Ron Kerdasha & Greg Walker | January 6th, 2016 | MMG
Demand for loans by lower middle-market companies—despite the continuing modest economic upsurge—still falls short of expectations.
The result is a supply and demand imbalance as lenders anxiously put their cheap capital to work, driving borrowing costs down and overall availability up. Companies are often surprised by the aggressive loan terms and overall availability offered in the lending market and are frequently caught off guard when making decisions about how much debt leverage they should hold on their balance sheets.
Finding a credit facility that meets short-term needs while paying heed to the long-term ramifications of leverage is important to the financial health of midsize firms. Management—especially within companies with more cyclical business models—must be prepared for changes in market conditions over which it has no control, but which may materially impact a business plan. Changing market forces include swings in the overall economy, rising interest rates, rising labor costs, the impact of regulatory issues and volatility of commodity prices and currencies.
Overall volatility has been heightened recently by movements in important variables such as the value of the U.S. dollar and oil prices. Costs related to health care and insurance are also constantly in flux. They represent potential challenges for management teams, particularly at smaller privately held companies, which typically have a lower threshold for pain.
So what to do? Companies should commit to a predetermined debt structure, work with lending partners they can trust and continuously review the impact of varying debt levels. It may be perilous to view loans as a commodity and to seek the most funds at the best price. The importance of the post-closing relationship with a lending partner cannot be overstated. Today’s senior lending market has pushed some lenders to uncomfortable levels of leverage, which can offer little or no margin for error. While it’s difficult to assess whether a bubble truly exists, we know how quickly the lending environment can turn for borrowers whose debt extends beyond a prudent level.
One approach to managing leverage levels is to find a senior credit facility primarily tied to the assets of a business sourced from a commercial bank. Known as asset-based lending, this strategy offers an alternative to a credit facility provided by a lender and tied to operating cash flow. ABL is often associated with less funding, but it may offer a lower overall risk profile for a borrower. The funding shortfall can be made up by pursuing a senior/junior borrowing structure to combine ABL with junior debt.
Asset-based lending has been a steady and consistent source of financing for smaller companies over many years and economic cycles. Asset-based lenders design a package by first seeking support from a company’s balance sheet and then formulating a credit facility around advances against accounts receivable, inventory, equipment and real estate. Some lenders may also include a small cash flow component based on the company’s ability to repay its debt.
Overall lending parameters proposed by asset-based lenders are typically predictable and rarely deviate based on market conditions. Because most of the loan exposure underwritten in an ABL facility is covered by assets, ABL remains a cheaper alternative to the higher leverage debt packages based purely on cash flow. If there are shortfalls in projected financial performance, asset-based lenders look to the assets as a secondary source of repayment behind operating cash flow. As a result, an asset-based lender is more inclined to be patient and to allow management to prepare and execute a turnaround plan. Financial covenant structures in ABL deals are often limited relative to those included in a cash flow financing, and they’re easier to manage in the event of default.
As noted, an ABL loan can be blended with junior debt—priced in the 10 percent to 12 percent range—to provide increased funding. An ABL product coupled with junior debt, such as “last-out” or mezzanine debt, may ultimately provide a price advantage on a blended basis versus one-stop cash flow lending. The ability to turn to a team of lenders with deeper resources, as opposed to a single lender, may further mitigate risk in executing future strategies, whether a borrower is tackling a crisis or implementing a growth plan. Borrowers can further benefit from a lending team that has worked together in the past and is familiar with the various lenders’ credit cultures. This arrangement can prove valuable for supporting a growth or add-on strategy by leveraging an expanding or acquired asset pool and seeking incremental funding from a junior debt partner.
Asset-based lending is clearly not suitable for every company on the lower end of the market; however, over the years it has become a readily available financing option for manufacturing and distribution businesses, and to a lesser extent, service businesses. Companies in these sectors would clearly benefit by utilizing flexible, lower-risk ABL structures as a financing solution in volatile times. //
Ron Kerdasha is group president and region executive with MB Business Capital, a division of Chicago-based MB Financial Bank, N.A., and a member of ACG Maryland. Greg Walker is a senior vice president with MB Business Capital and a member of ACG New York.