Latham & Watkins partner David Crumbaugh takes a look at the current state of the rapidly growing asset-based loan (ABL) market.
Asset-based lending was once considered a last-resort method of raising capital, but it seems to be growing in popularity. What has spurred this change?
Crumbaugh: For one thing, sponsors have discovered some of the benefits of asset-based lending — there are three principal benefits that are really important to sponsors. One is price. The lending community, and to a growing degree the regulatory community, view asset-based loans as safer than cash flow loans; the consequence of that is there is a lot of competition to do asset-based loans, and the further result of that is that there is a substantial difference in pricing. If you have a good asset-based loan, you might have an interest rate of LIBOR (London Interbank Offered Rate) plus an applicable margin of 1.75 - 2.00 percent. Let's assume it is LIBOR plus 2 percent, three months LIBOR right now is only slightly more than a quarter of one percent, so if you had LIBOR plus 2 percent that gives you an effective interest rate of 2.26 percent per year. That's ridiculously low, but people can get that with an asset-based loan.
A good middle-market LIBOR cash flow loan would currently be around LIBOR plus 4.25 percent, with a LIBOR floor of 1.25 percent. Effectively you have an interest rate of 5.50 percent, so it is literally half as expensive to do it as an asset-based loan as opposed to doing it as a cash flow loan. Sponsors have discovered they can do revolving loans very inexpensively, if they are ABLs.
Second of all, in middle market deals it is very common to require one or two financial covenants (a leverage ratio and/or a fixed charge coverage ratio). In contrast, ABLs are going to be done with either no financial covenants or a springing financial covenant that only gets tested when borrowing availability falls below a very small percentage of the revolving loan commitment, such that in all likelihood it will never, ever be tested. That means sponsors don't have to worry about financial covenant testing and they don't have to worry about having an event of default under a financial covenant. If you couple an ABL revolver with high yield notes, which don't have financial covenants in them at all, you effectively have a covenant-free financing package. You will never have to worry about financial covenants resulting in the event of a default on your financing. That's a huge benefit.
Thirdly, ABL lenders are also less concerned about permitted acquisitions, incremental senior debt and restricted payments, so long as their borrowing base is maintained. As a result, an ABL loan is often more flexible than a cash flow loan on these issues.
With that, I would say that ABL loans have gone mainstream in the last four or five years and as people find more uses for them they are going to continue to increase in popularity.
What impact has this growing popularity had on the players in the market?
Crumbaugh: The reason you don't see too many new players in this market is because collateralized loan obligations (CLOs), which are borrowing money that they are then re-lending, need to have a higher return on investment than an ABL can offer. Furthermore, typically the CLOs, who are the newcomers to the market, don't have the back office sufficient to run a revolving loan. It takes manpower to monitor a revolving loan and the pricing is so cheap that it’s hard to see a commercial finance shop that has higher cost of funds being a very active player in the ABL market. They are much more likely to want to do a cash flow loan. What you are seeing is mainstream banks devoting more and more resources to their ABL lending units because the banks’ cost of funds at this time is at a historic low. They are turning into very, very aggressive competitors in the ABL loan market.
What are some of the main issues lending institutions run into with asset based loans?
Crumbaugh: First of all, anything involving food requires you to take a second look. Whether it’s the Food Security Act, which relates to continuing liens that are going to impact borrowers that buy directly from farmers, or the Packers and Stockyards Act, which impacts anybody who is lending to borrowers that buy and slaughter live cattle, hogs, or chickens, or the Perishable Agricultural Commodities Act, which applies to any borrower that buys fresh fruits and vegetables and cherries packed in brine — there is the potential to be subject to competing liens of unpaid growers or suppliers. These laws are aimed at protecting people who are the primary producers of these products, mainly farmers, cattlemen, ranchers and fruit and vegetable growers. Once they sell their product, it has a limited shelf life and if the buyer doesn't pay them, they are not going to be able to reclaim the inventory, it will be gone or it will be spoiled. As a consequence, those laws were all put in place to protect the primary growers. This reflects the globalization of the farming industry, where you are not selling to a buyer who lives in the same town, instead you are shipping your products long distances and selling them to strangers. Congress felt that the farmers needed to be protected against long distance scammers, so the farmers retain liens on the goods and on the accounts receivable until they have been paid.
I would warn people, if you are loaning against food products or farm products you better be very careful because that is the one category of inventory that has more hidden liens than any other area. You also need to be careful with any regulated good, for example alcohol, tobacco, fire arms, drugs, pharmaceuticals, etc. With a pharmacy chain, for example, you can loan against the products in the front end of the drugstore, but it is extremely difficult to lend against the items behind the counter, because a lot of those items can only be disposed of by somebody that has a license from the Drug Enforcement Administration (DEA). All of these factors have to be taken into account when you are lending.
What does the future of the ABL market look like?
Crumbaugh: I view the expansion of the lending market as being driven by leveraged buyouts, in particular by equity sponsors. I think as more and more of them discover the freedom, flexibility and cost savings that ABL lending affords, particularly in middle market deals, they are going to be more favorably disposed to using that tool. I've never seen spreads between ABL and cash flow this large — literally half the interest expense for comparable cash flow to ABL loans. I would say that no financial covenants or a single springing financial covenant that only gets tested if availability falls to a very low level is here to stay. I don't think you are ever going to see robust financial covenants in an ABL deal again.
I think that you are going to find more and more deals where certain classes of lenders who can't do revolvers are going to do a cash flow term loan coupled with an ABL revolver from an ABL lender with a split collateral intercreditor agreement between the two of them. When you do that, you are getting the best of all worlds because you are probably not giving much in the way of any ongoing financial covenants and the ongoing interest cost is probably about as cheap as it can get.
So I see growth in the area. I've seen a lot more ABLs in the last six months than I did five years ago.