Many times with distressed credit situations, using collateral instead of current and future cash flow projections may be the best way to underwrite a given transaction and design a true exit strategy. When are conditions right to use this approach?
Despite an improving economy, many companies still find themselves in challenging financial situations. Often, these distressed entities have experienced margin compression, increased leverage and reduced revenues and profits, all of which result in reduced cash flow to service debt, reduced liquidity and an inability to access capital through conventional means. When these conditions exist, and additional liquidity and creative structuring for a refinancing are required, a more prudent approach may be underwriting to a liquidation scenario. In these cases, recovery of principal will largely come from the sale of fixed assets against which the lender advances funds at a conservative rate from inception.
For a term lender, taking a collateral underwriting approach will lean heavily on the ability to recover and quickly sell fixed assets to repay outstanding principal. A cash flow analysis should be conducted to determine if a possible day-one default is evident. Management prepared financial projections in these circumstances are oftentimes unreliable at best. Underwriting to TTM EBITDA (trailing 12 months; earnings before income taxes, depreciation and amortization) and pro forma debt service coverage (a theoretical review of ratios as if a refinancing had taken place month-one, with the resulting fixed-charge coverage ratio) may be the best cash flow analysis as it may serve as a base for 12-month advance projections. Also, this test could serve as a determinant for proposing prudent advance rates against the assets to be financed day-one forced liquidation value (FLV), and ensuring adequate day-one collateral coverage.
Determining the Value
For a term loan transaction that appears to be collateral dependent, the first step will be determining the estimated day-one value both on an orderly liquidation value (OLV) and FLV basis, an appropriate advance rate predicated on the cash flow and liquidity needs of the borrower as well as risk profile and a pro forma fixed charge coverage ratio test that will depict a borrower’s ability to service new and existing debt. As a starting point for estimating the initial values of the fixed assets, a desktop analysis by a qualified appraisal firm should give term lenders good insight as to what they are working with and if there will be enough collateral value to make a deal, even if bifurcated with an asset based lending (ABL) group.
Conservative advances against day-one values are not enough, however. More importantly, especially if you are underwriting to a potential liquidation strategy on a base case scenario, the term lender/lessor should be comfortable with the “collateral curve” — the graph showing investment dollars out at any given time versus the collateral values of assets used as security during the term of the deal. The collateral coverage ratios will be more important than the cash-flow tests in these situations, and most will want to achieve coverage of around 1.20x to 1.40x by the end of the loan’s first year. For this reason, long-life assets are desirable for a financing, especially when refinancing. This requirement will vary based on the asset specialty and knowledge of the term lender/lessor, but will typically consist of the following asset classes:
- Yellow iron
- Transportation equipment
- Heavy manufacturing equipment (critical use assets, i.e., metal fabrication, CNC lathes and presses)
Assets prone to obsolescence, like medical equipment, restaurant equipment, hospital assets and high tech assets are not desirable.
Advantages of Sale/Leaseback
Lenders/lessors typically have existing relationships with auction groups that understand certain fixed assets better than others (i.e., construction, transportation or manufacturing) and potentially serve as a backstop in the event of foreclosure, recovery and liquidation. Many times an auction group will hold auctions at a borrower’s premises and have an agreement, sometimes up to 90 days, for the rights to access the property to conduct an auction. Digital technology has drastically reduced advertising and marketing expenses to run an auction since auctioneers no longer rely solely on print advertising. This has considerably reduced the expense of recovery and liquidation. Finally, depending on the relationship between auctioneer and lender/lessor as well as the asset type that may be recovered and liquidated, it is common to guarantee — at inception of a financing transaction or at the beginning of an auction — payment of a certain dollar amount to the lender/lessor from the auctioneer conducting the auction. This potentially provides an additional backstop that may assist the lender/lessor in properly structuring a minimally risky transaction while giving the auctioneer inventory to sell and realize a profit.
Financing instruments that are ideal in collateral-dependent transactions are sale/leasebacks. Typically, lenders that understand certain types of collateral and are comfortable with collateral-dependent transactions are able to lend more against the value of desired assets due to confidence in their ability to recover and liquidate the assets in the event of foreclosure. With a sale/leaseback, the assets to be financed are sold by the borrower to the lender/lessor via a bill of sale, then leased back to the borrower, typically for up to 48 months in tenor. The aforementioned tenor is normally the maximum because the fixed assets used are to be sold, and an adequate “collateral versus investment” curve should be maintained with a 48-month, or shorter, term (collateral coverage should hover around 1.2x, based on the advance against day-one FLV). The advantages of structuring a sale/leaseback is the additional protection this instrument provides to a lender/lessor. As an owner and not a lienholder of assets, the lender/lessor will have more protection in bankruptcy by virtue of the lease and retaining ownership in the fixed assets serving as collateral. In the event of foreclosure under a sale/leaseback, the lender/lessor has an even more expeditious path to liquidation because, as owners, lien releases from other lenders to the borrower will not affect the ability to go to auction, providing a speed-to-market opportunity.
A Two-Lender Approach
Bifurcated transactions, a two-lender approach, between an ABL lender and a term lender can be an ideal solution for a financially challenged client. The benefit is that each can focus on what they do best: accounts receivable and inventory financing for an ABL group, and equipment and real estate for a term lender. Having two groups, each with its own distinct specialty areas, may result in added protection for both groups and the potential for increased funds available at closing for the borrower.
Many opportunities exist for term lenders/lessors to obtain good yields in relation to the amount of risk being assumed, especially for those who have a keen focus and experience structuring term loan/lease financing for certain types of assets. With a sale/leaseback arrangement, the lender/lessor has additional protection. Since many sale/leasebacks have no covenants (typically not necessary since the lender/lessor has title to assets, rather than liens), a favorable opportunity exists when working with other lenders, primarily ABL groups, in structuring a bifurcated transaction that will potentially lead to the liquidity and terms necessary for a successful closing and refinancing.