26 Good Accounts Receivable

 Sale to: Coca Cola, Amazon, Home Depot, etc.  Sale of: A commodity product  Invoice Size: Large, but not too large ($5,000-10,000)  Delivery: Picked Up and Signed For  Due: In 15 Days

ABL 2020 27 APPLICATION OF TOOLS  Is the sale complete?  Complete with Documentation—Most Desirable  (Bill of Lading, Verification, Etc.)  Lacks Shipment or Additional documentation

 Work In Progress- Least Desirable  Percentage Billings (payments based on % completed)  Progress Billings (payments made at set intervals until completion)  Is there the possibility of dispute of the receivable?  No Dispute, Sale Complete and Verifiable- Most Desirable  Possibility of Dispute due to workmanship or Completion of Sale- Least Desirable  How long is the collection cycle (A/R turnover)?  Consistent with or Better than Industry Averages - Most Desirable  Extended Collection Cycle,

 Higher than Industry Averages - Least Desirable

ABL 2020 28 Standard Ineligible Categories for Accounts Receivable: • Accounts Over 60 or 90 • Credit Memos Days from Invoice Date • Governmental • Customer Concentration Accounts • Cross Aged Receivables • Foreign Accounts • Receivable balances • Intercompany or over predetermined Affiliated Accounts credit limit • Progress Billings • Contra Accounts • Guaranteed Sales

ABL 2020 29 Rules of Thumb in Establishing Account Receivable Advance Rates:  Accounts Receivable Advance Rates typically range from 65 to 90%. The most typical advance rate range is 75-85%.  The higher the quality of Accounts, the higher the advance rate.  A general formula for estimating A/R advance rates = 100% minus (past due percentage + 10%) or 100% minus (dilution percentage + 10%)  Dilution happens when A/R is credited for any reason other than cash collection of an outstanding balance.  Dilution is the difference between the face amount of an invoice or group of invoices and what the customer or account debtor actually pays.  Non-cash credits include credit memos, bad debt write offs, fast pay discounts, and returns.  The dilution calculation shows the percentage of billings that are actually historically collected.

ABL 2020 30 Client Collateral to Avoid

 Construction Receivables (progress billings)  Medical A/R  Progress bill A/R  Sub-contract bill A/R  International Receivables  Inventory at numerous locations  Inventory in transit from foreign countries  Foreign inventory

ABL 2020 31 Issues to Consider in Accounts Receivable Availability

 Performance of Accounts  Concentrations (Both Historical and Seasonal)  If one customer represents 100% of your outstanding accounts receivable, you have a 100% concentration exposure  banks prefer to make line of credit loans to businesses that have less than a 10 to 15% concentration to any one customer.  Quality of Customer Base  Seasonality of Business

ABL 2020 32 Agenda

ABL 2020 33 Evaluation of and Lending on Inventory

 Tools for General Evaluation of Inventory  Rules of Thumb in Establishing Inventory Advance Rates  Credit Risk—liquidation of inventory will probably shut down borrower and its ability to repay from operations

ABL 2020 34 Tools for General Evaluation of Inventory

 What makes up the Inventory?  How is it accounted for?  How is it valued?  Is there a ready market for the Inventory?  What must be done to prepare Inventory for sale?  How long is Inventory sales process?

ABL 2020 35 Good Inventory  What is it:  A commodity good (lumber, gold, etc.)  Where is it:  A third party Bonded Warehouse  Accounted for:  Perpetual Accounting System  Valued:  Public Exchange  Buyers:  Many

ABL 2020 36 Application of Tools:  What makes up the Inventory?  Is there a ready market for the Inventory?  Commodity Good- Most Desirable  Large Number of Potential Buyers - Most Desirable  Components of Manufactured Goods - Least Desirable  Limited Number of Industry Suppliers

 How is accounted for?  Competitors- Least Desirable  Perpetual, real-time inventory  What must be done to prepare acctg. - Most Desirable Inventory for sale?  Periodic count, count-based  Completed and Ready for Shipment acctg.- Least Desirable - Most Desirable  How is it valued?  Assembly Required- Least Desirable  Price Set By Seller- Most  How long is Inventory sales process? Desirable  Immediate Buyers Available -  Market Driven- Least Desirable Most Desirable  Extended Sales Process - Least Desirable

ABL 2020 37 Rules of Thumb in Establishing Inventory Advance Rates:

 Inventory Advance Rates typically are much less than against accounts receivable. Typical ranges are 25-50%.  The more liquid the Inventory the higher the Advance Rate.  The more commodity in nature the Inventory, the higher the Advance Rate.  The more control a lender may exercise over the inventory, the higher the Advance Rate.

