The ABCs of asset-based financing

Features - Workplace Management

ABLs are particularly well-suited to businesses experiencing either rapid growth (to fund that growth) or with volatile cash flow (to smooth out the ups and downs).

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March 8, 2016
Alex Mazer
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The fall in ferrous and nonferrous scrap metals pricing has not only put pressure on cash flow for all metals recyclers, it also has put pressure on banks that have financed those businesses.

Even if the business remains profitable, declining revenue and margins may trigger loan covenants in traditional bank financing.

As a result, metals recyclers are looking closely at alternative sources of financing to maintain operations while they take additional steps to deal with price decreases of as much as 50 percent in 2015.

ASSET-BASED LOANS

Asset-based loans (ABLs) are a good option for recyclers for a number of reasons. These types of loans are based on the value of the recycler’s hard assets rather than on the recycler’s cash flow. As long as the underlying assets continue to have value, the structure of the loan can be much more flexible than traditional bank financing.

According to the Office of the Comptroller of the Currency (OCC), the federal agency overseeing ABLs, these loans offer several key advantages to business owners, including:

  • providing ready cash to support liquidity needs;
  • providing important funding for companies in cyclical or seasonal industries by providing liquidity during slow sales periods and periods of inventory buildup;
  • providing rapidly growing companies the cash to fund growth or to replenish internal capital used to fund growth by financing increases in receivables and inventory;
  • underwriting typically involves a limited number of financial covenants;
  • borrowing terms and repayment schedules generally provide more flexibility and can be customized to fit the individual business requirements or business cycle; and
  • borrowers can monitor availability on a daily basis.

ABLs are particularly well-suited to businesses experiencing either rapid growth (to fund that growth) or with volatile cash flow (to smooth out the ups and downs). An ABL is, by definition, less sensitive to operating cash flow and the metrics that constrain traditional cash flow lenders.

In addition to the working capital lenders and factors, asset-based lenders provide term loans against the value of machinery and equipment. These term loans are different than those offered by factoring companies or from those based on working capital. Rather than advancing funds on invoices or goods being shipped to generate invoices as a factoring company would, term asset-based lenders will offer loans based on the hard assets of the business (i.e., machinery, equipment, rolling stock, etc.), without being constrained the way a typical bank would be.

Alex Mazer

Other circumstances that often make a conventional lender hesitant to advance funds include companies in transition or those that are restructuring; companies that are experiencing the loss of a major account; a company’s customer concentration; litigation against the business; tax liens; the divorce of the principals; bankruptcy; or consecutive quarters of reduced profitability. All of these are red flags for banks but may not be for an asset-based lender, depending on the value of the company’s hard assets.

SIMILARITIES & DIFFERENCES

ABLs are available with different structures. These include a revolving line of credit, which provides advances against eligible accounts receivable and inventory; and term loans, which are advances based on the appraised value of fixed assets.

Asset-based lenders can be regulated or unregulated.

A regulated lender often is a subsidiary of a large bank and often can be constrained by capital reserve ratios that have tightened considerably since 2008. Regulated banks have required liquidity ratios, or cash they must hold to protect against losses, and, therefore, cannot loan. When a credit is in default or considered a higher risk, the bank has to hold more cash on its books to reserve against a potential loss. These same banks earn money by making loans. Therefore, if the regulated banks have to hold cash and are prevented from using that cash to make loans, it is not profitable or prudent for most regulated banks to finance these credits. Banks can call the loan, choose not to extend financing at maturity or sell the loan to exit the credit and free up liquidity to satisfy regulators.

The unregulated lender may be privately funded, entrepreneurial and often a specialist in a particular industry or group of industries.

Following the recession in 2008, several regulatory agencies have imposed new restrictions on lenders, which have tended to increase the cost of capital (despite historically low federal funds rates) or have made capital less accessible. As a result, regulated bankers actually are partnering with unregulated lenders to make capital available to businesses that would otherwise have more limited access to funds.

In the past year, lenders such as Big Shoulders Capital have been asked to assist several banks by participating as a term lender or by refinancing long-standing borrower relationships to provide the flexibility and liquidity to companies that bankers themselves cannot provide.

“Out of favor industries,” such as those tied directly to commodity prices, including metals recycling or oil and gas, may require that banks maintain higher reserves than they would for other industries and, therefore, are not as profitable for the traditional bank. These same companies—even if they are restructuring, downsizing or experiencing rapid growth—may be particularly good candidates for an ABL.

In 2015, for example, we helped a metal recycler finance an opportunistic acquisition of a regional competitor whose bank was forcing a sale. The loan was collateralized by the company’s equipment. As commodity prices fell further, the company fell out of favor with the bank it had been using for years. Now, we are working on a solution to finance the entire business, largely in light of the flexibility and creativity we can offer as a unregulated asset-based lender specializing in offering financing solutions for industrial companies.

ABLs can be used for any business purpose, including operations, acquisitions, reorganization, restructuring and other uses. The unregulated asset-based lender often is more creative and can uncover value where other lenders may not find it. A lender specializing in loans backed by industrial machinery and equipment often will recognize the value of that equipment and is familiar with the market values.

“ABLs can be used for any business purpose, including operations, acquisitions, reorganization, restructuring and other uses. The unregulated asset-based lender often is more creative and can uncover value where other lenders may not find it.”

RISKS

What are the risks recyclers will find associated with financing through an ABL?

Obviously, if the recycling company defaults on the ABL, the lender would have a claim on the assets. Typically, these agreements allow the lender to take control of the borrower’s cash or to seize collateral more readily if the business declines to a level that does not support the loan. This outcome likely also would be true with conventional lenders, depending on the terms of the loan.

If a business is highly leveraged already, it may not make sense for the owners to add additional debt, even if it can be secured. Highly leveraged companies generally are considered more risky and can be a warning sign of a distressed business. However, if the company has a clear workout plan and the ABL can provide additional liquidity for working capital, an ABL may provide a real benefit, even for companies in these circumstances.

Another consideration is that ABLs may carry higher interest rates than a bank, but this is not always the case.

Generally, these loans also are higher risk. The OCC points out that administering and monitoring an ABL is time- and cost-intensive and may be the most economical type of financing available to the borrower.

For recyclers attempting to work through the current volatility of metals pricing, ABLs are an additional resource available to help sustain and grow their businesses, even in the face of tough market conditions.

Alex Mazer is vice president of Big Shoulders Capital, www.bigshoulderscap.com, a Northbrook, Illinois, asset-based lender specializing in creative financing solutions for manufacturing and industrial businesses. He completed his undergraduate studies at the University of Richmond’s Robins School of Business and received his MBA with a concentration in finance and innovation/entrepreneurship from Northwestern University’s Kellogg School of Management. Mazer has lived and worked in Hong Kong, China and the United States.