There has been much discussion about whether the fragility of the financial markets in the last four years would have a significant impact on asset-based lending (ABL) in Europe and propel it to become a mainstream financing source as it is in the US.
Despite the retrenchment of European banks to their domestic markets and the inaccessibility of a number of forms of capital market financings, the growth in European ABL has been somewhat muted. This may be largely attributable to the reduction in working capital requirements of corporates, reduced M&A activity and the propensity to extend maturing debt facilities. That said, where European buyouts and refinancings are taking place, arrangers of debt financings are at the whim of whichever market is available, and it is widely recognised that ABL has had a long run of being able to consistently offer financing to corporates in size and at competitive funding costs.
In the buyout market, especially the mid-market, there has historically been an expectation that a spectrum of debt financing products should be available. Now that these product offerings are more constrained, ABL arrangers see the potential to grow this financing offering and make it a more mainstream source of funding. The challenges remain speed of execution and the development of a more defined market infrastructure especially when considering cross-border transactions.
Historically, ABL has been regarded as the alternative funding domain of SMEs and companies in distress. But ABL now is a mainstream funding option in the US market. Indeed it is utilised by investment-grade corporates, through receivables securitisation, itself a form of asset-based lending, and is now increasingly evidenced in the capital structures of mid-market and corporate borrowers across the UK and Europe.
ABL is typically offered by providing funding against a company’s trade receivables pools, but can also be provided against a company’s inventory and longer-term fixed assets1. ABL is a form of financing where the amount that the financier is prepared to advance is calculated by reference to certain asset classes, typically receivables, inventory, plant and machinery and real estate.
Advance rates, the amounts by which a financier will advance against the value of receivables, varies according to the asset class financed. In the case of trade receivables, this is typically 85 percent to 90 percent, while financing against other asset classes is generally determined as a percentage of the net orderly liquidation value in the case of inventory and plant and machinery, and a percentage of a current real estate valuation.
Where trade receivables are financed it is also common for the underlying receivables to be covered by a trade insurance policy. The forms of these policies typically vary from transaction to transaction.
It is difficult to be too prescriptive about the type of corporate that is ideally suited to ABL financing, since each transaction, by its nature, is bespoke. Industries most suited to ABL tend to be have cyclical characteristics and have output which tends to be commoditised, whether a physical product or more service in nature. Basic industries are generally ideally suited, as are those whose inventory is relatively commoditised, if that is also to be financed. Transactions are also often event-led, whether as a result of a restructuring, acquisition, spin-off or refinancing.
It is important the assets’ cash-flow streams are both predictable and contractual in nature. Predictability can easily be determined by examining historical payment or collection patterns with delinquent payments being typically modest and bad-debt history low. It is also important to consider ‘set-off risk’, which may arise if the seller of the receivable has yet to perform some form of contractual obligation before the payment of the receivable can be considered fully due. Contractual set-off is typically assessed by reviewing underlying customer contracts.
Where inventory, plant and machinery or other assets are financed the same principles apply. ABL will be a relevant financing source if the asset can be easily valued either through a recognised market price or a valuer’s appraisal.
All ABL facilities are underpinned by the concept that the financier can look to the proceeds on the sale of assets or collect against receivables financed in a workout situation. The legal framework in the jurisdiction in which the transaction is being structured is obviously a key consideration. There are two legal mechanisms in Europe which enable a financier of receivables to have a robust claim against the receivables financed: by taking security against the receivables; or by taking title to the receivables. In mainland Europe, often the only satisfactory means of recovery against an asset is via a sale of the receivables, whereas in the UK it is either by enforcing security (provision of a fixed-security interest being generally the most flexible option for the borrower), or via a sale of the receivables.
ABL and other asset financings
ABL is commonly mistaken for asset finance and asset-backed financing. Asset finance is primarily focused on financing capital assets with potentially higher loan-to-value advance rates, such as aircraft, ships and other moveable assets. There tends to be less emphasis on asset realisation but rather a focus on discounted cash flow, income streams and underlying corporate covenants, which often result in wider spreads from a pricing perspective. Asset-backed financings are typically revolving credit facilities with less operational and structural rigour. The financings typically have a higher loan-to-value with less emphasis on asset realisation and consequently, higher loss-given default. Security tends to be more wide-ranging and the facilities are often priced more widely than ABL facilities.
