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COVID-19 is popularizing asset-based lending. Here’s why.
By Ed Gately
Edward Gately (pictured above) of MUFG discusses the reasons for ABLs rise in popularity as a result of the pandemic.
A public health crisis is projecting a seemingly unlikely spotlight on an area of corporate finance that used to carry a negative association, yet is now the option of choice for many borrowers. I’m talking, of course, about asset-based lending (ABL).
According to what we’re seeing at MUFG, the financial hardship resulting from the COVID-19 pandemic is driving some companies to convert their revolving credit facilities from secured cash-flow-based to asset-based lines of credit, which are applicable to businesses in retail, wholesale (such as equipment-rental and food-and-beverage companies), and general distribution, where large quantities of inventory are more common.
ABL was once stigmatized as an option of last resort for corporate borrowers that found it difficult to qualify for a traditional bank loan or line of credit, or companies undergoing operational challenges, experiencing declines in sales or lost customers, or wishing to take on more leverage in order to pursue acquisitions. This is no longer the case. ABL has become more mainstream for consideration nowadays—even among some investment-grade borrowers—because of its accommodative structures that require little or no covenants. And the coronavirus has only fanned its popularity amid the uncertainty afflicting the business sector right now.
The reasons for current conversions to ABL
Why are conversions to asset-based credit facilities taking place? We observe two reasons.
The first is the fear of running afoul of covenants. When a company’s EBITDA (or earnings before interest, taxes, depreciation and amortization) drops below a certain level, it risks violating the terms of its cash-flow-based revolving line of credit. We’re seeing companies take a proactive approach by converting to asset-based lending revolvers upfront rather than waiting until they’re close to breaching their covenants.
The second reason for the conversion to asset-based credit facilities is companies’ need for liquidity. ABL facilities commonly provide access to greater liquidity because borrowing limits are based upon margined collateral values rather than traditional financial metrics (such as multiples of EBITDA or leverage ratios), which are only used in the case of ABL to determine creditworthiness—not borrowing limits.
Typical ABL advance rates (i.e., the maximum percentage of the value of collateral that a lender is willing to extend as the loan amount) are roughly 85% of the net orderly liquidation value of inventory. Using that kind of methodology provides much more liquidity. As an aside, for this very reason, ABL facilities are also popular among companies experiencing high growth that need to fund their expansion.
We believe there will be more conversions to asset-based facilities for some time—possibly over the next 12 to 18 months—until conditions normalize. Shelter-in-place orders have the potential to shape longer-term patterns, and even after those orders are lifted, we don’t think people will return so quickly to their old consumption habits in terms of what they buy, where they buy it, and how much they spend. Until businesses are able to fully rebound, we foresee more of them pursuing facility conversions.
Of note, companies with asset-based revolvers are already drawing down on their credit facilities, borrowing to add cash to their balance sheets in order to make sure they have access to sufficient liquidity to weather this crisis. But the story doesn’t end here. In conjunction with companies’ migration to ABL, we’re also witnessing an evolution in loan terms.
The evolving terms of asset-based lending
The physical and economic consequences of the pandemic are making it difficult to conduct in-person inventory appraisals in order to assess the value of companies’ loan collateral, and ABL terms are evolving as a result.
After all, it’s an unsafe environment for appraisers to perform physical assessments of inventory and make decisions based on real-time appraisals. Moreover, the liquidation market is disrupted because retail distribution channels are closed. There’s also the question of timing: How do you appraise merchandise meant to be sold during a given season if it needs to be replaced with inventory for a subsequent season by the time you reopen for business?
Apparel is one example of merchandise affected by seasonality, though other types of merchandise, such as technology products and home appliances, are not exempt from seasonal and other considerations. Ultimately, the monetary assessment of inventory is based on the price at which the appraiser believes the retailer can liquidate the inventory.
What’s more, we are still at the early stages of this crisis, and we haven’t yet seen the full financial implications of this pandemic for most companies. Current levels of unemployment will affect consumer demand for some time and, until the economy normalizes, liquidation values could be impacted.
There are three ways in which we see ABL terms evolve. First, and most naturally, is a gradual shift toward lower appraisals. We expect monetary assessments of inventories— from consumer products to rental equipment—to decline across the board and reflect more conservative estimates.
The second evolution we see is toward higher loan pricing: Interest rates on asset-based lending have already risen by 75–100 basis points since the COVID-19 outbreak to reflect the current liquidity environment and increased credit risk.
The third and final change we discern is that lenders are beginning to incorporate anti-cash-hoarding provisions into their asset-based lending agreements. These provisions are designed to preserve banks’ liquidity by ensuring that borrowers only draw funds for a need and deploy them accordingly.
Historically, it’s been common to witness back-and-forth movements between cash-flow-based funding and ABL every so often as companies’ preferences shift with changing financial circumstances. But it’s clear to us that COVID-19 is driving companies to pursue ABL conversions proactively, given economic uncertainty and the poor visibility into the future of their business.
These companies see potential covenant violations with their cash-flow-based lending facilities, having no clear picture of how the pandemic will affect sales or whether they’ll be able to operate at all if their current facilities are closed. Companies anticipate having more runway to ride out this difficult time if they can put their assets to use as collateral—whether inventory, receivables, real estate or other fixed assets.
Since ABL can be an attractive option to companies of all sizes—from middle-market companies with revenues as low as $100 million to large corporate borrowers that generate billions—we expect more conversions among businesses across the board.
These conversions might have a longer-term effect on companies’ financing preferences well beyond this crisis. Our experience has shown that, once a company gets accustomed to the financial reporting conventions of an asset-based facility, such as field examinations of collateral and inventory assessments, it usually becomes comfortable with ABL as a more lasting solution to its financing needs, especially since it’s a solution that provides maximum liquidity.
What a long way ABL has come. Once a less-than-popular financing strategy, it is now an overbanked market that will, we believe, only get bigger.