Asset-based lending (ABL) has historically provided capital to companies with credit ratings that were not sufficient to enable them to obtain financing based on their enterprise value. Asset-based lenders make loans based on the value of certain assets, typically accounts receivable and inventory and, to a lesser extent, equipment and real estate, rather than the enterprise value of the business. Companies with solid cash-flows but lacking an investment grade credit rating have historically obtained financing in the leveraged finance market, principally through high yield bonds and cash-flow loans. In these “highly leveraged” transactions, the bonds/loans are structured on the basis of the company’s cash-flow as measured by a leverage ratio of debt to adjusted LTM EBITDA. Leveraged loan facilities have historically included secured term loans and revolving loans issued under a single credit facility and secured on a pari passu basis. In contrast, ABL facilities are typically revolving credit facilities only, with no term loan component, and are structured on the basis of the liquidation or sale value of the collateral.
During the early 2000s, leveraged financings began incorporating ABL facilities into the financing package through a “split collateral” structure in which the ABL facility is secured by a first priority lien on inventory and account receivable and the term debt is secured by a first priority lien on equipment, real estate and other assets. The ABL facility and the term debt are also secured by second priority liens on the collateral in which they do not hold a first priority lien. According to Thomson Reuters LPC, since 2004 ABL has represented between 10% and 18% of all leveraged loan volume, reaching its peak at 18% ($101 billion) in 2011. At the peak of the market in 2007, total leveraged loan volume was $688 billion with ABL representing 11% ($76 billion) and total high yield volume was $136 billion. Below, we will discuss certain of the advantages of ABL facilities that have contributed to its growth as a financing source in leveraged transactions and then examine the basic structure of an ABL facility and the key negotiated terms of an ABL facility in the context of a leveraged finance transaction.
Growth of ABL
What accounts for the growth of ABL in the leveraged finance market? In contrast to cash-flow revolvers, ABL facilities provide several advantages for those companies with sufficient assets. One advantage is that an ABL facility permits borrowers to obtain higher leverage at a lower cost when compared to cash-flow alternatives. As ABL facilities are not structured on the basis of total leverage (debt to EBITDA), the funds provided under the ABL facility are generally not included in the leverage calculation at issuance, thus enabling greater leverage. By combining an ABL facility with a high yield facility or syndicated term loan, companies are able to obtain liquidity based on the value of their assets under the ABL facility and to obtain liquidity based on their enterprise value under the high yield facility or syndicated term loan.
Perhaps more importantly, ABL facilities are competitively priced in contrast to cash-flow loans and may be priced at a spread over LIBOR that is several hundred basis points lower than a cash-flow loan. Thus the combination of higher leverage and a lower average cost of funds is an important advantage. Additionally, as more fully discussed below, while ABL facilities have increased reporting and monitoring provisions, ABL facilities also provide a flexible covenant package to the borrower.
Another advantage of ABL facilities is that they may not be subject to syndication risk or market flex risk. ABL facilities often are fully committed to by the banks providing the financing without the right to change terms through the exercise of flex provisions. Banks are often willing to underwrite the entire ABL facility transaction or hold a large portion because of low risk profile enjoyed by ABL facilities. This provides the borrower with greater certainty of execution with respect to the ABL facility in contrast to other financing sources.
Basic Structure of the ABL Facility
ABL facilities are typically structured as revolving credit facilities in which borrowings and other extensions of credit (such as letters of credit) are limited to the value of the collateral included in a “borrowing base” formula. ABL facilities usually have a five-year term (which is in any event shorter than the final maturity of the term debt) and a floating interest rate based on LIBOR plus a margin. Although less common, ABL facilities can also be structured to include term loans and other last out or junior tranches.
The borrowing base is calculated on the basis of a percentage “advance rate” against the value of the collateral included in the borrowing base. The borrowing base collateral usually consists of accounts receivable and inventory but may also include other assets such as equipment, real estate and intellectual property. The borrowing base value of the collateral is calculated based on the lender’s assessment of its ability to liquidate or sell the collateral within a short time period. A typical borrowing base would be calculated as the sum of 85% of the value of “eligible accounts receivable” plus 65% of the value of “eligible inventory.” The eligibility criteria for accounts receivable, inventory and other borrowing base collateral are detailed provisions set forth in the loan documents that are designed to ensure that the lender’s expected value of the collateral would be realized in a liquidation or sale.
In leveraged finance transactions, the ABL facility is often paired with secured term debt in the form of term B loans, first/second lien term loans or secured high yield bonds. The ABL facility provides liquidity for working capital, capital expenditures and other corporate purposes while the term debt provides longer term fixed capital. As discussed above, the ABL facility and the term debt are often secured by the borrower’s assets through a “split collateral” structure in which the ABL facility is secured by a first priority lien on inventory, accounts receivable and cash (including deposit and other accounts) and the term debt is secured by a first priority lien on equipment, real estate and other assets.