ABL’s defining features and important considerations
Fundamentally, the product provides a genuine alternative working-capital financing solution for businesses. Companies often find the disciplines of an ABL facility provide enhanced liquidity benefits to the business through the close management of the working-capital cycle. In today’s market, corporate structures are increasingly in evidence where legal entities have been specifically created to maximise the funding benefits from the asset collateral pool in the business. In more complex transactions the facilities also optimise financing through ‘cash-pooling’ mechanisms.
ABL is typically revolving in nature with funding commitments ranging from three to five years. While they are secured against current assets they are also able to accommodate term loan financing against longer-term assets including plant and machinery and real estate, in certain situations. For assets other than trade receivables funding is based on liquidated asset value, as opposed to enterprise value, and generally assume short asset realisation periods.
Generally ABL financings are considered to be financial covenant-light and therefore often considered more cost-flexible than institutional funding or bank leverage financing, in the case of non-investment grade or levered businesses. They are appropriate for asset-intensive businesses, generating a predictable level of funding availability and are typically less susceptible to volatility in earnings as the main determinant of funding is the assets themselves as opposed to other financial measures (for example, historical and predicted EBITDA levels). Transactions also involve close real-time monitoring, control and security. Since the funding provided by ABL is not expected to be at risk, large customer exposures can be accommodated, minimising distribution risk for the discerning financial controller, treasurer or CFO.
Given that financiers focus on institutional capital effectiveness, which is driven by regulatory changes, the attractiveness of the ABL product to financiers is expected to continue. ABL is therefore expected to be not only a credible but also an increasing source of liquidity over the coming years.
ABL in the capital structure
ABL is increasingly present as one of multiple components in a multi-tiered capital structure, working alongside equity, high-yield bonds, mezzanine, equipment finance and senior debt. The nature of the intercreditor relationship is of paramount importance, as is the future accommodation of ABL into a capital structure, by ensuring appropriate ABL carve-out language is accommodated within existing finance and security documentation.
Whenever an ABL facility sits alongside another form of debt financing it is important to clearly specify which debt financiers have security or title to the different assets of the corporate and, should more than one party have a claim against an asset, what is the respective security ranking of each party. These arrangements are generally documented in an intercreditor agreement. With any ABL financing, an ABL financier will expect to have title or a first-ranking charge over the assets it purports to finance. If in a wind-down situation the collections or proceeds from those assets exceed any amounts outstanding under the ABL financing, then those excess collections or realisations can be used to pay down other debt whose ranking is subordinated to the ABL providers. Similarly ABL financiers, if permitted under relevant jurisdictional law, would expect to have a claim against other assets of the corporate, albeit in a subordinated position.
The ABL market has also developed sufficiently to see the emergence of mezzanine ABL providers. As with traditional mezzanine debt providers the ABL funding is tranched into senior and junior debt financings and security priority being ranked accordingly.
Looking to the future
Pools of alternative liquidity are certainly available to the discerning financial controller, treasurer or CFO willing to explore the funding options available to their business. A common theme is that pools of liquidity can be drawn from sources other than traditional bank lending and the capital markets. Whether the financing requirement is for working capital, M&A, organic growth, turnaround or even refinancing away from traditional sources of liquidity, businesses are increasingly turning to their asset base to secure the finance they require to stabilise, grow and even survive in a continuing volatile environment that is challenging traditional sources of supply.
Considering the valuable lessons of the past and looking to the regulatory and political climate of the future, we see alternative specialist finance business models emerging into the mainstream. From dedicated specialist ABL, asset-based and asset-backed lenders to mainstream banks, co-ordinating product verticals to follow the trade flow of their clients, funders will devise considered solutions to meet both the liquidity needs of corporates and fulfil the ever-increasing return on capital requirements of banks as well as independent and institutional funding partners.