April 2013

Creative Thinking — New Ways For ABLs to Realize Returns

Although today’s economic environment leaves many middle- and lower middle-market companies struggling to secure capital, it allows asset-based lenders to develop creative strategies and identify overlooked areas of opportunity to realize considerable returns, while enabling access to liquidity for these businesses.

At this point, there’s no question that larger companies have recovered substantially from the worst lingering effects of the financial crisis, having a relatively easy time accessing both equity and debt-based financing. The rebound has been so widespread in fact that it has prompted talk in many circles of a “bubble” in the upper-tier of the asset-based lending market.

Not everyone, however, has been so fortunate. The middle- and lower middle-market (those companies with EBITDAs ranging from $10 million to $50 million) have been far less successful in their efforts to secure capital that will enable continued growth and expansion — even as many of the companies operating in this space have the potential to grow significantly faster than the more mature, upper-tier companies, in tandem with the economy’s continued, albeit gradual, improvement.

While this gap in access to credit has presented a significant barrier to growth for medium-sized companies, it has created a tremendous opening for asset-based and cash-flow based lenders.

By thinking outside the box and developing creative, innovative strategies, lenders can realize considerable returns for themselves, while enabling access to liquidity for middle- and lower middle-market firms seeking to capitalize on improved economic conditions. Even in cases where hard assets, such as equipment and real estate, are thought to be limited, there remains an opportunity to put together creative financing strategies by lending against a raft of frequently overlooked but highly valuable cash-flow streams and assets that many of these companies possess.

There is very little doubt that lenders who continue to look at assets in a very fixed, traditional way are selling both themselves and would-be borrowers short. Other assets, while less obvious and sometimes far more complex, provide greater opportunity. Asset-based lenders looking to grow with the companies of the middle market should consider lending based on the following items of collateral:

Brand Equity

At times elusive and difficult to define, brand value heavily influences markets and drives consumer behavior across all industries — a basic economic principle that is surprisingly underappreciated by some lenders. When borrowers and sponsors are able to build associations with well-established, distinctive and appealing brands, they gain access not only to a built-in and loyal customer base but in most cases to profitable licensing arrangements. Furthermore, lucrative brands often encompass more than just one particular product or good, leading to other growth opportunities that, while on the periphery, are too far removed from the company’s core line of business. All these dynamics working together help businesses to better build, grow and sustain cash-flows.

Franchise Value

Borrowers or sponsors wedded to a well-known, established franchise with a proven growth model are frequently able to gain financing and extra liquidity on the basis of the equity value of the concept — which, depending on the circumstances, may have more value than tangible assets. For example, GB Credit Partners recently facilitated a loan for a sponsor to help it gain entry into a successful restaurant franchise after it struggled to find financing elsewhere. Try as it might, the sponsor, limited by its relatively small size and the company’s lack of hard collateral, was unsuccessful in its attempts to access second lien credit through traditional lending channels, such as banks or CLOs. What’s more, accessing lines of incremental equity proved prohibitively expensive, further complicating matters.

Having lent to both franchisees and original concept companies, we had an appreciation of the capital requirements for restaurant operators, a belief in the growth patterns of the franchise in question and an unwavering faith in the leadership of the management team. The key for asset-based lenders in this area is to do a deep dive with respect to industry, market and company data to project the sustainability of future cash-flows. From there, a lending solution can often be developed by providing traditional second lien financing and building in an additional layer of equity into the loan via a packaged mezzanine strip.

Real Estate Leases

Borrowers that have leases on all of their underlying properties without owning any hard assets are often assumed to present considerable risk to creditors. However, by looking beneath the surface and performing some additional due diligence, asset-based lenders can look at such borrowers as an opportunity.

In some cases, it is as simple as poring over the lease terms, such as the length, the amount owed and any fees or deposits required. In others, however, it requires a deeper dive to understand that there is frequently a variable level of value between different types of leases, and that it is not uncommon for certain long-term leases to have significant hidden value relative to current leasing prices in today’s market. Asset-based lenders should consider partnering closely with a real estate leasing expert to identify these areas of hidden value within a borrower’s portfolio of leases.

Long-Term Customer Contracts

For asset-based lenders attempting to identify opportunities in the small to middle-market, more important than hard assets is perhaps the prospect of guaranteed cash-flows. Companies that have locked multiple customers into long-term contracts offer something that lenders should consider far more valuable than a piece of real estate — the safety and security of a diversified and recurring revenue stream, derived from repeat customers.

A good example of this is might be a trucking company, which typically may not have the tangible assets to secure a loan because it normally leases all of its equipment and real estate. But by operating routes with long-term contracts under favorable terms with numerous customers, trucking companies represent enormous equity potential, even as they “own” next to nothing.

Misunderstood or Overlooked Hard Assets

Within the asset-based lending industry, most, if not all, firms have experience leveraging company-owned inventory, accounts receivables or machinery or equipment into capital. However, there are less traditional forms of collateral that asset-based lenders may actively seek out if they spend the time to understand the true value, including airplane parts, jewelry, artwork or even drill rigs.

While many may balk at the chance to work with smaller companies trying to access more liquidity, asset-based lenders (especially those with access to proprietary asset valuation expertise) pursuing innovative strategies that seek to provide financing to the middle market can yield lucrative results, for both the lender and the borrower.

By identifying frequently overlooked areas of opportunity and creatively protecting against risk by mixing and matching groups of assets into a loan package, lenders are able to achieve substantial returns, while positioning themselves to grow on a parallel path with the middle-market companies they support. However, it is only through a greater understanding of the asset-based lending industry, combined with a cash-flow and asset valuation skill set, that lenders are able to gain a unique line of sight into the quality of each prospective lending opportunity. And the deeper the understanding, the easier it is for a lender to predict sustainable and regular cash-flows.

Wendy Landon is a managing director of GB Credit Partners (www.gbcredit.com), the investment management affiliate of Gordon Brothers Group, which invests in structured and secondary debt. She can be reached at wlandon [at] gbcredit [dot] com.