Financing Products: Asset-Based Lending
In our latest blog post, we continue our Financing Products series with a discussion on Asset-Based Lending, or ABL. This financing product is best suited to companies looking to inject further capital into their business by leveraging existing short-term (e.g. accounts receivables and inventory) and long-term assets (e.g. machinery and equipment), to grow their business.
Certainly in today’s Covid environment where generating strong cash flow is critical and where many businesses are trying to ramp up sales to pre-Covid levels, an Asset-Based facility might be an appropriate solution to make that happen. We spoke with Tammy Kemp at the Garrington Group of Companies to get her insights.
Kaeros Q1: From your vantage point, as Chief Credit Officer of the Garrington Group of Companies, how would you describe the ideal ABL client?
Tammy: A good candidate for asset-based lending generally exhibits the following features:
a) Robust accounting and reporting capabilities. By this I mean, they can provide reliable and timely financial reporting. In particular if they are seeking funding against their inventory, they must be able to reliably and accurately report movements of inventory from raw materials to finished goods, and this reporting will be integrated with sales reporting so that when an invoice is created the inventory is relieved.
b) Product sales to creditworthy customers who pay regularly and generally without disputes or unusual discounts.
c) A short work in process cycle is also helpful when seeking financing on inventory. Most asset-based lenders will obtain a professional appraisal of the inventory, raw materials will have value in their original form and finished goods will have lending value of course as well, often it is the in between period where inventory valuation is lower. The company will need to provide details about the conversion cycle as well as information around the cost of materials and production along with selling margins to obtain the best appraisal results.
d) Well cared for equipment will also receive the best appraisal results. A company should be able to evidence that they have properly maintained their equipment. Clean equipment that is working shows best.
e) Ideally a growing business. At Garrington, we focus on understanding the needs of the client, we recognize that businesses have challenges and it is not always smooth sailing and as such we spend the time to understand how we can assist and how our funding will help. If it is a business that has recently experienced challenges or is going through a challenge, that is ok, there should, however, be light at the end of the tunnel. The company will need to be able to explain the current challenges and provide details about how they have addressed the challenges and what the future looks like.
f) Asset-Based Lenders will also, generally, require that a professional examiner review the books, records, credit processes and controls that the business has in place. Therefore, having good historical accounting records that reconcile and processes and controls that are documented and followed will make that process go smoothly.
Kaeros Q2: What are the key features of an asset-based loan (e.g. lending value / advance rates and their relationship to OLV, covenants (financial, negative and otherwise), reporting requirements, ongoing collateral monitoring) and how do these features differ from a traditional senior debt facility?
Tammy: Asset-based lenders really do focus on the value of the collateral. Bluntly, we lend against what we believe the realizable value of the collateral may be. This allows a business with less than stellar financial performance to unlock value in the assets that they have invested in, historically, such as equipment to sustain their business today.
Advance rates on inventory are based on a percentage of the orderly liquidation value, as determined by an appraiser. These advance rates can vary, based on the lender, the nature of the inventory, and the sophistication of the borrower and their ability to provide reporting.
Equipment advance rates are generally based on a forced sales value of the equipment. Simply, what the equipment will sell for at an auction.
Accounts receivable advance rates are generally determined by the creditworthiness of customers and take into consideration historical sales discounts or other agreements with customers that reduce the amount that customers pay. Discounts in some industries are more prevalent, lenders know that and expect to see it, so it really comes back to how easily the borrower can evidence what the discounts are and how they account for it. Better accounting records and ability to deliver reliable information generally supports higher advance rates.
Most asset-based lenders are known for being “covenant light”. When covenants do exist, they are generally debt service or equity related covenants. Conversely, more traditional senior debt lenders generally provide lower advance rates on collateral and rely more on covenants to assess the financial strength of a borrower. They may also not require specific asset appraisals but will rely upon audited financial statements with positive historical trends and results.
Asset-based lenders tend to receive weekly and monthly reporting that is collateral focused which allows borrowers to access cash, based on weekly activities such as sales and collections. Traditional senior debt providers often require periodic reporting, monthly or quarterly where results are positive, consistent, and predictable.
Kaeros Q3: How are ABL lenders compensated for the additional risk they are taking on? (e.g. pricing, ongoing monitoring and monthly maintenance fees, annual review fees, etc.)
Tammy: Asset-based lending rates are generally higher than traditional senior lenders.
I like to focus on what the client receives in return for paying higher rates. Fast, flexible funding is a hallmark of asset-based lending. For us, at Garrington, getting to know our borrower is key. What will our funding do for them and, frankly, how are we helping this company? We will not compete on price. We will however compete on advance rates, meeting the needs of the client, and being flexible. By flexible I mean, we have the luxury of being able to craft one-of-a-kind lending solutions that meet the needs of each client.
