The Benefits of Asset Based Lending

The challenges facing small- and medium- sized companies because of current economic volatility can be extremely difficult to navigate. While some companies lack working capital to build inventories, others are growing in the current environment and need financing to help spur further growth. For many firms, a solution to these challenges is asset based lending.

A Proven Lending Strategy

What is ABL? Asset based lending (ABL) has long thrived in both good times and bad as a financing solution for companies with large inventories and working capital needs. "Asset based lending is a flexible financial solution that is able to provide credit through the credit cycle and the life cycle of a company," said Richard D. Gumbrecht, CEO of the Secured Finance Network. "As economic uncertainty has increased, we’re seeing businesses once again turning to asset based lending for the financial capital they need to remain viable and competitive in the face of uncertainty."

As the name implies, asset based financing is directly correlated to the value of a company’s assets, which serves as the lender’s collateral for the loan. Once regarded as creative financing for troubled companies, private equity and investment banks began using asset based lending to finance larger leveraged deals. This was a game changer for the industry.

Today, asset based loans are well-collateralized, competitively priced vehicles that are effectively used by companies of all sizes for acquisitions, growth, turnarounds or to simply support working capital needs. "Asset based lending has developed into a well-established financing option for companies with varying needs and is particularly useful for manufacturing, retail and distribution businesses that make good use of their assets to structure a flexible credit facility," noted Greg Eck, Managing Director, Asset Based Lending Group Head for Fifth Third Bank.

Overall, ABL parameters rarely deviate—no matter the market conditions. This is an especially good solution for working capital-intensive industries, like manufacturing and distribution, which typically have large inventories and receivables.

A key difference between ABL and cash-flow financing is covenant structures that are typically less restrictive and easier to manage. ABL lenders lean on collateral to support their financing exposure, which allows them to be more flexible and patient in most situations.

A key metric for cash-flow financing, Total Debt to EBITDA, can change rapidly when performance declines, making it a significant issue when the lender has tied much of underwriting to that measure. ABL lenders, on the other hand, design a lending package by first analyzing the liquid aspects of a company’s asset pool, then formulating a credit facility around advances against collateral

Many cash-flow lenders provide most of their financing in the form of term loans as opposed to revolving lines of credit, often seeking to minimize revolver sizes. While ABL lenders provide term loans, most specialize in providing and administering revolving lines of credit. Some lenders will provide revolvers in conjunction with a treasury management relationship which makes it very efficient for companies to manage various aspects of working capital and cash cycles.

Another attractive feature for companies considering ABL is cost. Because most loans provided by ABL lenders are collateralized and covered by assets with a perceived lower risk profile, they can offer a cheaper alternative to higher-leverage debt packages based purely on cash flow—typically 150 to 200 basis points lower—and come with lower closing fees.

Better Prepared When Challenges Arise

Many cash flow lenders, having pushed the limits on leverage, tend to be more proactive in protecting themselves with a covenant default. Not so for ABL lenders; they are set up to monitor loan exposure on a continuous basis, often monthly. This allows them to become intimately familiar with working capital cycles of borrowers and are better prepared to react quickly and work with clients when unique challenges arise.

While this may create extra work for a company as they adhere to reporting requirements, stockholders and management see this heightened level of oversight as a valuable supplement to their own financial tracking, particularly in volatile times. The same can be said for junior lending partners who know the ABL lender is paying close attention to liquidity dynamics.

A Team Approach

ABL, coupled with a tranche of "last out" or subordinated debt, may be a safer approach for many middle-market businesses as opposed to large, cash-flow term loans with one lender. It may offer a lower overall risk profile and support for capital preservation. Being able to turn to a team of lenders with deeper resources, as opposed to one lender, also may mitigate risk in executing strategies in a company’s future—whether that’s navigating through a crisis or even executing a growth plan.

The proof of this strategy can be seen in the strong relationships built over the years between ABL lenders and junior debt partners. These relationships offer benefits for all participants:

• For borrowers, this two-tiered debt approach can be a benefit. Lenders with a history of completing financings together often have legal document templates in place and know each other’s processes and work styles. This lowers the risk of lengthy or failed loan execution.
• Junior debt providers gain comfort in knowing an ABL lender is closely monitoring a borrower’s business trends and is more likely to act pragmatically in a crisis.
• Senior lenders appreciate that the junior lender is often proactive with management and ownership and may even hold a board seat or have observation rights.
• And lenders with existing relationships provide for effective lines of communication, a lack of confusion and rapport with the management team that benefits all.

M & A Considerations

Middle-market companies across most industries are solely focused on managing through a possible downturn, as are their advisors and lenders, with most growth strategies being reassessed given the uncertain environment. In fact, global M&A was 30% lower in 2022 compared with 2021, according to Bloomberg.

While there are many hard-to-estimate factors that could affect the timing of the economic recovery, the Conference Board said in its March 2023 Global Economic Outlook that it expects growth to slow to 2.3% in 2023.

In an environment roiled by uncertainty—now and moving forward—ABL structures may be a more prudent way to finance acquisitions, particularly for manufacturing and distribution companies. The equity gap to be filled may not be materially different than a cash flow structure as purchase price and leverage lending multiples pull back in response to volatility created by inflation and the Fed’s recent interest rate hikes.

The distressed buyout market will eventually heat up. Here, too, there is a role for ABL structures, which always lead with a revolving line of credit. Draws against revolving lines of credit have several under-appreciated features in the absence of scheduled principal amortization and the borrowing base expansion that accompanies growth in sales, which provides added liquidity without a term loan. These features can lower fixed charges, making it easier to meet covenants and free up cash flow to reinvest in a recovering or growing business.

As businesses look to the future, ABL may be the answer to solid execution for sound and strategic planning—for both companies and their advisors. As organizations begin to consider their first steps back to financial stability, ABL can be a powerful tool, particularly in capital-intensive industries. The capital structure can be diversified, borrowing capacity can be freed up for other purposes and businesses gain a source of working capital.

Investors seem to agree. According to an article by Daniel Pietrzak, a partner and co-head of private credit at buyout firm KKR, "ABF is a strategy well suited to these times, owing to the downside protection of collateral-based loans, diversity of borrowers, and customized investment structures."

To find out more about asset based loans, contact a Fifth Third Bank ABL specialist to discuss your unique financing needs and options.