There is no debating the over-arching importance of collateral as the default option in “getting out” of a distressed loan. To that end, lender due diligence is centered on determining the values of assets through periodic third-party appraisals and field examinations, with an added emphasis on confirming the borrower’s ability to provide timely and accurate reporting on collateral and financial performance.

As the ABL market has grown, borrowing bases have been “stretched” with respect to advance rates and eligibility requirements, and have expanded to include non-traditional collateral in multi-layered capital structures. Asset-based lenders have started to require Quality of Earnings reports to assess a borrower’s historical profitability to determine the future reliability of cashflows driven from profits. Lenders have also engaged third-party consultants to review the assumptions in borrower-provided projections. The advent of AI has now given lenders new tools for being able to analyze borrowers' financials, sensitizing projections, as well as analyzing borrower collateral and exposure trends that can also help detect the first signs of fraud. 

Despite the noted improvements in underwriting and portfolio management, lenders are still reliant on financial covenants as the early warning signs of borrower financial distress. Long gone are the days of a borrower being subject to multiple covenants. In today's competitive market, lenders are often left to rely on only a quarterly fixed-charge covenant. However, the problem with our industry’s traditional financial covenants is that they are often in the rear-view mirror, and subject to error or manipulation. This is not to imply that the traditional financial covenants are not important bellwethers of borrower distress. But there is value to a simple, readily verifiable, and timely test, as an early warning of borrower distress. To this end, what is often overlooked is the importance of monitoring trade payable trends as the canary in the coal mine for borrower liquidity distress. Deferring payables is often the first place a borrower turns to fund unprojected losses and disbursements, which eventually lead to liquidity and operational issues.

Donald Clarke, president of Asset Based Lending Consultants, emphasized the key role of field exams in reporting, verifying, and analyzing payable trends. “A good field examination is not just about collateral; it is also about understanding the liabilities that could impact the realizable value of collateral and a borrower's liquidity. With the use of AI-driven technologies, field examinations today are far more analytical and are designed not only to validate collateral data, but to analyze liquidity and revenue trends and the correlations of asset classes to liabilities. There is certainly a correlation between payables and borrowing base availability that we analyze. From my experience, deteriorating payables are one of the first signs of borrower stress."

Ideally, covenanting permissible levels of past-due payables provides a lender with the remedies associated with an event of default and the added leverage with the borrower to address the underlying reasons for eroding liquidity. It must be acknowledged that obtaining a Monthly Payable Covenant in the initial underwriting will be challenging in today’s competitive market. However, there should be less resistance in waiver or amendment situations, especially in down-market turnarounds.

The strength of the Payable Covenant rests in its simplicity. The Covenant is based on calculations derived from primary source documents, which should be readily obtainable and verifiable during field examinations. A borrower should be able to produce an accurate payable aging, adjusted for the “checks in the draw,” within days of their end-of-the month close and should be part of a borrower’s monthly required reporting package.

Like most covenants, a good place to start in negotiating the covenant levels is the borrower-provided projections that are acceptable to the lender, in conjunction with payable information from a recent field examination. Keep in mind, many borrowers operate with some level of manageable past-due payables. The point is that those levels should not deteriorate further to the point of placing the borrower’s business at risk.

An example of a basic Payable Covenant, assuming customary supplier terms of sixty (60) days, would be as follows:

At end of month, Trade Payables over thirty (30) days past due or over ninety (90) days from invoice date shall not exceed ten percent (10%) of the Total Trade Payables.

Jeanne Siegel, partner at the law firm of Thompson Coburn LLC, noted that, “Payable Covenants in financed transactions have proven to be an effective way for lenders to monitor and detect developing liquidity issues. An event of default provides the lender with the leverage to have the borrower engage consultants and/or seek additional capital as part of a waiver request. Without the legal and financial weight of a covenant default, lenders have fewer options to have the borrower proactively address liquidity issues.”

In the absence of a Trade Payable Covenant, lenders should still be able to monitor payable trends for early signs of distress. Even without the weight of a covenant, lenders can still proactively engage with the borrower for potential solutions to negative liquidity trends, as well as the ramifications for inaction.

The early warning signs of distress also provides the lender with the opportunity to enhance the monitoring and valuations of the borrower’s collateral by increasing the frequency and the scope of field examinations, as well as requiring enhanced inventory reporting to properly margin collateral. Lenders may also have the ability to establish appropriate reserves under the loan agreement for some level of past due payables and other critical unpaid liabilities to maintain the value of their collateral.

While typically used in down-market turnaround situations, Minimum Availability Blocks structured to require a reserve for past dues can also be effective in pressuring borrowers to address eroding liquidity. Blocks without consideration of past-due payables are less effective, given that a borrower can defer payables to maintain the block.

In analyzing borrower payables, special attention needs to be given to any Supply Chain Financed Payables, which are often co-mingled with trade payables. Supply Chain Financed Payables should be reported separately since they typically have contractually stated maturity dates, with limited, or no-cure periods, and are not subject to any borrower counterclaims or offsets. In the event of a payment default, the unsecured supply chain lender can seek a judgment on an expedited basis and cease discounting supplier payables, potentially leading to an unexpected borrower liquidity and operational crisis.

Buyer-centric supply chain finance programs that provide extended payment terms above customary supplier terms are noteworthy since they can be used to mask liquidity issues. These types of programs are often referred to as Accounts Payable Financing. For example, if the vendor’s standard terms of sale are 60 days, having the supply finance lender agree to extend payment terms to 120 days is effectively providing 60 additional days of liquidity to the borrower.

To mitigate and monitor the risk associated with supply chain financing programs, loan agreements should require the consent of the lender and provide for limitations on outstandings and terms, with required notices of reduction or termination of programs. Lenders also need to assess the risk to operations should key vendors, for any reason, not be able to supply the borrower. This is often an understated risk for lenders.

Lenders need to be keenly aware of the ultimate repercussions of deferring payables to the borrower’s operations and underlying collateral. Open trade credit is “hot money,” since it is uncommitted and contingent on the borrower keeping payments reasonably within terms. At a certain point of pain, suppliers with material past-due balances are left with no choice, but to cease or curtail shipments of new goods. Also, keep in mind that the supplier is more than likely to borrow from a lender that has similar eligibility criteria on past-due receivables.

Any prolonged disruption of supply from key vendors, for any reason, will typically lead to declines in revenue, an erosion of profitability, further straining liquidity. A vicious cycle, that eventually becomes a death spiral for the borrower and a workout for the lender. Saks’ recent bankruptcy filing illustrates the point and importance of maintaining vendor support.

Borrower liquidations that involve material unfilled orders often result in the borrower’s receivables being diluted above the reserve margin, as well as inventories becoming unbalanced, materially reducing the realizable values in liquidation.

Clearly, getting an early warning on a borrower’s eroding liquidity and resulting operational issues by monitoring borrower trade payables, whether by covenant or analytical observation, provides valuable time for the lender to engage with the borrower for a solution, and take proactive steps to preserve the value of the underlying collateral.