SVP/Director of Commercial Banking
Pacific Premier Bank
In November 2019 I wrote an article describing asset-based lending as a viable financing option to help lower middle market businesses weather all business conditions.
At the end of 2019, the unemployment rate in the U.S. was at a 50-year low and major U.S. equity markets were reaching all-time highs. In line with these favorable economic conditions, many lower middle market borrowers were able to command very competitive terms from their lenders.
Advance rates against most classes of commercial loan collateral — accounts receivable, inventory, machinery and equipment, and real estate — were stretched higher by lenders to remain competitive with the market. Commercial banks, commercial finance companies and newly raised direct lending funds joined in providing credit solutions to privately held companies. Lower middle market credit was plentiful and in pursuit of a limited number of opportunities.
Fewer than six months later, business conditions have changed drastically due to the COVID 19 pandemic. U.S. unemployment has spiked higher and U.S. equities markets have headed lower. Lower middle market borrowers that once had stable cash flows now have less visibility into future revenues, cash flow and collateral values.
While credit and economic conditions have shifted, the versatility of ABL lending remains the same. ABL lenders’ ability to underwrite collateral on par with — or at times as a priority over — cash flow as a primary source of repayment allows lenders to provide financing under a variety of different economic conditions.
A Lender’s Market
Lower middle market lenders have become more selective in deploying new capital because of the sudden changes in business conditions and limited visibility into near term revenues caused by the pandemic. Some lenders have adopted an inward facing approach, preferring to dedicate their energy to their existing loan portfolios. Other lenders have taken the opposite approach because the change in market conditions has unlocked a flood of new opportunities.
Maximum advance rates against different classes of commercial loan collateral and flexibility regarding the requirement for recourse/personal guarantees had become the norm previously for lower middle market borrowers, but the credit pendulum may have shifted in the other direction temporarily. This may be reflected in the current structure and overall terms of credit facilities for lower middle market borrowers, shifting us from a borrower’s market to a lender’s market.
Implications for Borrowers
Lower middle market borrowers should be prepared to proactively provide visibility into how COVID-19 has impacted their revenues, cash flow and collateral.
If a borrower is actively seeking refinancing, information related to the COVID-19 impact on business should be prepared for prospective lenders. As existing and prospective lenders evaluate new financing requests, COVID-19 will be one of the top credit risks for any business.
Lower middle market borrowers should consider the following preliminary questions as they either engage their existing lender or speak with new prospective lenders, depending on whether lenders are using accounts receivable, inventory, machinery and equipment, or real estate as the commercial loan collateral.
Accounts receivable
- What is the quality of the account debtor mix (creditworthiness and diversification of customers) and how well do customers pay (AR turnover)?
- Have days sales outstanding/accounts receivable turn increased or decreased?
- Have any account debtors begun to pay more slowly?
- What, if anything, can be done to speed up collections?
Inventory
- How resalable is the inventory (commodity in nature versus perishable or subject to obsolescence)?
- Have days of inventory on hand increased or decreased?
- What has caused the increase or decrease?
- Have the different types of inventory been rationalized in terms of margin, turnover and resale value?
Machinery and equipment
- Has the business recently had its machinery and equipment appraised to gauge net orderly liquidation value or forced liquidation value? Untapped equity in machinery and equipment can, at times, be a source for additional liquidity for businesses.
Commercial and non-commercial real estate
- Untapped equity in real estate can, at times, be a source for additional liquidity for a business.
In addition to reviewing the value and performance of their collateral, borrowers should also consider reviewing their cash flow. There are likely to be one-time, extraordinary expenses caused by the pandemic. These one-time expenses should be carefully tracked and recorded so that earnings can be normalized when looking back at this period in the future.
Stay Connected to Financing Sources
In my last article, I stated that lower middle market companies may lack the network and resources to tap into a broader galaxy of bank and non-bank debt financing sources. This point is worth reinforcing given the change in market conditions. Specifically I posed the below example:
Company A recently lost a major customer and has begun showing operating losses and has breached a financial covenant. What type of financing should be recommended if it is no longer able to secure traditional bank financing?
The above example may describe the experience of more borrowers today than it did in late 2019. A variety of asset-based lending solutions including purchase order financing, accounts receivable factoring and asset-based lending could all be non-dilutive asset-based financing solutions for this company.
Again, now may be a good time for lower middle market borrowers to reach out to their commercial lender to update them on what they are doing to navigate the new normal caused by the COVID-19 pandemic. Communication is always important in any relationship and this is particularly true in these unprecedented times. Regardless of the extremes that the economy may visit, asset-based lending remains a valuable financing solution to help lower middle market borrowers weather any storm.
