Asset-Based Lending (2)
May 31, 2006
According to the 2004 Survey of Operating Statistics compiled by the Commercial Finance Association, total asset-based loans outstanding in the United States in 2004 were valued at $347.2 billion. By contrast, in Canada total asset-based loans outstanding in 2004 were valued at approximately $10.45 billion1. While the total figures for Canada pale considerably in comparison to the US figures, the market in Canada is clearly growing2. The growth is being fuelled by continued entry of US asset-based lending financial institutions into the Canadian market, the establishment by several Canadian banks of asset-based lending divisions, the entry of aggressive new players like hedge funds who in certain cases will make asset-based style loans and the increasing market acceptance of asset-based lenders as a standard alternative rather than a "lender of last resort".
Given the trends noted above and the advantages that this style of lending can offer a borrower in comparison to more traditional styles of lending (which will be discussed below), corporations should take the time to learn and understand this style of lending.
What is Asset-Based Lending?
Asset-based lending is a form of financing provided by banks and other financial institutions where borrowing capacity is based on the amount, liquidity and quality of the assets of the borrower. An asset-based lender bases its analysis on the ability to repay the loans from the sale of the assets rather than from the borrower’s cashflow.
Asset-based loans are typically made available by way of a revolving line of credit where the borrower can borrow, repay and re-borrow during the term of the credit facility. Borrowing capacity under these revolving lines of credit are based on the most liquid assets of a borrower like accounts receivables and inventory. While revolving facilities have traditionally been the most common structure used in asset-based loans, term loans have become popular as well as an enhancement to the revolving facilities. Term loans may permit the borrower to leverage its fixed assets, such as equipment and real property on favourable terms.
As indicated by its name, the central feature of an asset-based loan are the assets of the borrower. The asset-based lender will take a first priority security interest in the assets to secure or collateralize the loan. The maximum "availability", or the amount that can be borrowed by the customer, is determined using a borrowing base calculation where the asset-based lender establishes certain advance rates for different types of assets and then makes available to the customer the lower of a maximum committed amount and the amount generated by the borrowing base calculation.
Asset-Based Lending vs. Traditional Bank Financing
A focus on the assets is what distinguishes asset-based lending from traditional "cash flow" financing. Where the traditional cash flow lender looks first to the borrower’s cash flow and the overall credit worthiness of the borrower and its business, the asset-based lender looks mainly to the assets of the borrower valued on a liquidation basis for repayment of the loan. The covenant patterns in the loan agreements for each type of financing reflect this focus.
Cash flow lenders will require a variety of financial covenants including leverage and cash flow coverage tests as a gauge to measure the borrower’s financial health and ability to repay the loan. By contrast, asset-based lenders require far fewer financial covenants and in some cases, none at all. As a result, a borrower who is suffering negative earnings may continue to access its credit facility so long as it has sufficient assets. Asset-based loan documentation will often contain a "minimum availability" covenant so as to ensure that the borrower has enough available funds at its disposal to weather a downturn in the economy. The balance of the covenants are designed with an emphasis on monitoring and protecting the assets.
Top Five Things You Should Know About An Asset-Based Loan
A difference in focus between an asset-based lender and the cash flow lender has an impact on many aspects of the loan transaction. In particular, an asset-based lender will have requirements or deliverables that may not be required by a cash flow lender (or even if required by the cash flow lender will not have the same level of focus and importance as in an asset-based loan). Set out below are five requirements/factors that form part of any asset-based loan:
1. Cash Management. Most asset-based lenders will require some form of cash management to be implemented before the initial advance of the loan. Cash management is a system set up by the asset-based lender to control as well as monitor the cash proceeds of collateral.
2. Collateral Monitoring. In addition to cash management, the asset-based lender will require fairly sophisticated information systems at the borrower level. So that the borrower is able to monitor and determine with accuracy the level of its inventory and accounts receivables as well as their quality (i.e. saleability of the inventory, accounts receivable aging, concentration, etc.).
3. Due Diligence. The asset-based lender generally conducts far more extensive due diligence over the assets than a cash flow lender. This can result in funding delays if sufficient time is not budgeted at the outset, the borrower is not well organized or counsel is engaged late in the process.
4. Eligibility of Assets and Reserves. While all assets will generally form part of the collateral for the asset-based lender, not all assets will be included in the borrowing base calculation against which loans may be advanced. For example, if the asset-based lender establishes an eighty percent (80%) advance rate on accounts receivables the amount that can be borrowed on accounts receivables will not be 80% of the total value of all receivables, but 80% of the total value of all "eligible" receivables. Within the loan documentation, the asset-based lender will set out the eligibility requirements for each category of asset. The lender will also establish reserves which reduce availability which are designed to protect the lender against recovery risks should the security be enforced.
5. Third Party Documents. Asset-based lenders will be more insistent on obtaining documents from third parties where it views them necessary to ensure the priority of their security over the assets or to ensure access to the assets. This may include agreements from prior secured parties that confirm the limited scope of their security, landlord waivers, mortgagee waivers, bailee waivers blocked account agreements and priority agreements with other lenders.
The continued growth of asset-based lending in Canada will certainly increase the likelihood of Canadian companies finding themselves dealing with asset-based concepts in the future. Although asset-based lending is just a form of lending with many shared traits to traditional cash flow lending, asset-based lending also involves several unique characteristics as well as different points of focus from the traditional cash flow loan. However, companies and their CFOs should familiarize themselves with the key concepts of asset based lending to evaluate whether such an alternative would be advantageous to their situation and if an asset based solution is chosen, to ensure a smooth and efficient transaction.
These transactions require appropriate lead time and are document intensive. Companies are often well served by choosing counsel who have asset-based lending experience.
2 Total asset-based loans outstanding in the United States from 2003 to 2004 grew by approximately 5.6%. In Canada, over the same period, total asset-based loans outstanding grew by 368%.