For those of us who remember “Lost in Space” (the 1965 TV series), these words are part of our lexicon.  In the show, a robot would warn a young man living in space of impending danger.

Well, some potential investors react the same way when a company pledges its assets as collateral.  If the company can’t rely on its cash flow to get bank financing, they think the company must be in danger.

”Asset-based” financing (or ABL) to these folks suggests a company is close to failing and, thus, a bank will reject it. After all, a bank wants a well-performing portfolio – one with few failures – to generate more interest income.

To others, it may connote a company that is growing faster than its revenues. Perhaps it already has too much debt on its books. Or it is embroiled in a merger or acquisition.  But that isn’t necessarily true.

Over the years, we’ve found that companies choose an asset-based loan over bank financing because it’s simpler to do so.  Let’s take a deeper look.

First, let’s define what we mean by asset-based loans (ABL)[1].  Essentially, an asset-based loan is secured by collateral. That can be in the form of marketable securities, Inventory, Accounts Receivable, equipment — or other property, such as real estate.

In Cash-flow lending, the lender provides financing to a company, generally for working capital uses, based upon the expected cash flows of the company.  This form can be used for other needs, such as acquisitions, recapitalizations, etc.

What’s so flexible about an ABL loan? Stay with us here – this is about to get a little more technical.

Cash flow vs. Assets: The first line of defense a traditional (cash-flow) lender will look at is the cash flow of the company.  Does it have enough to cover the company’s operations and to pay the interest and principal (if amortizing) of the loan? Perhaps not; therefore, the loan will likely be made by an ABL lender who will look to the assets first in case of a default.

The ABL lender will allow the company to borrow less than the current value of the collateral. In that way, it creates a cushion in case the borrower gets into trouble. The discount below the market value will be slight, say 5 or 10%, if the collateral is highly liquid and stable, like treasury bonds.  Put another way, the borrower may keep $900,000 outstanding if his collateral is worth $1,000,000 ($900,000/1,000,000 = 90%)[2].  A less liquid asset will receive a much steeper discount.

Several leverage ratios are commonly used by traditional lenders, but these are less important to ABL lenders.  One such is the debt ratio, which compares total assets to total debt.  Another is the debt-to-equity ratio (total debt divided by total equity).  High leverage levels increase the risk of failure because of the demands the debt places on revenues.  Again, these are less important to ABL lenders.

Loan Covenants[3]: Remember, the most important ratio to an ABL lender is the asset coverage ratio described above. So, ABL loan agreements are less restrictive than cash-flow lenders’ agreements.

Personal Guarantees: When lending to a small company, banks require personal guarantees more often than do lenders to companies that have pledged underlying assets.

Higher advance rates: This can depend, as noted above, on the type of pledged collateral.  Other factors can proscribe how much money a company can borrow, such as a large amount of past-due receivables (or inventory that is selling slowly – not “turning over” quickly).  As a rule, however, cash flow lenders will offer lower amounts to identical companies than will asset-based lenders.

Careful, Will Robinson – it’s not a cakewalk for ABL borrowers. Lenders will monitor the value of the collateral closely. If you’re lending to a company with perishable goods – tomatoes, for instance – you’re going to want regular assurances that the goods are retaining their value – more frequently than if the collateral is, say, a commercial building.

You’ll also want to be sure the collateral is still on-premises.  In one deal offered through Carolina Financial Securities, Carofin’s parent company, investors had claims on 65,000 4’x4’x3’oak bins!  It might be tough to move those without raising concerns, you still want to know you’re protected.  There may be times that you’ll want a third-party evaluation expert to confirm the collateral’s value.  Frequent financial reporting is called for in these cases as well.

Investors in a CFS deal once made an ABL loan to a company in the metals recycling business.  When the company asked for more money, a valuation expert reduced the estimated value enough to precipitate an event of default (the value of the collateral was insufficient to support the outstanding loan), which, when unresolved, led to serious consequences for the company.

So, two different approaches to lending offer investors significantly different sets of considerations. But, one key takeaway is that, even if a borrower decides to pledge collateral (and likely is paying more to the lenders than with bank financing), this doesn’t mean that the company is in distress.  It may mean that this approach fits the company’s composition better than through traditional finance providers.

 

[1]  To understand the difference between different types of loan structures, see our article Forms of Lending.

[2] To further complicate matters, lenders will dictate a “maintenance” level.  Where the value of the collateral to drop below a pre-agreed level, a “margin call” would be triggered, forcing the borrower either to add collateral or to pay back a portion (or all) of the loan.

[3]  Click here for a sample copy of a private lending term sheet to see typical loan covenants.