November/December 2017

Why Is Asset-Based Lending So Expensive? Comparing Cost Structures for ABL and C&I Loans

There is a common belief, especially among business borrowers, private equity funds and M&A sponsors, that inefficiencies leading to predatory pricing exist in the small-cap and lower middle market business lending space. That assumption may be incorrect because the ABL cost structure is very different in comparison to inexpensive bank lending. By utilizing a new, more optimized funding structure, ABL firms may be able to greatly reduce their cost of capital.



Jeffrey Sweeney, Chairman & CEO, US Capital Partners

Jeffrey Sweeney, Chairman & CEO, US Capital Partners

Many smaller businesses don’t qualify for bank financing. The asset-based lending (ABL) marketplace is well developed for providing capital to such smaller businesses with assets, which may include accounts receivable, inventory, purchase orders, real estate, machinery, equipment and intellectual property.

However, these ABL loans are more expensive than commercial and industrial (C&I) loans. Why is this?

Drivers for higher pricing might include:

  • Risk — or perception of risk — is higher than C&I profiles
  • Lack of competition in the marketplace
  • High loan administration and origination costs relative to transaction size
  • High costs of capital for ABL lenders

Increased Risk or Perception of Risk

Interestingly, the default rates on ABL and C&I loans are similar. Although the true risk in ABL is similar to that in C&I lending, as indicated by loan performance, the perception of risk is much higher for ABL because the borrowers often have issues related to financial performance, time in business or type of business. This increased perception of risk by banks will not necessarily be shared by ABL lenders who are specialists in assessing and managing collateral in a particular asset class.

Lack of Competition

The highly fragmented ABL market is made up of many pools of lenders with different risk appetites and asset class sector expertise. An efficient and competitive environment usually exists within each pool. But a borrower needs to know which pool to approach for borrowing and must be able to find appropriate lenders in that pool. This is no easy task given the current state of the ABL market, which consists of many specialty lenders. Borrowers often have difficulty finding the appropriate pool of lenders or a sufficient number of lenders in the pool. This inefficiency can lead to higher pricing due to lack of competition.

High Loan Administration & Origination Costs

Loan administration and origination costs, many of which are more like fixed costs, drive up the overall cost of ABL. The cost of initial underwriting and collateral monitoring over time is low for C&I loans. In ABL, however, there are more complex risk assessments and mitigation, so more investigation, administration and oversight of the collateral is required. Unlike C&I loans, the task of regularly and thoroughly monitoring assets extends throughout the term of the loan.

The cost of originating proprietary deal flow and structuring the deal flow to meet the lender’s specific investment guidelines is also higher in ABL. Origination cost for a bank is usually limited to cross-selling existing customers or networking within its regional community.

Specialty finance companies, by contrast, generally have a very narrow investment focus and are smaller and more numerous. These ABL lenders don’t usually venture outside their specialty field, so the cost of fielding a number of sales people either regionally or nationally, as a percentage of transaction costs, is much higher than for banks.

These costs are, of course, proportionally higher for smaller credits. For larger companies, these costs are amortized over greater financing amounts.

High Costs of Capital for ABL Lenders

The cost of capital for an ABL lender is the cost of bank leverage, which is relatively low, plus the cost of private sources of capital (or equity-like debt), which is very high. Size also affects this cost structure substantially. Smaller companies’ capital stacks cost significantly more than larger facilities, leading to a higher lender cost of capital.

A commercial bank lending to a specialty finance firm will carefully assess the finance firm’s underlying portfolio and its quality and structure as well as any legal claims on these rights. The bank will provide different levels of availability depending upon underlying asset type and industry and will typically request an interest rate from 2% to 7%.

Additionally, banks will not allow any other debt on the portfolio or finance company, but will require equity. In the past, subordinated debt was usually considered equity, but due to changes in the banking regulatory climate, banks that finance lending lines of credit increasingly cannot consider subordinated debt to be equity, but will require true equity in the finance company.

The traditional way to launch or scale an ABL finance company is by bringing in investors as partners under promissory, demand or subordinate notes. These investors may be family funds, private investors, private equity firms and the like — essentially most of the equity of the business. These partners usually represent a 10% to 12% cost of capital for the specialty lender and sometimes also require a further profit share. Some specialty finance companies may have as many as 30 to 40 investors, which creates a complicated debt schedule.

Bank leverage has gradually been reduced for finance companies, because of pressure from regulators and new underwriting guidelines for underlying assets in portfolios. Consequently, private capital for specialty finance companies is in demand, and, due to the subordinate equity-like risk involved, the cost of private capital is higher. To attract private capital, specialty finance companies are under additional pressure to have a sufficient volume of deal flow and assets under management to create a return on investment appropriate to meet mounting costs.

How to Deliver the Greatest Reduction in Costs

Operational costs, origination costs and costs related to the smaller size of transactions are relatively intractable. Although significant, they are not easily addressed. High costs of capital due to decreasing leverage, high cost of subordinated debt and even the withdrawal or reduction of leverage lines due to changes in bank requirements for equity are probably the most important issues to address to reduce ultimate borrowing costs. Reshaping the debt and equity ratios on the balance sheet is the best way to address them.

Bringing in investment partners using a private investment fund structure as an equity investor in the specialty lender is one way to address this. Recently, for example, we helped a specialty finance company transition to a preferred equity fund structure. This finance company was obtaining bank leverage on a deal-by-deal basis. It had approximately 40 private investors, many holding high-interest demand notes with various interest rates and terms. With such demand notes, a lending partner can often request repayment by giving as little as three to four months’ notice. The capital supply of this specialty finance company was therefore quite volatile.

The finance company was able to shift almost all its investors over into a new preferred equity fund structure. These investors became limited partners (LPs). Typically, investment funds have a hurdle rate of between 7% and 10% per annum in favor of their LPs. This means that the general partner (GP) of the fund cannot take a share of profits from the fund’s activities until the LPs have first received their preferred return for that year. After this, any profits are divided between the GP and the LPs. The initial dividend rate can appear lower, but the profit share component can lead to equivalent or higher returns for investors to encourage this transition.

One immediate benefit of such an equity-like fund structure is that any leverage from the bank now becomes fund-level leverage, which is less expensive than portfolio leverage. If a specialty finance company has an SEC-registered investment advisor as well as a broker dealer placement agent, the new structure immediately gives comfort to wealth managers, making it easier to raise capital. It also transforms the company’s profile as a borrower for a commercial bank, making it easier for the bank to reduce its leverage interest rates and increase its advance rates.

Tapping New Sources of Private Capital

Small investment funds, if properly designed in a compliant manner and supported by a registered broker dealer with this credit specialty, can fundraise through “general solicitation.” In other words, an SEC-registered private placement offering can be advertised to a wide variety of potential investors through either social media or direct advertising.

Such offerings can also be made widely available to registered investment advisors (RIAs) acting on behalf of their clients through popular investment custodial platforms, provided the offerings have an assigned CUSIP number and have gone through the onboarding process for those platforms. Offerings, compliantly built, can be listed on popular public brokerage platforms such as TD Ameritrade, E*TRADE and State Street. TD Ameritrade, for example, is one of the biggest discount brokerages in the U.S., with more than 10 million client accounts.

The supply of capital for specialty retail companies is restricted, so the cost of capital is high. Specialty finance companies may find it helpful to evaluate new, optimized fund structures to reshape their own balance sheet capital structures. Making use of a private investment fund structure allows specialty finance companies to give a greater number of investors access to their asset class, potentially driving down the costs of capital.