ABL 2020 38 Agenda

ABL 2020 39 Structuring a Working Capital Line of Credit

 The Ultimate Structure of the Line of Credit Should Reflect:  Collateral Risk which should be collectible in a liquidation  Appropriate Advance Rates based on prudent underwriting of the collateral  Availability which allows the borrower to accomplish its business plan  The Credit Risk Profile of the Bank

ABL 2020 40 Issues to Consider in Inventory Availability

 Maximum Exposure (both seasonal and non seasonal)  Limits on Inventory Advances ‐ Hard Dollar  ‐ Percentage of A/R Availability

ABL 2020 41 Protecting the Downside: Inventory Caps and Limits

 Hard Dollar Cap are the absolute maximum dollar amount of exposure the lender is willing to take on certain inventory under any circumstances.  Example: $1,000,000 line of credit, with an 80% advance on eligible A/R and a 40% advance on Inventory, with an Inventory Cap of $300,000.  Percentage of A/R Limits reduce the inventory exposure to a percentage of what a borrower can access to a percentage of accounts receivable availability.  Example: $1,000,000 line of credit, with an 80% advance on eligible A/R and a 40% advance on Inventory, limited to 50% of accounts receivable availability.  The best way to protect your downside is with a structure which references both.  Example: $1,000,000 line of credit, with an 80% advance on eligible A/R and a 40% advance on Inventory, limited to the lesser of $350,000 or 50% of accounts receivable availability.

ABL 2020 42 Agenda

ABL 2020 43 Administration of Lines of Credit

 The Collateral Loan Report is the primary document used to monitor a C&I or ABL Loan.  The quality of information provided in the Collateral Loan Report is critical to the collectability of the loan.  The Collateral Loan Report is a reconciliation of all changes to the  Collateral Base; that brings Borrower and Lender up to the present.  Borrowing base certificate is what borrower uses to support borrowing availability . . .

ABL 2020 Sample Borrowing Base Certificate 44

ABL 2020 COLLATERAL LOAN REPORT 45  The Collateral Loan Report Should Reflect:  Vendors within Terms  The collateral underlying the Loan at a point in  Collateral Performing time and  Line usage at 70% or less of total availability  What changes have occurred in the collateral  More Frequent Reporting should be base since the last report. considered if:  Frequency of Reporting  Business is having profitability issues (get on  The Frequency of Reporting should be determined this early!) based on:  Balance Sheet is weakend by a specific  Percentage Line Utilization event or is weakend over time.  Quality of Collateral  Vendor payable turnover is increasing, or there are signs of vendor pressure.  Strength of Credit (earnings, leverage, etc.)  The collateral performance (turnover of A/R  Quality of Accounting Function and Inventory) is weakening.  Most bank C&I Loans require monthly reporting, but  Line usage is increasing . do not hesitate to require more frequent reporting.  Frequency of Reporting Recommendations  Monthly Reporting:  Business Profitable  Strong Balance Sheet

ABL 2020 46 The Collateral Loan Report should have supporting documentation

 The Report should be supported by the following:  Completed collateral loan report as of month end.  A report of new billings (sales journal) for the month.  A report of collections (cash receipts journal) for the month.  An A/R Aging as of month end.  An inventory listing as of month end.  A monthly P&L and Balance sheet.

ABL 2020 47 Here’s a Simple Monthly Checklist for Lenders and Credit Officers  Review the month end A/R Aging. Do the following:  Review Summary Columns to see if Ineligible A/R has increased (Over 90 days).  Compare Gross A/R on the Collateral Loan Report to Month End A/R Aging (Check 1) and A/R on the Balance Sheet (Check 2).  Do they reconcile?  Review the month End Inventory Report. Do the following:  Compare Total Inventory on the Collateral Loan Report to Month End Inventory Report (Check 3) and Inventory on the Balance Sheet (Check 4).  Do they Reconcile?  Review the Monthly Sales Journal. Do the following:  Compare Total of Monthly Sales Journal to Sales on the Income Statement (Check 5) and Additions to Accounts Receivable on the Collateral Loan Report (Check 6).  Do they reconcile?  Review the Loan Balance on the Collateral Loan Report.  Compare the Loan Balance on the Collateral Loan Report to the Balance Sheet (Check 7) and Bank Records (Check 8).  Do the reconcile?

ABL 2020 48 Agenda

ABL 2020 49 Summary and Closing

 ABL is a viable financing option for cash-flow strapped companies if  Sufficient and adequate collateral exists  Their operating performance is reliable, growing sales, creditworthy customers, smooth cash cycle  ABL lending rests on 3 pillars  Lender has cash dominion  Lender has audit controls in place  Lender has borrowing base infrastructure  Trust but verify . . .

ABL 2020 50 Questions?

Dev Strischek, Principal Devon Risk Advisory Group, Atlanta GA [email protected] or 404-394-6294 or LinkedIn: https://www.linkedin.com/in/dev-strischek-b5b1b93/

ABL 2020 51 References and Resources

 Troy Childers and Marc Marin, Asset Based Lending: A Training Guide to Secured Financing, First Edition, Commercial Finance Institute, 2005, https://gatewaycfs.com/downloads/Asset-Based-Lending-Training- Guide.pdf  Comptroller’s Handbook: Asset Based Lending, Version 1.1, January 27, 2017, https://www.occ.treas.gov/publications/publications-by- type/comptrollers-handbook/asset-based-lending/pub-ch-asset-based- lending.pdf

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ABL 2020