LEVERAGED FINANCE SPECIAL(6)

Asset-based lenders want financing-hungry GPs to give this traditional form of lending a second look. By Matt Levin.

It's difficult to recall a time when GPs faced as grim a financing landscape as they are currently confronting.

Not only are the days of abundant, covenant-lite, and inexpensive debt a thing of the past, but banks already locked into deals they once deemed no-brainers are renegotiating their leverage agreements or – in the most extreme cases – walking away from them entirely.

Under these conditions, GPs are scrambling to find any and all alternatives to traditional sources of cash-flow debt, the lifeblood of the leveraged buyout boom. Many have resigned themselves to larger equity infusions until the worst of the credit turmoil boils over.

An increasing number of firms, however, are turning to an old, basic lending practice that has rarely been associated with private equity – asset-based loans. A firmly rooted US form of finance now gaining traction in Europe, asset-based loans, or ABLs, are becoming popular among GPs as a relatively inexpensive and flexible substitute for cash-flow senior debt, say ABL promoters. Partly as a result of its expanding relationship with private equity, asset-based finance is reaching new heights while other financial products are ailing.

“The credit crunch, frankly, has been great news from our perspective,” says James Cullen, an ABL specialist in UK-based Investec's Growth and Acquisition finance division. “We're busy as hell at the moment, competing head-on with senior debt providers.”

OLD-SCHOOL LENDING
American asset-based lending, a $489 billion (€309 billion) industry as of 2006 (the most recent year for which data is available), is as old as the US commercial credit system itself. In contrast to cash flow debt, ABLs collateralise a company's fixed and current assets – everything from machinery and working capital to inventory and receivables.

More recently lenders have introduced new “intangibles” to their asset lists, which include the value of company trademarks and brand names.

This type of debt has proved particularly adaptable to the current credit contraction, according to several industry observers.

Because ABLs are generally fully collateralised by the assets of the borrower, lenders are often willing to hold a larger piece of the loan and are thus less dependent on the heavily backlogged syndication markets.

ABL collateralisation also allows borrowers greater freedom from financial covenants, which have become increasingly onerous in cash-flow deals since last summer.

Finally, and perhaps most importantly, ABLs are currently much cheaper than competing financial products.

“Right now, the interest rate spread between a mid-market cash flow loan and a middle market asset-based loan is as wide as I can recall in many years,” says Chet Zara, managing director at New York-based GE Antares Capital, part of GE's commercial financing division, which has financed deals sponsored by private equity firms Kohlberg & Co., North Castle Partners, and Wellspring Capital Management.

Zara, a 22-year veteran of the asset-based lending industry, estimates that the pricing floor for a typical mid-market ABL hovers around LIBOR plus 200, while the floor for a comparable cash flow loan is LIBOR plus 450.

That price differential, combined with other advantages, has caused an explosion of interest among private equity firms desperate to finance an acquisition or refinance a portfolio company, says Zara.

Although little statistical analysis exists regarding private equity's utilisation of ABLs, most industry observers agree that private equity usage of the product has rarely been higher.

“Anecdotally, what we've seen is an influx of private equity firms and hedge funds into this space,” says Andrej Suskavcev, chief executive officer of the Commercial Finance Association (CFA), which has tracked asset-based lending for more than 30 years.

According to the most recent data compiled by the CFA, North American asset-based lending is approaching the $500 billion milestone in aggregate outstanding debt after a 16.5 percent growth rate in 2006.

ABL's rising prominence comes as little surprise, considering the financial product's historic track record during business cycle downturns.

“Generally, the business … has ticked up during times of recession or economic slowdown,” says Zara.

DEAL SAVIOUR
Examples of private equity's increasing reliance on asset-based financing abound, from Bain Capital and The Carlyle Group's restructuring of a Home Depot spinout last autumn to the $140 million in ABL debt Fleet Capital extended to a Kohlberg & Co. motorcoach deal.

However, ABLs' emerging importance in private equity is perhaps more vividly illustrated in the £15 million acquisition of UK human resource specialist Eden Brown by private equity firm Hamilton Bradshaw.

As credit markets tightened worldwide last year, Hamilton Bradshaw Human Capital (HBHC), a subdivision of private equity firm Hamilton Bradshaw, found it frustratingly difficult to secure financing to acquire the recruitment company.

“I must have spent six months walking through the corridors of every private equity lender you could consider,” says managing director Tristan Ramus, who intends to use Eden Brown as the platform in a buy and build.

Despite an EBITDA of £2.1 million, gross revenue of £150 million, and receivables of roughly £17 million, Ramus struggled to find anyone willing to lend to Eden Brown.

Finally, Ramus “stumbled” upon Investec's Growth and Acquisition Finance department, which had just six months prior launched an asset-based lending unit headed by Cullen. Although ABLs are typically not associated with service companies such as Eden Brown, the firm's significant receivables holdings made financing possible.

“Suddenly, I found an appetite to approve deals from a completely different mindset,” says Ramus.

After completing the Eden Brown deal, HBHC went on to purchase another human resource firm in an ABL-financed transaction.

Ramus' credit quest not only illustrates ABLs' current role in the pinched credit market, but also poses an intriguing question increasingly on the minds of GPs and lenders: What effect will the rise of asset-based lending have on the types of deals private equity will pursue?

In other words, will GPs focus more on industries with strong fixed and current assets where they can get cheap ABL financing?

“It's a good question,” says Zara, whose GE Antares manages over $8 billion in assets. “There are certain types of businesses that are going to be very challenging to finance in the cash-flow market. And that may encourage some private equity firms to look at industries they previously didn't consider.”

Answers to the question are mixed, with many GPs still seemingly pining for the return of cheap cash-flow debt.

But in Eden Brown's case, asset-based lending was extended to an industry with which ABLs are not commonly associated – the service sector.

And with the cash-flow market so diminished, many lenders are expanding the breadth of the private equity deals they finance with asset-based debt or are coupling ABLs with other forms of leverage to complete transactions.

TRANSATLANTIC DIVIDE
Although asset-based lending is increasingly popular among private equity firms on both sides of the Atlantic, the American and European ABL communities are still two very different creatures.

The fundamental difference is experience. Asset-based lending enjoys a long and successful history in American commercial finance, and US private equity firms are well-acquainted with the structure and requirements. On the other hand, European firms are just getting their feet wet, as ABLs only took root in the UK and elsewhere in the mid 1990s.

“When you're dealing with a lot of the straight European private equity funds, that have used cash-flow lending for the last 20 or 30 years, it's usually a more difficult sell,” says Carmen Bernardis, who joined Bank of America's London-based ABL division in 1999, just two years after it was opened.

European-based lenders also caution that the continent's hodgepodge regulatory and bankruptcy framework can pose a significant obstacle to pan-European investors.

Despite these hurdles, however, Bernardis and others remain optimistic that asset-based lending will continue to play an expanding role in European private equity. Hamilton Bradshaw's Tristan Ramus, for one, would surely agree.