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Asset-based lending in buy-out transactions: Key issues for borrowers and lenders13/07/2004. Source: Testa, Hurwitz & Thibeault. Mark Smith 
 The pace of acquisition and buy-out activity has picked up significantly over the past year. Readily available financing, at historically low rates, from high-yield investors and leveraged loan providers has fuelled this increased activity, according to Mark Smith of Testa, Hurwitz & Thibeault.
Over the last several months, however, interest rates have begun to move up, and
high-yield investors have become more concerned about credit quality. As a result,
buyout sponsors have had to rely more heavily on providers of leveraged loans
–primarily banks and their affiliated lenders.
What Type of Lender and What Type of Loan? Most large banks,
investment banks and other non-bank financial services companies have several
affiliated lenders offering different types of loans (e.g., unsecured cash-flow
loans and secured asset-based loans). Many buyout targets have substantial assets
(receivables, inventory, equipment) to offer as collateral. In addition, buyout
sponsors often want or need significant leverage in order to complete their
transactions and maximize returns on their equity. For these reasons, buyout
sponsors often turn to asset-based lenders.
What defines asset-based lending — and distinguishes it from cash-flow
lending — is that the amount of available borrowing is tied directly to
the amount of assets (usually receivables and inventory) serving as collateral.
The advantage for both the lender and the borrower is that asset-based lending
changes the focus from the borrower’s overall creditworthiness (and the
need for extensive financial covenants) to the credit quality of specific liquid
assets — though the lender will generally require the borrower to put
up all of its assets (including its intellectual property and deposit accounts)
as collateral. Therefore, the critical terms to be agreed upon between the asset-based
lender and the borrower are (1) the definition of "eligible receivables"
and "eligible inventory" that the lender will loan against, (2) the
"advance rate" at which the lender will loan against such eligible
assets, and (3) any reserves that the lender may establish to reduce the amount
of loans available to the borrower.
Lender’s Discretion. Perhaps the fundamental issue in
any asset-based lending facility is the extent of the lender’s discretion.
Asset-based lenders, citing their need to be able to react to the borrower’s
changing business conditions, frequently offer discretionary loan facilities,
which give them the ability to make lending decisions on a case-by-case basis.
Borrowers, citing their need to be certain of their ability to borrow, usually
prefer committed loan facilities in which the lender commits to lend against
eligible receivables or inventory.
Many asset-based lenders are prepared to offer committed loan facilities if
(1) the borrower is willing to pay a commitment fee to compensate the lender
for tying up its capital and (2) the lender has discretion to change the eligibility
criteria for receivables and inventory, reduce the advance rate and impose reserves.
Many borrowers are willing to pay a commitment fee and to allow the lender some
discretion to change these terms —but not unlimited discretion, since
that would effectively be equivalent to a discretionary facility.
A common compromise is for the borrower in a committed loan facility to agree
that the lender may change the eligibility criteria for receivables and inventory,
reduce the advance rate and/or impose reserves, but only with a certain number
of days’ prior notice to the borrower — with the exact number to
be negotiated by the parties.
Control of Cash Flow. Another critical operational issue is
who controls the borrower’s cash flow. Many asset-based lenders insist
upon the borrower establishing a "lockbox account" for collection
of the borrower’s accounts receivable. In this arrangement, the borrower’s
customers must make all payments to the borrower into an account located at
or controlled by the lender. Even though these arrangements are invisible to
the customers of the borrower, they can create problems for some borrowers.
The problems arise from limitations often imposed by lenders on disbursements
of the funds collected in the lockbox account. The central question is what
percentage of these collected funds must be applied to repayment of outstanding
loans. At a minimum, the lender generally will want the same percentage it had
advanced (often 70-85%) to the borrower against the account (which has now been
collected) to be repaid. At the maximum, the lender may require that all collected
funds be applied to repayment of loans – effectively requiring the borrower
either to pay off the loans before using its cash flow for other purposes or
to borrow against new eligible accounts to fund other expenditures.
A requirement that all collected funds be applied to repayment of outstanding
advances works best for borrowers who have a steady (or better yet, steadily
increasing) flow of similar-sized receivables – older accounts collected
are simultaneously replaced in the borrowing base by newly generated accounts.
This arrangement can be troublesome, however, for borrowers with significant
seasonal or other variability in either the flow or the size of their accounts.
Such borrowers may find themselves facing the awkward (and counter-intuitive)
situation that collection of large accounts (generally a good thing) actually
reduces their short-term borrowing capacity.
Reporting. Not surprisingly, asset-based lenders generally
require frequent and extensive reports on the assets that serve as their collateral.
In addition to periodic financial statements and annual budgets, lenders often
require, among other reports, monthly accounts receivable and accounts payable
aging reports and periodic borrowing base reports, which compare loan availability
(eligible accounts and inventory multiplied by the advance rate) to outstanding
advances plus required reserves.
Costs. Asset-based lending is a time- and people-intensive
process, which results in numerous costs to the borrower. In addition to the
standard interest rate (usually the prime rate plus several points), the borrower
can expect to pay an up-front origination fee, a commitment fee (for a committed
loan facility), a collateral handling or processing fee and fees for periodic
collateral audits. Some lenders also require payment of minimum monthly interest
(whether or not advances are actually made), unused line fees and/or prepayment
or early termination fees. Finally, certain lenders will ask for deferred interest
("final payments") or warrants.
The requirements for asset-based lending summarized here – significant
"hard" assets, well-established account collection and financial reporting
functions and sufficient cash flow – often mirror the operating company
attributes sought by buyout sponsors. The devil, as always, is in the details:
making sure that the terms of the asset-based lending facility offered by the
lender are a good fit for the particular company involved.
This article is reproduced with permission of Testa, Hurwitz &
Thibeault, LLP. For more information about Testa, Hurwitz & Thibeault,
LLP, please contact www.tht.com
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