As limited partners have become more educated about private debt, some have sought to diversify their portfolios beyond the corporate cashflow direct lenders to include other strategies, which can include asset-based loans. While the strategy is nothing new for banks, asset managers have moved into the space and tackled a strategy that requires a much different thought process than direct lending: your debtor and borrower are not one and the same, says Andre Hakkak, chief executive of White Oak Global Advisors.
What are the attractions and some challenges of doing asset-based loans or factor financing?
The number one challenge is their competitive nature. In ABL and factoring, the prominent players are banks. Banks control 98 percent of the marketplace for ABL, generally speaking. The big banks have access to a large national origination salesforce and the infrastructure to support monitoring and servicing these types of loans, which is also the case for factor financing.
In short, some of the challenges in establishing successful ABL capabilities are having an experienced team, building out the infrastructure and having the appropriate cost of capital.
How popular is the strategy currently relative to historic levels?
ABL has always been a prominent part of the bank’s balance sheet. It’s not about popularity for them. Asset-based lending and factoring has been around for 200-plus years in the US, and it’s probably one of the first lending products banks offered.
Underwriting ABL and factoring facilities are easier to understand and underwrite versus a cashflow term loan. So, the popularity has been there for a long time, and I would suggest that about 20 percent of a bank’s balance sheet is focused on working capital assets like ABL.
However, this space has not been popular for asset managers historically. This business requires a significant amount of human capital and infrastructure investment in technology and systems to be able to originate, underwrite and monitor these kinds of loans.
What are some of the ways that that underwriting, monitoring and servicing all these loans differ from the corporate cashflow term loans offered by a lot of credit managers?
Term loans, by definition, have a longer term, whereas ABLs revolve in 30, 60 or 90 days. They go up and down in capital availability based on the daily borrowing base and capital needs of a particular company.
So, you’re not only underwriting to the borrower, like a term loan, but you are really underwriting to what we call the debtor, where the receivable is coming from. You want to be confident in the creditworthiness of the debtor.
Additionally, you want to observe how fast the inventory is turning. If the inventory is turning every 30 or 60 days, that’s a good thing, a credit-positive metric. If your inventory is churning every six months, that’s not so good, and the ABL facility may start looking like a term loan.
So, the primary difference between ABL and term loan is that for ABL facilities you are underwriting to a borrowing base based on inventory coming in, and it goes up and down in availability. When you underwrite to a term loan, such as a cashflow term loan, you’re primarily underwriting to the EBITDA or leverage ratio of the business.
What type of businesses should consider ABL or factoring finance?
I would say most businesses that have purchased a good service that is not a point of sale, for example, if it’s not a credit card. Most companies have a 30-to-90-day payable program for them. If Wal-Mart buys a widget from a widget manufacturer and the manufacturer sends its goods to Wal-Mart, Wal-Mart will have a payable. Usually the timing for Wal-Mart is 60 days, and the manufacturer has a receivable due to Wal-Mart in about 60 days.
In summary, ABL and factoring are relevant for companies that typically don’t have a point-of-sale business. There’s a mismatch of timing between when they need the cash and when they’re going to receive it. So, banks come in and bridge that 60-day period.
What are the main benefits to borrowers and investors of ABLs and factoring?
For borrowers, they want to receive payment for services and products that they’ve sold or rendered more quickly. The benefit for investors lies in the short duration, high velocity loan that is underwritten to cash receivables. You’re less concerned about the EBITDA of the business; you’re just doing cash collections every 30, 60, 90 days. From a security standpoint, it’s a much higher quality loan than a term loan.
What are the typical returns for ABLs and factoring financing?
It’s a wide range. They range all the way from LIBOR plus 1 percent to LIBOR plus 10 percent. There is a lot of variability as to what you can price the risk of the opportunity for.
As an example, consider dealing with high-quality debtors, an investment-grade borrower that has a long history and track record of consistent payments, and you’re only lending against the receivables and not the inventory. Then your advance rate is conservative. That’s going to be in the LIBOR plus 1 percent range.
However, look at a case where the lender is lending against the receivables and inventory at a high advance rate with inventory that doesn’t turn as quickly and/or their debt or risk profile is not higher quality, let’s call it near-investment grade. You can charge a higher interest rates for that type of loan.
I’d say approximately 30 percent of the return for ABL and factoring comes from fees, and returns are less focused on LIBOR plus a spread.
What type of fees are those normally?
Predominantly an unused borrowing base fee, loan servicing, and collateral monitoring, among others, depending on structure.
Healthcare is a sector that has been very active in the ABL space. What do you think about the risk-return profile of healthcare, specifically?
It’s consistent with other businesses. Healthcare is important for banks in the ABL space. I would say no different than industrials or any other major sector. What makes healthcare a little bit more specialised is the risk profile is predominantly either insurance companies and/or government agencies in the US such as Medicare or Medicaid.
Your debtor risk in a widget manufacturer could range from Wal-Mart to Sears to storefronts down the street from your offices. There’s a lot more variability into doing due diligence on their debtor risk profiles for non-healthcare businesses. But healthcare, you’ve got really two categories that you have to underwrite to: the insurance companies and government-sponsored healthcare organisations.
When you’re looking at the debtor, the person that will be supplying the borrower’s receivables, what are some qualities that you look for?
Again, it’s the higher the risk, the higher the return. So, assuming that we’re all in the business of pricing risk appropriately, sometimes you are looking for companies that have lower quality debt profiles or companies that you know are not the best credit. For asset managers like White Oak, while our cost of capital has decreased over the years, it’s not LIBOR plus 150 basis points. For us, imperfection is an opportunity to get paid more for the additional risk that we would consider.
Why should LPs consider investing in an ABL strategy?
It’s the safest part of any corporate credit loan out there. With an exception to government bonds and treasuries, it’s the safest investment one can have. Investments normally come out of the alternative credit or fixed income buckets.
This article is sponsored by White Oak Global Advisors.