Just like its record setting weather this year, the Midwest’s asset-based lending market has been heating up. New competitors have entered the market and many existing lenders have expanded their presence. Loan spreads have been declining and structures have become less restrictive. As a result, it’s a good time for borrowers to re-examine their banking relationship or to think about expanding their businesses. For lenders, the challenge is to grow while still maintaining appropriately priced and structured asset-based loans.

The Midwest has traditionally been fertile ground for middle-market asset-based lenders. The area is concentrated with privately held manufacturing and distribution companies that typically make for good asset-based clients. Most of the businesses that weathered the recession are now performing fairly well and some are looking at new growth opportunities. Although the uneven economy has resulted in relatively soft middle-market loan demand, for companies looking to expand their borrowing needs, the market is wide open.

Strengthening Industry Segments

Medium to heavy manufacturing still makes up a significant portion of the Midwest’s economy. Manufacturing, as a percentage of gross state product, ranges from 12% in Illinois to 20% in Wisconsin, 21% in Iowa and 25% in Indiana, higher than most other areas of the U.S. In addition, most segments have been improving. According to a recent Chicago Fed Midwest Manufacturing Index (CFMMI), overall Midwest manufacturing output is now nearly back to pre-recessions levels, with the Industrial Production Index for Manufacturing (IPMFG) following closely behind.

Statistics and graph provided from the Chicago Fed Midwest Manufacturing Index (CFMMI) released July 30, 2012 by the Federal Reserve Board of Chicago. The CFMMI is a monthly estimate of manufacturing output in the region by major industry. The CFMMI provides a regional comparison with the manufacturing component of the Industrial Production Index (IPMFG) compiled by the Federal Reserve Board.

Among specific sectors, auto, steel and machinery are performing particularly well due to improving conditions in the automotive industry, agricultural equipment manufacturing and the mining and energy industry. The resources category, which includes wood, paper, chemicals and minerals, is still lagging somewhat due to continued softness in housing.

Competitive Landscape

As in many areas of the country, company revenue and loan size are some of the key segmentation drivers of the asset-based lending market. Large, national lenders such as Wells Fargo, Bank of America, J.P. Morgan Chase, PNC and U.S. Bank are all active in the Midwest. However, they tend to gravitate toward larger companies and credit relationships. While there are a significant number of larger borrowers in this region, they are not as prevalent as borrowers in the lower end of the middle-market, with approximate revenue ranging from $10 million to $100 million.

This segment of the market is generally served by regional or local bank-affiliated asset-based lenders. This group includes BMO, Citizens, Cole Taylor, First Business, First Financial, First Midwest, First Merit, Huntington, Private Bank and RBS. Associated Bank Commercial Finance is part of this group as well. Among these lenders, risk appetite and loan size parameters vary, but all are currently active in the Midwest. A number have recently expanded their staffs and ramped-up their calling efforts. Most have capital to lend and are looking at their asset-based groups as a natural way to grow assets as the economy slowly improves.

With this many lenders to choose from and overall loan demand that is still relatively soft, it’s easy to understand why pricing and structure have become very favorable for borrowers. From a pricing perspective, spreads came down at least 50 basis points in the last year for typical asset-based loans in the $5 million to $15 million range. For better quality credits, loans are now being quoted at LIBOR + 250 to 300 or even lower for borrowers on the larger end of the loan size spectrum. Smaller or lower quality credits are still being priced in the mid to upper 300s, but these spreads are also under pressure.

For example, a Wisconsin-based distributor with a history of marginal profitability and negative cash flow was looking for proposals to refinance its $15 million revolving credit facility. The company primarily focused on pricing and ended up with a deal priced at under LIBOR + 250 with no unused line fee, no field exam or other monitoring fees and a minimal closing fee. From a structural perspective, advance rates were 85% against accounts receivable and 60% to 65% against inventory. This deal was attractive to lenders because there was no term debt involved and the borrower made fairly heavy usage of its revolver.

As it currently stands, minimum interest rate floors have mostly evaporated. Closing and other fees have also declined, especially on straightforward refinancing opportunities. A bright spot for bank-affiliated asset-based lenders is that ancillary services, such as treasury management, can help boost overall yields.

