The changing face of asset based lending

Piers Harmer and Chris Hart of Lloyds Commercial Finance speak to Pilot’s Log about the changing definition of asset based lending; its role as a complimentary funding gap for certain sectors and businesses; and how the team has developed a pan-European product that has been tested and has private equity’s commitment needs in mind.

Interview by Katherine Steiner-Dicks
Piers, the ABFA completed a survey last year, which they said revealed that half of private equity houses used asset based lending. Being specialised in this segment, do you agree with the findings?

I think it was an interesting survey, but from my experience the private equity houses use asset finance facilities like leasing and HP. My perception is that they consider that as asset based lending, rather than what we do, which is to lend against both current and fixed assets.

They are not using our particular product, which we call asset based lending and which is currently used on a limited basis by private equity in the UK. That is why I was called in to Lloyds TSB Commercial Finance to get the message across what the product capabilities are in three different areas.

One example is when a private equity firm is looking to do a primary transaction, such as the acquisition from a vendor or an MBO. This is where we believe that asset based lending is a very suitable product in a number of specific cases. That is probably our primary focus.

We also did a number of transactions last year in private equity where firms acquired a business with our funding to fill a gap where there was no other suitable bank to lend them the money at that particular time, or it was just a matter of speed and they need funding in a short period of time.

Our products can also be used in a refinancing of an existing investment. This may be driven by any number of factors, such as an amortisation schedule on an existing loan that is putting a lot of pressure on the business, or the business is doing very well and growth tends to absorb a lot of working capital.

I think private equity just isn’t fully aware of what resource is available to them through our product. That is why we are getting out there, to let people become fully aware of what is available and also to speak to people in the industry to see if the product has any deficiencies, so that we can make it more private equity friendly.

Chris, how would you explain what asset based lending can be?

I don’t think private equity actually fully understands what asset based lending, based loosely on the definition by the ABFA, actually is.

I agree with Piers in that a lot of private equity houses think they are using ABL because they are using leasing on fixed assets.

The product we have is funding against the majority of the entire balance sheet. We base funding on the asset classes on the balance sheet, not the profit and loss statement. We lend against assets, such as the receivables, inventory, plants and machinery and property.

We’re not in the business of lending on intangible assets, such as goodwill and intellectual property. But we will lend on most of the other asset classes.

Piers, how does it really work and how can you ensure to make money from it?

There are some technical aspects that we try not to spend too much time on. ABL is very different from banking because it is important to understand in much greater detail what the assets are; what is likely to affect the value of those assets; and most importantly how we would get paid in an insolvency situation.

It is a different product and that is why we focus much more on the assets and seeing how the assets work together and how they are valued. The movement of the working capital is what we base our business on and then that enables us to determine the level of secure funding since that is what we are, secured lenders.

We also offer traditional banking facilities when needed. But we aren’t just going to lend because there are secured assets. We are in the relationship business and seek to ensure that we have a viable proposition going forward.

Piers, how are the assets valued when you take them on if they are being purchased from an existing lender?

If there’s an existing loan in place we can often pay that back in its entirety.

Say you have a mature highly leveraged loan with an increasing amortisation profile, which will absorb a lot of capital resource. If this is an asset rich business it is quite possible that we are able to generate enough funding based on all the assets on the balance sheet to pay off that leveraged loan. That completely defuses any pressure on cash flow due to amortisation.

Occasionally, we are in a situation where there is a substantial loan alongside some working capital facilities and we will then use our facilities to replace those. That is better for the company since we can generate more funding from the working capital than traditional funders because we know how much it is really worth.

Chris, does the technicality of the product turn people off?

It can be viewed as a black art by people who have not worked with it before. But it can also be viewed by those that do use it as a valuable tool to deal with operational issues.

US private equity firms tell us they like to work with an ABL provider since the information flow we generate actually can help them identify even operational problems in a way they could not do, or could only do much more slowly with traditional bank information flow. We have a great deal of expertise in our team for managing operational requirements and assisting customers in understanding and using the data we generate.

The other thing is, we have a closer relationship with the company because we are seeing receivables and working capital flows on a daily basis, whereas with a leveraged commitment you may be waiting for a significant amount of time for management figures to come through. We are seeing those figures every day and can identify problems much sooner.

Is there any hesitancy from the investee companies in regards to greater expectations or resource from the FD?

Piers: It is fair to say that the resource requirement is higher, but not significantly higher. And certainly the process runs almost automatically. You have to make some extra resource available upfront, but it tends to be done at an operational level, where the senior guys in finance are not affected and it’s the company’s operational people that spend time with our people.

Once we have explained how it works then they see the benefits significantly and quickly. Most of the finance teams say that once they start this process they see things more clearly with more information than before and have improved working capital management.

Chris: An American FD of a company I was working with once told me that I didn’t need to sell him the benefits of asset based lending since, in his experience, the data that comes out of ABL was the information that provided him with his to do list on how on how to better manage the business.

What is the most common concern or question that comes up in your meetings with private equity companies about your product?

