During the 1990s, asset-based lending was plain vanilla. Companies had few alternatives. The best performing companies on an earnings and total enterprise value basis could access the pure leverage cash-flow market. Others with significant balance sheets accessed the asset-based, or ABL market.
Twenty years ago, ABL loans were focused on asset classes. Most ABL lenders focused on lending on a portion of accounts receivable, inventory and perhaps some equipment and real estate. So companies that traditionally had large amounts of AR and inventory, such as retailers, distributors and manufacturers could meet their financing needs regardless of the operational environment. But what about younger companies that were growing that hadn’t reached the highest credit rating rungs on the ladder to tap the traditional cash flow market? When seeking capital, they could obtain asset-based financing but in many cases it wasn’t enough to meet all the needs of those growing companies.
Emergence of the Second Lien Debt Market
During the run-up to Dot.bomb in late 2000, capital flowed freely, the U.S. government balanced its budget and business plans drawn on restaurant napkins were being awarded millions of dollars of venture capital. This environment affected the debt markets and ABL market as well. Hedge funds investing institutional dollars stepped into the senior debt market when ABL lenders couldn’t meet the entire capital needs of companies. The hedge funds provided the second-lien term loan portion of the total debt package.
Traditional ABL lenders would take senior liens on all assets of the company and advance credit based on AR/inventory, while hedge funds such as Cerberus, Back Bay Capital and Silver Point would provide second-lien loans based on all the assets of the company.
The size of the first- or second-lien loans was not uniform. Each could be larger than the other. These second-lien loans by hedge funds backed by institutional investors such as pension funds and insurance companies, were not mezzanine debt, which had more equity-like features. The second-lien loans were strictly debt, with strict covenants just as with cash-flow loans, priced in the mid- to high teens, but were still several percentage points cheaper than mezzanine debt.
These ABL/second-lien combination loans were not as popular as the traditional leveraged ABL facility or the cash-flow loans available to better performing or well-capitalized companies. The combination loans were only perhaps approximately a fifth of the market but that still represented $50 billion dollars (Thomson Reuters) or more.
Next evolution: Bifurcated Collateral Loans
About mid-decade, a new finance package involving ABL emerged, the bifurcated collateral deal. This wasn’t a first-lien, second-lien combination. In the bifurcated loan, the ABL side of the transaction placed a first on current assets, or AR/inventory. The second part of the loan package would be a hedge fund term loan secured by first liens on all other fixed assets and the total enterprise value of the company. It was more expensive than a pure ABL facility, but cheaper than the ABL/second-lien combination described above, priced in the low teens.
Then the market shifted again. Institutional investors, such as banks, pension funds and prime-rate mutual funds jumped into the bifurcated structure, flooding the market with cash. Again, these term loans were backed by a first lien on fixed assets such as equipment and real estate plus the enterprise value of the borrower. As a result, lending emphasis became more reliant on the enterprise value of companies. Meanwhile, ABL lenders kept to their traditional asset base – primarily AR/inventory – while the broader capital markets expanded the bifurcated loan to the mainstream.
The size of these loans was again all over the lot, but pricing dove to 7-, 8- and 9 percent. This is where the loan markets started to become irrational. It is important to stress that the leveraged cash-flow market was still dominant during this period while this bifurcated, third evolution wasn’t dominant. But it perhaps could be argued that it contributed to the loan froth of 2007.
During the run-up to the financial crash, ABL stayed true to its roots, lending on a percentage of AR/inventory. Subsequently, the crash didn’t affect the ABL industry as much as other forms of lending and the segment continued to lend through 2008-10, although at slightly lower levels. In fact, ABL was about the only way some companies – even some that previously qualified for cash-flow debt – could access debt capital.
The post-crash period saw a pause in the evolution of ABL. But in late 2010 and 11, ABL partnered with an institutional term loan package re-emerged. Just like before, the ABL portion is secured by AR/inventory and the term portion is secured by remaining assets and the enterprise value of the company. It’s an attractive package, well-structured and fairly priced for both sides and a viable alternative to a bank revolving loan combined with a high-yield bond structure. Once again this market is healthy for companies that don’t qualify for cash-flow loans – typically they fall in the CCC/BB or B rated classes – but whose needs aren’t totally met only by asset-based lenders.
The facts show that ABL is increasing in importance. Thomson Reuters analyst Maria C. Dikeos points out in ABF Journal that the percentage of asset-based loans to all debt rose from 10 percent to about 17 percent in 2011 and during that same time asset-based loans doubled to more than $100 billion.
Here are a couple examples of the new bifurcated loans. Targus Group International of Anaheim, Calif., which manufacturer mobile computing cases and accessories, accessed the bifurcated loan market last year. The company, which included in its ownership group previous second-lien lenders, accessed $187 million in a five-year B term loan packaged with $60 million in ABL from Bank of America, to refinance debt.
Deluxe Entertainment Services, a Hollywood-based film production services company, borrowed $575 million, with $100 million in asset-based revolving credit and $475 million in institutional term debt. Bloomberg said that the loan pays interest at 6.5 percentage points more than the London interbank offered rate, with a 1.5 percent floor on the benchmark.
These are just two of many examples of this loan category. As the nation works its way out of recession, there are thousands of companies that will apply these techniques. They need working capital to grow. The bifurcated ABL/institutional cash-flow term loan is available to them as an alternative to not having enough cash to grow into the recovering economy.
Reprinted with permission from Bank of America Merrill Lynch’s CapitalEyes May-June 2012 newsletter.