Borrowers can expect to pay for appraisals as well as field examinations directly as a pass-through cost, both at the start and on an on-going periodic basis, which is usually agreed at the start of the relationship. These costs can vary widely depending on the type, location and complexity of the collateral or company.
The costs associated with facilities may be expressed in different ways: an all-in annual interest rate, an interest rate plus monthly monitoring fees and annual fees. In addition, there may be administrative or unused line fees that, combined, calculate the full cost.
Traditional senior debt providers often allocate multiple fees in addition to an interest rate and should be combined when calculating a borrower’s total cost of borrowing. Administrative fees, unused line fees and annual renewal fees are common.
From a Borrower’s point of view, the additional costs associated with asset-based lending may be outweighed by the additional borrowing capacity that is unlocked. The ease with which facilities may be upsized, or the flexibility to temporarily increase the facility size, both of which accommodate growth due to seasonal swings or new business opportunities, cannot be over looked, as the loan is based on collateral value and not historical financials.
Kaeros Q4: What are you seeing in the current Covid-19 market environment today, that you haven’t seen previously? (e.g. higher defaults at major FI’s looking for alternate sources of financing, businesses putting up more collateral to keep their existing ABL loan facilities in place, collateral (i.e. A/R’s and inventory) being sensitized downward, in term of lending &/or margin value, due to increased risk of obsolescence / non-collection of the receivables, etc.)
Tammy: COVID 19 has had a significant and widespread impact on lenders and their clients.
The impact goes beyond historical economic down turns as there are few, if any, sectors not impacted. It is significantly more difficult to ascertain asset values, and certainly to predict what asset values may look like, even on a short-term outlook basis.
Certainly, we have begun to see an increase in bankruptcy and bankruptcy protective filings where companies are seeking time and protection from creditors to assess the options available to them to continue their business.
This, coupled with the collapse of the energy sector, a dramatic fall in demand and the correlating dismal oil prices, have, in many formerly robust companies, resulted in a double whammy that is simply unprecedented, and beyond what may have been provided for in a rainy day fund.
I think that most lenders have taken the position of focusing on their current clients, meeting their needs, and finding ways to be creative in helping them weather the storm. This approach really evidences the value of cultivating the relationship between the lender and the borrower.
Inasmuch as companies have been able to continue to operate and make payments against loans, I think lenders have generally sought to keep the status quo. Focused on funding in areas closest to cash, specifically inventory for production and accounts receivable, where sales are being made to creditworthy customers.
Absent the robust government assistance programs, I think the situation would be much more dire.
The concern now, I think, is focused on the potential second wave or surges in infections that may lead to further lock downs and claw backs on re-openings. It is difficult, in the face of this, to determine who will be able to weather the next waves.
On the other side, we have also seen companies pivot to complementary opportunities where they can put their supplier relationships or manufacturing ingenuity into “pandemic proof” businesses, such as sourcing or manufacturing personal protective equipment, hand sanitizers and the like.
In addition, there is pent up demand in certain sectors that will need to be met by increasing production that will provide employment opportunities and will increase funding demand as materials begin to flow back into Canada and production ramps up.
Kaeros Q5: What advice would you offer business owners considering ABL financing to support their growth objectives, both in today’s environment and going forward?
Tammy: For some businesses, asset-based lending is a preferred source of financing. Where there is significant demand on short term cash or for highly seasonal businesses, asset-based lending makes a lot of sense as a long-term lending solution.
For others it may just be a stop along the way as they “graduate” to a more traditional senior debt provider.
Often, business owners, when considering a higher cost alternative lender, are also balancing this option against a longer term equity partner; so, weighing the option of paying a little more for debt today versus selling off equity at what may not be their highest valuation point.
The other consideration often comes down to an opportunity cost. Whether going with a flexible lender who can provide financing quickly and allow the company to take on a new contract, acquire a competitor or complementary business or to let the opportunity pass.
Asset values are key and, unfortunately, there can be a vast delta between the value of an asset to the business and the liquidation value of an asset, and this divide can often be challenging to navigate. So, it is important to spend time to explain the appraisal process from the lender’s perspective with the prospective client and certainly for the prospective client to spend time with the appraiser. The borrower knows their equipment and inventory best, so they should be prepared to spend time with the appraiser, to talk about how they source inventory and the value they provide to their customers, their maintenance program, maybe even why they are in this business.
The more time a lender and borrower spend together to understand their respective way of doing business, the higher the likelihood of a long and mutually advantageous relationship. What both the lender and borrower are looking for is someone they can work with in tough times
Are you thinking about an Asset-Based Loan as a potential option to finance the growth of your business by leveraging existing assets? If so, please reach out for a free one-hour consultation.
Cheers, Trevor
Founder & Managing Director