Credit retrenchment continues to be the norm for banks and other traditional capital providers for companies with a less than pristine credit profile. As the regulatory environment becomes more complex and with the implementation of Basel III capital and leverage requirements set to phase in beginning in 2013, traditional banks will have additional limitations to their lending parameters. Specifically, unless a loan can be structured on a highly formulaic basis against very liquid collateral (i.e. inventory and accounts receivable), there will be reluctance on the part of regulated institutions to provide financing. Additionally, there tends to be minimal appetite to lend against fixed assets (i.e., real estate, machinery and equipment), and almost no capital is available for untraditional assets like intellectual property or streams of contractual revenue within a traditional borrowing base.
As a result, many middle-market and asset-intensive businesses, especially those whose fixed assets would create a significantly larger term loan relative to the size of their working capital revolving credit facility, struggle to find a cost effective capital structure that provides the levels of liquidity needed to accomplish their corporate goals. However, senior management, owners or private equity sponsors may not be aware that there is another potential solution—bifurcated collateral loans. Whether for working capital, growth, restructuring or to facilitate a turnaround, this alternative structure could provide an attractive option.
In a split or bifurcated collateral capital structure, two distinct tranches of debt are structured and secured by first lien security interests on separate pools of collateral. For example, a traditional ABL lender would structure a revolving credit facility against the inventory, accounts receivables and perhaps some fixed assets. At the same time, a separate lender, like Crystal Financial, would structure a term loan against fixed and/or intangible assets such as real estate, machinery and equipment or intellectual property. Each lender has a first lien position on their primary collateral and then, in most cases, the lenders will cross-collateralize their positions (often referred to as “swapping seconds”) through a second lien security position in the other lender’s primary collateral for an enhanced level of protection.
Less Expensive, More Liquidity, Better Terms
When banks say “no,” companies seeking more capital will often consider junior capital or equity as a solution. Yet, this option may not be readily available for smaller middle-market companies or companies who are in the midst of a transition. Again, bifurcated collateral loans are often a very attractive option in this case. This year these loans have accounted for about one-third of the transactions we have completed to date. They can offer distinct advantages to borrowers over traditional junior capital solutions, and in some instances, unitranche structures. The real benefits are seen in the areas of cost, liquidity and terms.
Less expensive. Bifurcated loans often have a cost advantage over traditional second lien or subordinated debt financing. In a bifurcated loan, the lender is investing from the first dollar of risk against their collateral pool. Therefore, the percentage of the loan that is subject to principal risk is typically lower relative to other junior capital solutions. This improved total risk position typically results in a pricing improvement of 200-400 basis points in a bifurcated loan vs. a traditional second lien facility, assuming the same leverage point and last dollar of risk into the capital structure.
More Liquidity. Bifurcated collateral loans can often provide a borrower with more favorable advance rates as well as higher levels of debt capital. Bifurcated collateral lenders typically offer greater advance rates than banks, albeit at an increased cost. When combining the bifurcated loan with a traditional asset-based loan, more often than not, the same assets usually generate more total dollars than a first lien/second lien capital structure. Again, the first lien position reduces the first dollar of principal risk for the bifurcated lender, providing better downside protection and the ability for the lender to provide more capital. When comparing a bifurcated collateral structure to a standard leveraged loan or unitranche structure, the separate asset collateral pools often create more debt financing and availability than could be generated through a leveraged loan structure governed by a multiple of EBITDA or free cash flow.
Better Terms. Finally, loan terms are also likely to be less onerous when both lenders have a first lien position. For example, many bifurcated loans have no financial covenants—a huge plus to a borrower that may experience “lumpiness” in its quarter-to-quarter or year-to-year financial performance or is subject to cyclical swings. The loans are typically governed by advance rates against its primary collateral that is tracked monthly, and as long as the loan is within those advance rates, no other financial performance metrics need to be maintained. The assets are usually appraised quarterly, semi-annually, or annually depending upon the potential variability of the asset class to account for any broader market changes. Additionally, the intercreditor loan documentation that governs the relationship between the lenders is typically easier to negotiate and more cost effective for the borrower. Again, this is because each lender has a first lien position and less principal risk.
