Preparing for an Asset-Based Financing

Posted by John Slater on November 20, 2011

Many businesses have recently faced a new reality when they are abandoned by their traditional commercial banks and are forced to search for non-traditional sources of capital. Commercial banks have tightened their credit standards dramatically over the last several years or have abandoned commercial lending entirely. For many middle market distributors, manufacturers and service firms, asset-based lending (“ABL”) may be the best alternative.   Such firms typically have plentiful working capital assets that have historically not been leveraged to their full potential.

The basic concepts of an asset based financing are simple.  Rather than rely on balance sheet ratios or the earning power of the business, the lender can advance funding based upon the expected net liquidation value of the available collateral, typically inventory and receivables.  In theory asset based lenders (sometimes call “hard money lenders”)  can provide funding to even the most troubled borrowers.  In fact debtor in possessions (“DIP”) loans in Chapter XI bankruptcy have been a stock in trade for a number of such lenders.

The reality of ABL financing turns out to be more complex.  Most ABLs do care about the financial condition of their borrowers and will expect to see historical cash flow performance that supports loan payment plus a comfortable cushion. The resulting financial package will often include a variety of constraints, many of which the borrower may not be aware of until the closing table:

  • Restrictions on advances, dividends, and other related party transactions
  • Restrictions on capital expenditures and leases
  • Strictly constructed personal guarantees (including spousal)
  • Tight financial covenants
  • Requirements to maintain excess liquidity or deposits
  • Reserves for technical collateral protection issues (landlord payments, payroll taxes, lender-perceived weaknesses in working capital collateral, etc.)
  • Prohibitions on disposition of assets
  • Prohibitions from entering alternative financial arrangements and acquisitions
  • Surrender of cash management to the lender

Planning for the Transaction

It is extremely important that the borrower understand these issues in advance so that he can position his business and balance sheet to minimize the structural constraints of a typical asset-based transaction, while obtaining the maximum benefit of leveraging the collateral.  We have outlined below some of the key issues to consider when preparing to go to market for an asset-based loan.

Getting personal finances in order

While larger ABL deals may be non-recourse to the borrower’s shareholders, most ABL financings under $10 million will require very strict personal guarantees prohibiting the guarantor from significantly transferring assets to other parties, requiring spousal guarantees, and other restrictive requirements.  In addition, the lender will most likely restrict or totally prohibit advances and other payments to the business owners outside of pre-negotiated salary and bonus amounts.

The owners should establish reasonable compensation guidelines for themselves and senior management, obtaining proper board of director approval prior to taking the deal to market.  The business owners should assure that their approved compensation is satisfactory to maintain their lifestyle requirements, as increases in compensation will likely require lender approval.  This may be difficult to obtain absent evidence of substantial performance improvement in the business.

The owners should consult with counsel regarding setting up trusts, estate planning, and other tax-advantaged vehicles (profit-sharing plans, SEP plans, etc.) prior to entering into a financing.  The owners will likely need lender consent to establish these types of plans after their company has closed an asset-based transaction, particularly if corporate assets or securities are involved in the plans.

Ensure that personal assets are properly titled.  For example, if the owner has purchased her child a car, she might consider placing the car title in the child’s name.  If the owner shares or has inherited a second home with others, ensure the ownership interests are properly segregated to shield equity held by third parties from the personal guarantee of company debts.  Similarly if a spouse not directly involved in the business has separate assets through inheritance or otherwise, it may make sense to establish trusts to shield those assets from the lender’s grasp.  Many attorneys recommend LLC structures of secondary real estate holdings for a variety of reasons and such a structure could be advantageous in protecting third parties from corporate obligations.

Prepare a very detailed monthly financial plan and identify all significant cash needs in the near future

Being aware that the borrower may be restricted in its use of cash under an asset-based loan agreement.  Working capital asset levels almost always vary seasonally, so it is imperative that the potential capital structure from an asset-based financing is adequate.  The rule of thumb is the company probably won’t be able to negotiate any more liquidity from the lender than is provided for at the date of closing, and should plan accordingly. If the borrower has a major capital expenditure item or other non-recurring cash need, make it a part of the financing request.  Lenders are generally amenable to providing for specific growth items in the initial financing package, but once the relationship is turned over to account management, their job is to get the money back.

Understand both the approval process and the relationship management of prospective capital providers

If the borrower is used to dealing with a commercial bank, it most likely had one relationship manager who sourced the relationship, closed the transaction, and managed it going forward.  Each of these functions is segregated in asset-based lending.  The calling officers are compensated solely to bring in business.  Due diligence is handled by a team specific to new business underwriting.  Two groups handle account management:  collateral analysts monitoring the asset quality and account executives responsible for overall account management.  Additionally, an independent group or a separate bank generally performs cash management if the lender is a non-bank commercial finance company.  Insist on meeting account management personnel prior to closing. These are the people the company will be dealing with throughout the relationship.

Stress test the structure

Take the company’s business plan and stress test it for factors that might arise, including both negative shocks and positive growth scenarios.  Either may pose liquidity issues for the business.  These tests will verify if there is adequate liquidity to deal with volume drop offs, seasonal issues, vendor terms (both existing and prospective), cash flow timing, margin pressures, or product development cycles.  The lender will perform a similar exercise, but they certainly don’t have the detailed knowledge of what might or might not happen to the business that the owners and senior management will have.  With the information gained through the stress test process, the borrower can often negotiate structural flexibility on the front end to provide for predictable contingencies.