In contrast to the term debt that is often covenant lite as it contains no financial maintenance covenants, ABL facilities typically have a single financial covenant in the form of a “springing” fixed charge coverage ratio (FCCR), which is intended to measure whether the borrower’s cash-flow is sufficient to cover debt service and capital investment obligations. It should also be noted that the ABL facility will have more extensive collateral reporting, examination and appraisal requirements than the term debt as a result of its borrowing base nature. In addition, unlike the term debt, the ABL facility will have cash dominion over the borrower’s receivable collections, cash and bank accounts as discussed below.
Key Negotiated Terms of the ABL Facility
Many of the critical terms in an ABL facility involve the formulation of the borrowing base, the advance rates, the criteria for eligible accounts receivable, inventory or other assets included in the borrowing base, and the ability of the lender to implement reserves against availability. The details of these terms are typically specific to the business of the company and may be highly negotiated. For example, whether the borrowing base will include inventory in transit or work-in-process may be very important for certain businesses. In addition, since the lender has the right to adjust the eligibility criteria and implement or modify reserves (and in smaller facilities adjust advance rates), the standard by which the lender may implement such adjustments is important to both borrower and lender. The loan documentation would typically define this standard of care as the exercise of the lender’s reasonable credit judgment exercised in good faith in accordance with customary practices, but there are many variations and qualifications that are subject to negotiation.
A number of key provisions of the ABL facility are subject to tests that include a measurement of the maximum amount of credit available under the ABL facility, often referred to as excess or unused availability. These provisions include the interest rate margin, unused line fee, borrowing base reporting requirements, appraisal and field examination rights, cash dominion and springing financial covenant. Excess availability is measured as the excess of the lesser of the maximum commitments under the ABL facility and the borrowing base, less the amount of loans, letters of credit and other outstanding extensions of credit under the ABL facility. Excess availability can be measured as of a particular date, as an average over a historical period or as an average over a future period on a pro forma basis.
For example, the interest rate on the ABL facility often has a pricing grid for the applicable margin, that is based on average historical excess availability for the prior quarter or other period that provides for a higher interest rate as such excess availability declines (i.e., usage of the ABL facility increases). Conversely, the unused commitment fee may also be subject to a grid based on average usage of the ABL facility that provides for a lower unused commitment fee as usage of the ABL facility increases.
As noted above, the ABL lender will have control agreements over the borrower’s primary bank accounts providing for springing cash dominion in the event certain trigger tests are met. Once this test is met, the lender has the right to implement cash dominion pursuant to which the borrower’s collections are swept to the lender on a daily basis and applied to reduce the ABL facility loan balance, with the borrower using advances under the ABL facility to pay expenses and other obligations. The cash dominion test is typically triggered when excess availability falls below a specified dollar amount and/or percentage of commitments on any day or for a number of consecutive days. Once triggered, cash dominion continues until excess availability exceeds the trigger level for an agreed upon number of consecutive days. Cash dominion would also be triggered while an event of default (or in some cases certain agreed upon specified events of default) exists.
The frequency of delivery of borrowing base certificates, updated appraisals and field examinations may also be based on an excess availability test. For example, a borrowing base certificate that is required to be delivered on a monthly basis may be required to be delivered on a weekly or more frequent basis if excess availability falls below a specified dollar amount and/or percentage of commitments on any day. The lender’s right to require updated appraisals and field examinations (at borrower’s expense) will usually be limited to one or two per year absent an event of default. However, the ABL facility may also provide the lender with the right to require an additional updated appraisal and field examination (at borrower’s expense) if excess availability falls below a specified level.
The “springing” FCCR typically found in an ABL facility is also dependent on an excess availability test. The FCCR is only measured when the borrower’s excess availability falls below a specified dollar amount and/or percentage of commitments on any day. Once the excess availability trigger is met, the FCCR is measured as of the end of the last fiscal quarter and future fiscal quarters until the excess availability exceeds the trigger level for an agreed upon number of consecutive days.
ABL facilities will often provide the borrower with the flexibility to make investments and acquisitions, pay dividends and prepay certain types of indebtedness based upon a “payment conditions” test that includes an excess availability test. In contrast, term debt will often have a “builder basket” consisting of the borrower’s retained portion of excess cash-flow not required to be used to prepay debt, proceeds of equity issuances and returns on certain investments that may be used by the borrower to make investments and acquisitions, pay dividends and prepay certain types of indebtedness. In addition to minimum excess availability, the payment conditions test will include pro forma compliance with the FCCR financial covenant (whether or not then being tested) and a no default condition.
ABL facilities have proven to be an important part of the debt financing sources in leveraged finance transactions. ABL facilities permit borrowers to obtain higher leverage at a lower cost compared to cash-flow-based term debt, while also providing certainty of execution and a flexible covenant package. Given these advantages, ABL facilities will continue to be an important financing source in leveraged finance transaction for borrowers with financeable assets.
Mario Ippolito is a partner in the Corporate practice of Paul Hastings and is based in the firm’s New York office. Peter Burke and Jennifer Yount are partners in the Finance and Restructuring Group in the Los Angeles office. Shafiq Perry is an associate in the Corporate practice based in the New York office.