With investors’ appetite for asset-based loans continuing to strengthen over the course of 2013 — and with new lenders entering the ABL market on a regular basis — competition for deals has picked up substantially over the past 12 months. This trend is expected to continue in 2014. While most lenders realize the importance of maintaining structuring and risk management discipline when the number of solid lending opportunities becomes scarce relative to the capital available, it can be all too easy to overlook long-term issues that may eventually come back to undermine a lender’s returns.

As we have seen in our own experience, one area in which many asset-based lenders find themselves caught off-guard in environments like the current one is in accounting for long-term volatility in collateral asset values.

Accounting for shifts in the value of collateral assets over the life of a loan is no easy task. While many lenders take great care to understand the value of assets supporting a loan during the underwriting process, monitoring those values on an ongoing basis requires the lender to maintain constant contact with a broad array of markets as well as the potential diminution in value of a particular asset due to general depreciation, use of collateral or some other factor impacting value. Without this perspective, a lender may be caught flat-footed by, for example, a surge in the global supply of certain key types of inventory, or simply by the fact that values for various asset types respond differently at various points in the business cycle.

Developing a Long-Term View of Volatility

While lenders understand that each of the five major assets categories (accounts receivable, inventory, machinery & equipment, real estate and intellectual property) belongs to its own distinct market with its own discrete patterns, it can be difficult for lenders to anticipate how the values of each type of asset will respond to various developments in the overall business cycle. During a cyclical downturn, the value of a consumer brand, which is often derived from sales volume, for example, may weaken, while the value of machinery and equipment — which can often be redeployed for other purposes — may hold up better.

Moreover, it is important to bear in mind that sub-segments of each of the asset classes above follow their own distinct trends and respond differently to various economic factors and events, as well. Volatility within the inventory category, for example, varies across finished goods, work in process and raw materials; in real estate, suburban office space and manufacturing facilities often follow significantly different pricing trajectories than commercial space located in central business districts. The unique dynamics of each market can also cause disposal and maintenance costs to differ substantially from one asset type to the next.

In addition, lenders should take care not to base volatility assumptions on limited historical data. Developing an accurate view of asset volatility requires lenders to assess the performance of various assets over the course of multiple market cycles — potentially involving many years’ worth of data — rather than over shorter time frames. Some asset classes have less volatility and are easier to predict during shorter cycles such as accounts receivable and inventory. However, machinery & equipment and real estate may need to be viewed utilizing a longer-time horizon. Additionally, lenders must consider market dynamics during any period of time, since specific market events can dramatically impact views on value.

Mitigating Risk by Diversifying Collateral

Maintaining visibility into the market dynamics and volatility of multiple asset categories can also help lenders manage risk by employing a broader range of assets as backing for a given credit. For example, we are often able to reduce the risk of a loan by adding security interest against assets that may provide a secondary source of repayment, or “boot collateral,” based on our knowledge of asset markets across the full spectrum of collateral types. Additional collateral improves the loan-to-value ratio that GB Credit Partners is evaluating when providing an asset-backed facility. In theory, the lower the loan to value, the less the risk associated with the transaction. However, looking at pure math can be deceiving. Lenders must consider other factors including the asset class, the lenders’ comfort in that collateral category and existing and projected market dynamics. It is essential for a lender to consider both qualitative and quantitative factors when evaluating an opportunity. Additionally, where our assessment has been informed by the expertise of specialized business units within Gordon Brothers Group, our parent company whose understanding of asset values is supported by its valuation and disposition practices, it has allowed us to enter into environments of varying levels of volatility, including severely distressed markets with confidence and a full understanding of the risk.

For example, GB Credit Partners worked with a borrower in the lumber and plywood industry that found itself facing unprecedented challenges resulting from the housing crisis. Residential construction collapsed during this period, with housing starts nationwide falling by 74%. The borrower’s own sales fell by nearly half, forcing it to sell a portion of its real estate holdings and other assets and commence a restructuring plan to maintain liquidity.

After exhausting many of its other options, the borrower sought to leverage its real estate and machinery & equipment to access additional capital. The company was referred to GB Credit Partners by a specialty lender on the basis of Gordon Brothers Group’s experience.

At a time when other lenders were leaving the industry, we looked past the borrower’s immediate struggles and enlisted Gordon Brothers Group’s Commercial & Industrial Division and real estate affiliate DJM Real Estate to assist with due diligence. Although the term loan facility was predicated assuming a liquidation of individual pieces of equipment, GB Credit Partners realized that the company’s state-of-the-art machinery & equipment held much greater value, as long as the borrower’s real estate and machinery & equipment assets could be held together to allow the equipment to be sold in place. As a result, GB Credit Partners required a first priority security interest in the real estate as “boot collateral.”

On that basis, we extended a $16 million facility to the borrower. The additional financing provided the company the necessary capital to support the business during the cycle. As the housing market improved, the company has recovered with sales volumes and profitability improving significantly.

In another recent example, GB Credit Partners was able to extend a crucial lifeline to a diversified consumer electronics retailer based on our understanding of the markets for both retail inventory and commercial real estate. Facing deteriorating results due to the recession, and experiencing pressure from its secured lender to refinance or seek other options to repay its existing line of credit, the retailer seemed to have few options other than a sale of part of its real estate portfolio at a significantly depressed value.

However, GB Credit Partners identified the under-recognized value in the real estate as well as in the company’s retail collateral and offered a flexible solution that would allow the borrower to keep its property holdings intact. DJM Real Estate provided a valuation of the real estate, which was utilized in developing a solution for the company. Ultimately we extended a $30 million facility to the borrower, secured by its real estate and retail collateral.

The speed with which GB Credit Partners was able to examine the situation and the prompt valuation provided by DJM Real Estate made all the difference. The borrower was able to avoid a significant loss in its real estate portfolio by selling an asset prematurely and at a time of weakness, while management has been able to return its focus to the business as opposed to its capital structure. The result has been a substantial improvement in performance and in the company’s vendor relationships.

Structuring Protections Against Collateral Value Volatility

As competition for deals accelerates further in 2014, lenders should not forget that the only thing certain about asset values is that they will continue to fluctuate.

Lenders can accomplish this by incorporating triggers based on collateral value — not just on EBITDA or cash-flow performance targets — into new loan agreements. While curtailing a borrower’s liquidity may not be the right answer when collateral values fall, lenders should still be aware of possible over-advances, and should position themselves to take advantage of other risk mitigation options such as increased frequency of field appraisals, higher spreads, forced asset sales or increased reserves.

Conclusion

Managing fluctuations in collateral asset values is a critical component of every asset-based lender’s business. While the industry remains a center of opportunity for strategic players with the ability to seize the initiative and find creative ways to help businesses meet their liquidity needs, the fact remains that the potential for volatility lingers at virtually every turn.

To effectively navigate this complicated environment, asset-based lenders must have a comprehensive understanding of the assets they lend against. That means having the expertise and knowledge to take a take a broad, 360-degree view of a borrower’s various asset classes, leveraging that ability to lend against as many of those assets as possible to take advantage of attractive opportunities while maintaining a reasonable risk profile and putting in place a series of protections early in the lending process to safeguard against the most likely downside outcomes.

Patrick Dalton is CEO of GB Credit Partners, the investment management affiliate of Gordon Brothers Group. With more than 20 years of credit and investment experience, his primary focus is maintaining and growing the debt portfolio.