Clean up the books

Lenders will perform various standard due diligence tests on collateral; however, the borrower can go a long way in getting a satisfactory structure if it: (1) writes off stale accounts receivable; (2) segregates or disposes of obsolete inventory, (3) discloses and provides structures (e.g. credit insurance) to address customer concentration issues, and (4) asks customers for payments on overdue but collectible amounts prior to due diligence.  The advance rates and other terms in a loan proposal are the highest possible amounts.  Even in a normal due diligence process, expect net advance rates to be 5 to 10 percent lower than initially proposed.

Consider multiple lenders

Running lenders “parallel” is a time consuming and costly process for both senior management and the accounting staff, but if there are potential wide varieties of interpretation of various issues the lender will encounter, consider more than one lender in the process.

Be aware of intercreditor issues

If the company has subordinated debt, seller notes to a prior owner, or indebtedness to controlling shareholders or other investors, expect considerable negotiations between the senior lender and junior capital.  Sometimes it is best to start over and replace all tranches of the capital structure.  It is easier for parties coming in new to a situation to negotiate terms than to restructure existing agreements.  If there are third parties involved with whom the company has little or no influence, this could be a deal killer. It could be prudent to address intercreditor issues  before engaging lenders to perform due diligence.

Watch for hidden costs

The stated interest rate in an asset-based financing can often be misleading for the borrower.  Extra fees like maintenance fees, deposit float, audit fees, and up front closing costs can add 2 to 3 percent  to the total cost of the financing.  Prepayment penalties can be burdensome if the financing is only needed for a short-term.

Negotiating Strategies

Business owners who have not previously been involved in an ABL transaction may be tempted to treat the process as they would historically have addressed a bank loan application.  In the past obtaining a loan was a matter of advising a few bankers that the loan was up for renewal, letting the bankers buy lunch, giving a tour of the facility, sharing some financial statements and waiting for the proposals to come in.  Unfortunately that world now fits in the same museum as the rotary telephone and the teletype machine.  In today’s hyper-competitive financial markets, preparing to go to market for financing is every bit as serious an undertaking as preparing for major litigation.  In the sections below we have outlined some of the tactics we utilize to assist our clients in navigating these treacherous waters.

Preparing to Attack the Market

Step one is a comprehensive due diligence exercise designed to identify in advance all of the issues likely to be of concern to prospective lenders.  We work to identify both the strengths and weaknesses of the business and emphasize the strengths, while addressing (but not ignoring) the weaknesses. In the due diligence process it is also important to gain a good understanding of the goals, both business and personal, that the borrower hopes to achieve with the financing.  The end result of this process will be a comprehensive loan request and disclosure document that answers all critical questions prospective lenders will ask.  While this is most definitely a sales document, our view is that real issues must be addressed up front, not sugarcoated.  It will be far more expensive if the prospective lender learns of a material issue (e.g. a major lawsuit) than if it is addressed forthrightly early in the process.

Negotiating with Existing Capital Providers

Sometimes a firm’s existing lender may be the best prospect to continue providing financing for the company.  Perhaps the issue driving the need for refinancing can be as simple as restructuring the existing funding to fit the changing regulatory constraints of the incumbent lender.  Often, however, a transaction is driven by the existing lender’s decision that the loan should be moved.  In such a case it is critical for the borrower to buy sufficient time to explore the available options.  Inserting a third party intermediary into the process provides the lender with assurance that action is being taken that will achieve the lender’s ultimate goal of getting paid.  This removes some of the time pressures that can become intense in such situations.

Knowing the players

Each deal has its own personality and the lenders that will find a logistics outsourcing provider attractive may not be the same as those that will chase a healthcare services firm.  FOCUS understands the various institutional biases of the current lenders and can match those against the needs and issues of specific borrowers.  We also track new entrants to the marketplace.  These institutions tend to be the most aggressive, but also bring the risk of indecision and inconsistency as the institution itself experiences start up pains.

Negotiating perspective

Everything is negotiable to some extent.  There is a lot of give and take in the various structural requirements of an ABL deal.  Lenders are willing to soften their position on things like hard guarantees, intercreditor issues, and pricing if the borrower’s message and goals are communicated concisely, collateral is well-performing, and cash flows are easily understood.

Structuring

How the deal is structured is at least as important as pricing for most ABL financings.  Issues such as funding availability vis-à-vis inventory and receivables can be the difference between a doable deal and a non-starter.  These issues need to be addressed upfront when there is competitive pressure and the business development representatives of the lenders have maximum incentive to carry the ball on behalf of the prospective borrower.

Shaking out the pricing

We have an Every Dollar Counts philosophy.  It’s important to do a detailed analysis of each proposed structure to determine the comprehensive all-in cost over the life of the credit facility, taking into consideration the nuances of timing of cash receipts (e.g., if the borrower’s collections are weighted toward the end of the week, it will want float calculated on a calendar day basis, not business day), upfront costs versus recurring costs, and any other hidden costs of the financing (for example, a bank charging wire fees for intrabank transfers).

In summary, asset-based financing can be a superior and cost effective financing structure for many businesses, but ABL is a much different world than commercial banking.  Preparation is critical, negotiation is a must and knowledge and experience have a significant impact on the ultimate outcome.

 

The Authors

Focus LLC Managing Director, Bob Beard has more than twenty-five years experience as a senior manager and C-level executive in the asset based lending industry.  His experience includes serving as southeast regional underwriting manager for Heller Financial and as a senior executive with  Capital Business Credit.   For the past nine years he has assisted middle market borrowers with negotiating ABL financings.

John Slater, Focus LLC Partner and Capital Financing Team Leader, has spent more than thirty-five years assisting private companies arrange debt and equity financings and  advising middle market firms on mergers and acquisitions.

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