Welcome to Credit Insights, a periodic series of articles where members of Torkin Manes' Banking & Financial Services Group examine and discuss technical aspects of lending transactions with a focus on the legal documentation and best practices in transaction execution. In this instalment, we examine the key considerations for a business when contemplating switching from a traditional commercial banking arrangement to an asset-based lending arrangement.
Why Would a Business Switch to an Asset-Based Loan?
Credit facilities offered by Canadian lenders are typically either cash-flow based (i.e., credit based on the financial health and strength of the borrower group as demonstrated by financial statements) or 'asset-based loans' ("ABL") (i.e., credit based directly on the value of certain assets of the borrower group).
There are many reasons why a business may switch from a traditional cash-flow-based loan to an ABL arrangement, including the following:
- The business is having cash-flow issues or is experiencing difficulties staying within prescribed financial covenants;
- Notwithstanding the cash-flow issues, the business has significant assets, such as inventory, accounts receivable, or equipment that would be sufficient to secure any required financing; or
- There may be 'hair' on the business such that a commercial banking group is not willing to lend to the borrower, whereas ABL groups at banks tend to have extensive experience dealing with 'out-of-the-box' situations.
Ultimately, ABL structures may be a way to access greater liquidity with less onerous financial covenants in a more flexible, fact-specific and solution-based environment.
What does an ABL Structure Typically Require?
Increased Fees:As an alternative financing structure, ABL deals typically involve higher fees, both in respect of the bank/financing fees and legal fees due to the increased complexity of the documentation and processes involved. There are also commonly other non-bank and non-legal fees, including, for example, third-party appraisals relating to marginable assets and insurance consultant costs.
Borrowing Base: Due to the focus on marginable assets, ABL facilities require a borrowing base structure with detailed eligibility parameters for the assets forming part of the borrowing base, including, for example, the exclusion of receivables that are past due or past their invoice date by a specified period (commonly 120 days or more) and excluding inventory not subject to a first-priority security interest or subject to third-party access or control arrangements. Also, lenders will typically not agree to fetter their discretion when it comes to reducing the borrowing base in the face of any factors that could impact the future realization value of the assets in the borrowing base.
Monitoring: ABL facilities also require frequent monitoring of asset values to facilitate ongoing updates to borrowing base calculations. It is common that reporting periods may increase in frequency to weekly or monthly reporting. Similarly, it is common that ABL facilities include more extensive information system requirements and more frequent inspections by the lender.
Blocked Account/Control Arrangements: Mechanically speaking, ABL facilities are often advanced by setting up two separate accounts with the lender – an operating account and a blocked/collection account. The lender advances funds to the borrower (based on the borrowing base) into the operating account while the borrower's revenues (from the collection of receivables, inventory sales, etc.) are deposited into the blocked/collection account and routinely swept by the lender to reduce the loan balance (with the process continually repeating). As the borrowing base changes, to the extent it increases, additional funds are advanced to the borrower's operating account. Through the blocked account arrangements, the borrower's access to the collection account is restricted. From the borrower's perspective, it may be beneficial to request a springing blocked account arrangement whereby the block is not triggered unless or until a notice is issued by the lender.
Third-Party Items: ABL lenders need to maintain their access to, and control over, any margined assets in the event of insolvency, given that an ABL lender's credit analysis is based on the projected value of those margined assets and not historic cash flow. There are several third-party rights that may impact an ABL lender's ability to access and control the margined collateral, including but not limited to landlord and warehousing agreements, third-party secured creditors, and insurance considerations. In particular, while traditional cash flow lenders will often have requirements relating to third-party liens and insurance, ABL lenders tend to have more stringent requirements.
One third-party item that tends to be more extensively negotiated (versus a traditional cash-flow lending situation) is an intercreditor agreement. For example, a common situation involves an ABL lender maintaining priority over inventory and receivables (as these are the margined assets under the ABL structure), and a second lender having priority over other assets, including equipment. The ABL lender in this scenario may require use rights to the equipment (which the other lender has priority over), to ensure that any raw materials or works-in-progress inventory can be transformed by the ABL lender into saleable finished goods inventory.
Increased Complexity in Documentation and Diligence: Tied to the increased fees noted above, it is rare to see an ABL structured arrangement that does not include a long-form loan agreement, extensive ancillary drawdown documents, custom security documents and more highly negotiated legal opinions of counsel to the borrower group. An ABL lender's due diligence process will also be more extensive than a traditional cash-flow loan. For example, ABL lenders typically require a review of material contracts, particularly where agreements may impact the ABL lender's ability to enforce its security, such as licensing agreements, or customer and supplier agreements.
Conclusion
Ultimately, the main differences between ABL financing structures and traditional cash-flow based loan structures are (i) the underlying collateral package that the lender seeks to take security against, (ii) the related increased complexity in documentation and negotiations, and (iii) the increased time that management of the borrower will spend both prior to closing in terms of diligence and post-closing relating to reporting.
As a practical approach, and a continuing theme in this Credit Insights series, getting ahead of the potential issues arising from the switch and ensuring that the borrower understands the process is the best way to ensure that transitions from a cash-flow-based loan structure to an ABL financing are as efficient as possible.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