Piers: Commitment. Because we are providing working capital, which is short-term and revolving. Historically, we provided this effectively on an on-demand basis and that just isn’t acceptable or compatible for private equity firms that need financing for a reasonable period of time.

That is one of the things that we have addressed and now we provide longer terms facilities and cannot just arbitrarily withdraw them. The private equity houses need to be assured on a time basis rather than resource business on our level of commitment.

Piers, now that leveraged finance is taking a backseat, is asset based lending filling a funding gap as an alternative?

It was a poor investment year last year for private equity, but we had our best year in terms of investments. But I do not see us ever competing with leverage finance. We complement leverage. If a private equity house is looking for financing on a primary transaction or primary plus refinancing or just a plain refinance–they are going to look at all types of markets, such as public market products.

What I want is ABL, as an industry, to be automatically considered as a product that should be thought of in whatever transaction. But suitability is variable.

Saying that, when is it ideal to use ABL and when not in terms of financials and sector-specific constraints?

Piers: ABL is not suitable in a lot of cases but it is suitable in a number of other situations.

If you’ve got a company with not many assets, but which is profitable, where human capital is the main resource deployed, this often does not work for ABL, because other sources of funding work better. But recruitment, which deploys human capital, but on behalf of others-now that creates proven receivables and is therefore an ideal asset for ABL.

That’s asset rich only in receivables—but that’s OK because we are primarily a receivables lending business.

But good receivables do not mean blue chip debtors, it means how quickly you can collect or get your money back. You have to keep in mind of the potentially dilutive effects of warranties, etc.

A food manufacturing business, which has receivables that are eminently collectible, is a good sector for ABL.

Asset rich, cash poor has been our motto. A company generating a lot of cash flow does not need ABL.

A leverage house will always look at sustainability of debt; debt service. The company may make £10m one year and £20m the next. This type of volatility does not match leveraged debt, but it does for ABL.

Chris, there are so many different legal systems across Europe, how can a private equity house therefore contemplate taking on asset based lending?

Asset based lending facilities, whilst potentially covering both working capital and fixed asset sides to the balance sheet, are generally based around a core receivables element. Most European jurisdictions have some form of mechanism, which allows funding to be raised against receivables. This makes a cross-border receivables based funding solution a possibility.

However, the means by which such funding is achieved varies greatly by country. Lloyds TSB Commercial Finance, has taken the view that the safest way to achieve a cross-border funding is to lend in each jurisdiction under local documents in local language, all pulled together under a centrally agreed Common Terms Agreement in the UK.

We also have local representation in a number of jurisdictions around Europe to enable us to deal with businesses in those countries directly; anticipating and resolving any issues which may arise, locally if possible.

Our offering in Europe is therefore simultaneously cross-border in implementation and local in nature. It offers the borrower the security of funding inherent in dealing with one of Europe’s major banks whilst at the same time giving comfort that the widely differing and complex issues, which often arise in cross-border transactions, are being dealt with by staff with a strong understanding of each of the local markets.

Chris, can you give us an example of a deal you did in a pan-European context?

In September 2009 we completed a pan-European private equity deal providing £26m of asset based lending facilities to support the £52m Rutland Partners-backed MBO of the CeDo Group. CeDo is a major European manufacturer of disposable household products. The buyout was facilitated by a complex capital structure comprising private equity funding from Rutland Partners, a cross-border ABL package from Lloyds TSB Commercial Finance, and a mezzanine tranche provided by Indigo Capital.

Commercial Finance put in place receivables finance facilities in the UK, Germany and France. We also provided inventory and fixed asset funding in the UK.

This was a stand-out deal at a time of great financial turmoil and demonstrated our desire, appetite and ability to fund cross-border deals on an ABL basis.

It should be noted, though, that the technique does not depend on corporate action and could also be used to refinance portfolio companies of a fund looking to release funds tied up in working capital.

Chris, have your contracts been tested in this recession? If yes, please explain.

The last 18 months have been difficult for everyone in the financing world and we are no exception. Within the last twelve months our local language, local law, documents have been called into action in both Germany and Spain. In both cases, those documents have stood up to scrutiny and have been confirmed as being enforceable in each jurisdiction.

This adds weight to our conviction that following local custom, within the context of a wider pan-European funding situation, is the method which should give ABLs the most comfort when originally putting in place cross-border facilities.

What would stop you in your tracks this year from meeting your objectives?

Piers: the biggest thing would be if the sales of target companies just rapidly declined again. The winter before last, Q4 in 2008, saw many of our clients’ receivables fall as companies destocked. If we are getting into a working capital crunch or where many companies are in a position where they are not happy with prospects and increasing pressure on margins, which could be a sign of a double dip.

If there was one thing you could change about this business what would it be?

Piers: I’d like to demystify what ABL is, which seems to be our largest barrier.
I’d also like to explore more sectors, such as life sciences, especially with businesses that are now generating revenues. I would also like to see an increase in syndication through our dedicated ABL team, to increase transactions and move ABL up the value chain and to see pan-European ABL, something we specialise in, become more prevalent.