The disruption of the credit markets since the financial crisis of 2008 has had a palpable impact on the availability of credit to support the growth of privately owned middle market companies. This unprecedented turmoil of the financial markets will in all likelihood continue unabated for several years before there is a return to some semblance of normalcy. One alternative to consider is an asset based loan.
An asset based loan, or ABL in the parlance of its practitioners, is a loan secured by the assets of a company and includes accounts receivable, inventory and often machinery and equipment. Since the financial crisis of 2008 ABL’s have seen remarkable growth among middle market companies that have had difficulty meeting the increased underwriting standards instituted by commercial banks.
An ABL lender relies principally on the value of a company’s collateral to ensure repayment of the loan as opposed to sustainable cash flow and credit ratings used by commercial banks. The lender calculates a borrowing base from the company’s eligible collateral assets to determine how much it will be able to lend.
Advance rates are decided for each class of asset based upon its quality. The primary determinant will be the lender’s evaluation of how quickly the assets could be converted into cash in the event of default and the assets are seized to repay the loan.
Generally, advance rates to support the revolving line of credit are 80% to 85% for eligible accounts receivable and 65% to 70% for eligible inventory. Term loans for machinery and equipment are usually 75% to 80% of the orderly liquidation value as determined by an independent third party. If the inventory is deemed to be readily and easily marketable advance rates can often be higher.
For companies with a better credit profile, intangible assets can sometimes be used as collateral to support what is known as an over-advance or a stretch loan that combines elements of a traditional cash-flow loan with an ABL.
There are drawbacks to an ABL. The secured lender holds a first lien on the assets and has the right to take the assets if the borrower defaults. There are additional costs for auditing the collateral as well as for the third party appraisal of the machinery and equipment. Loans require monthly reporting of accounts receivable aging, inventory and sales.
Loans tend to be more expensive than a commercial bank. However, intense competition and a surfeit of capital available in the credit markets have narrowed interest rate spreads considerably. “Today the interest rate may be lower than the commercial bank rates, but all-in cost may be higher.” commented Glenn S. Burroughs, Senior Vice President at Key Bank’s Asset Based Lending Group.
Drawbacks aside, ABL’s are especially attractive for asset intensive businesses such as manufacturers, distributors and retailers. They provide a number of very valuable benefits:
1. Greater credit availability and financial leverage
2. Greater flexibility in use of proceeds to capitalize on opportunities
3. Minimal financial covenants – typically limited to the fixed charge coverage ratio
4. Interest only for the term of the loan; principal amortization required for term loans
Burroughs noted that “In these turbulent economic times asset based lenders are a consistent source of capital.” The financial crisis and the ensuing disruption of the credit markets should have amply demonstrated to middle market companies the importance of having a dependable financial partner at their side.