Credit Structures Loosening

For those that have been in the industry a long time and have been through multiple credit cycles, we sometimes marvel at how short our collective memories are. It wasn’t that long ago that “ABL lite” deals were commonplace, especially for larger credits. Those deals were structured with minimal covenant packages and often included springing cash-flow covenants and springing cash dominion requirements. While these types of structures all but disappeared during the recession, they have recently been making a comeback, even for companies at the lower end of the middle market.

There have been a number deals in the lower middle market where the only real covenant requirement was minimum excess availability. As asset-based lenders, availability and liquidity are certainly the primary focus, but having a meaningful cash-flow covenant offers important protection, especially for companies with significant term debt financing needs. Availability can (at least for a period of time) be manipulated by stretching accounts payable or shrinking the balance sheet. Having an adequate measure of cash flow can sometimes trigger warning signs in advance of declining availability. The availability of personal guarantees, even on smaller, privately held businesses, has also become less common.

A recent transaction from an Indiana-based manufacturer illustrates the trends of declining pricing and looser structures. The company, which had lost significant money during the recession but rebounded nicely in 2011, was looking to refinance its $8 million credit facility. The balance sheet was highly leveraged, but with good collateral coverage and cash flow, the borrower was able to command sub LIBOR + 300 pricing with minimal fees and with no personal guarantees. The lender that won the business was also willing to advance against work in process.

Another example is an Illinois-based distributor related to the housing industry. The company had a recent history of declining revenues coupled with four years of significant losses, and it was looking to refinance its $20 million revolving credit facility. Despite being in business for a long time, the company’s losses had all but eliminated its net worth position and cash flow had just recently started turning around. However, the collateral position was strong and as a result the company was able to get pricing in the low 200s. The bigger surprise here was that there were no cash-flow or balance sheet covenants; the only covenant was a minimum availability floor.

The trends in acquisition oriented financings have been more favorable, with some recent examples in the senior debt size range of $10 million to $20 million still generating pricing near LIBOR + 300 with reasonable fees. Many private equity groups see value in structuring historically cash-flow uneven companies under an asset-based arrangement, where the key driver is availability. Most also realize that positive cash flow is expected and understand the need for a cash flow covenant.

A Collaborative Approach and What’s to Come

The go-to-market strategy that the Associated Bank’s Commercial Finance team has found most successful involves close collaboration with commercial banking partners throughout the region. This allows for deeper ties with customers, as well as the cross promotion of other offerings and services, which ultimately leads to increased opportunities for both the bank and our clients.

As we look at the market, we believe that key growth opportunities will come from middle-market borrowers with financing needs ranging from $3 million to $25 million. From a credit structure perspective, a traditional approach to asset-based fundamentals has historically served the market well and will drive success in the future. Primary analysis should center on collateral coverage and overall borrowing base liquidity with cash flow analysis as a close second, especially when there is term debt to service. It is also important to consider the wide range of turnaround situations, ensuring that there is reasonable evidence of a turnaround before proposing an opportunity. Balance sheet leverage and cash-flow leverage can also be factors in this analysis. A meaningful covenant package is important and traditional asset-based controls, such as cash dominion, are to be expected.

With the effects of the recession on their portfolios mostly in the past, the biggest near-term challenge for most asset-based lenders in the Midwest will be to grow their businesses without sacrificing too much on pricing and/or structure. Each of the many lenders in this active market will have to find their balance in this equation and go to market appropriately. A further strengthening of the economy and corresponding pickup in loan demand will also help lenders grow. However, as the Midwest weather starts to chill, there’s no evidence that the asset-based lending market will cool down anytime soon.

Mark Wierman has been the president of Associated Commercial Finance, Inc. since 2008 and has been in the asset-based lending industry for 27 years. Prior to joining Associated, he spent 12 years at LaSalle Business Credit. Prior to LaSalle, Wierman worked for Congress Financial and Firstar Financial.

Associated Commercial Finance, Inc. is a wholly owned subsidiary of Associated Banc-Corp, a publically traded, diversified, multi-bank holding company with assets of $22 billion. Associated has been in the asset-based lending space for approximately ten years. Associated Banc-Corp has over 250 banking locations serving more than 150 communities throughout Wisconsin, Illinois and Minnesota and commercial loan offices in Indiana, Michigan, Missouri, Ohio and Texas.