Four Bifurcated Loan Deals
Split collateral loans can come in a wide variety of forms and structures. As the following four deal examples demonstrate, they can be used for refinancing bridge capital during an industry’s cyclical trough, for acquisition financing, for dividend payouts during a corporate restructuring or to provide incremental capital to grow a business in a challenged industry. Each transaction highlighted below included a traditional senior asset-based loan secured by inventory and accounts receivable with Crystal providing incremental capital by taking a first lien position on three different types of collateral—materials and equipment, real estate and intellectual property.
Liquidity for Recapitalization
In 2010 and 2011, a private investment firm acquired several glass fabricators and distributors and consolidated the operations to establish a dominant player with a leading position in North America. Despite implementing nearly $29 million in annual cost savings through operational synergies, the new company had not found a level of stability in its operations and still maintained a negative equity account, largely because the industry was in a cyclical trough. Its cost structure, however, was aligned with current revenue levels.
The investment firm, which had financed all the acquisitions internally, wanted to refinance some of the debt that they had contributed in the previous acquisitions by raising additional capital beyond the company’s working capital revolver. Since the company’s performance was still soft and below projections, and top line improvements were difficult to predict, the ABL lenders did not have the appetite to lend against the fixed assets. Crystal was able to structure a $20MM term loan with a first lien position in the firm’s machinery and equipment and real estate. These assets were appraised and appropriate advance rates were applied to determine the amount of term debt we could provide.
Liquidity for Acquisitions
In another situation, Crystal (in conjunction with a lending partner) provided a $74.2million term loan that enabled an equity sponsor to complete the acquisition of a regional newspaper division being divested by another entity. Working capital financing was provided by a traditional bank while the Crystal term loan was secured by the real estate and printing equipment as well as operating cash flow. Given the challenges and volatility in the publishing sector and in particular, the declining performance of printed newspapers due to both the economy (lower advertising dollars) as well as declining circulation trends (given the evolution to online media sources), a true cash flow or enterprise value loan was not an option for this situation.
Intangible assets are usually considered boot collateral in asset-based structures and generally are not incorporated into the borrowing base. Crystal, however, has underwritten multiple transactions where this asset was our primary source of collateral. For example, in one such transaction, an equity firm purchased an apparel company in October 2011 with the intent of restructuring the European operations. The capital structure included a $30 million revolver secured by inventory and accounts receivables and a $12.5million term loan provided by Crystal that was secured by a first lien on the intellectual property (in this case the brand) for both the European and Canadian operations in addition to and a first lien on all the non-working capital assets in Canada. The term loan was used to return capital to the sponsor who had bridged the initial transaction with all equity capital.
Liquidity to Navigate a Turnaround
A final example involved a transaction with a privately held flatbed trucking company. The company has an extensive fleet of trucks and flatbeds and leases them, along with providing other trucking services to large public companies, such as Lowes and Home Depot. In addition to refinancing its existing revolver, the company leveraged its headquarter complex and Crystal provided a $4.66 million term loan to generate the liquidity the company needed to continue to evolve its business and navigate through a period of overexpansion and softness due to the recession.
Leverage the Liquidity in Your Balance Sheet
As these case studies demonstrate, companies wanting to optimize their liquidity can look beyond their conventional assets such as inventory and accounts receivables. There are other assets on their balance sheets that, while not always recognized by banks and traditional lenders, can be a valuable source for incremental financing. These assets, which include real estate, machinery and equipment and/or intellectual property, can be leveraged through the bifurcated collateral loan structure in a variety of situations and should be explored as part of evaluating the optimal financing options and capital structures needed to execute on a company’s goals and objectives.
Steven Migliero is Managing Director at Crystal Financial, responsible for business development and origination strategies. He can be reached at email@example.com or (617) 428-8704.