ABLs: Sharks or saviours?

By Yan Barcelo
Illustration: Gerard Dubois

The growth of asset-based lending is seen by some as dangerous. Is this view right?

When Harris Hester bought the John Forsyth Shirt Co. in 1997, it had plenty of equity, but needed an operating line and a chunk of sub-debt. “We approached banks across the province,” recalls the president and CEO of the Mississauga, Ont.-based apparel manufacturer, “but banks don’t seem to like the apparel sector. So we sought an asset-based lender, and chose Congress Financial in 1997.” He’s never looked back.

Only 10 years ago, asset-based lending (ABL) was stigmatized as “rescue financing” or “financing of last resort.” Some executives even considered asset-based lenders to be a slightly gentler species of loan shark. But the growth of the industry over the past decade or so is changing that image — thanks in large part to the increasing number of companies that, since the economic downturn of recent years, have gone knocking on asset-based lenders’ doors when they find that traditional banks are closed to them.

In fact, the industry has become so large it prompted Bank of Canada Governor David Dodge to comment: “The potential for disaster may build up. Non-regulated institutions have a tremendous potential to create havoc in the system.”

Dodge was referring to not only ABL players that provide secured loans to companies, but to all unregulated financial institutions that hand out loans, whether corporate or consumer, against the value of an asset. That would include not only traditional ABL giants such as General Electric Capital Corp. and Congress Financial, but consumer leasing leaders such as Ford Motor Credit and General Motors Acceptance Corp. (GMAC).

Indeed, according to New York-based Commercial Finance Association (CFA), from 1990 to today this type of lending has known only two dips (in 1991 and 2001) but has otherwise risen from US$96 billion in total loans outstanding to US$326 billion. Add to that factoring volumes of US$96 billion in 2002 (up from US$52 billion in 1990), and you get a total of US$422 billion in commercial asset-based lending outside of banks, a large portion of which escapes any regulatory overview.

“In Canada, numbers are hard to come by,” says Bill Patrick, senior vice-president of CCFL Parklea Capital Inc. in Toronto, a firm that specializes in matching prospective borrowers with lenders. “I’d guess that it stands between $6 billion and $10 billion, but it could easily be as high as $15 billion.” Such a number would, however, be surprising, since ABL has only emerged in Canada in the past 10 years, while its presence in the US goes back 50 years.

In fact, Lawrence Kryzanowski, Ned Goodman chair in investment finance at Montreal’s John Molson School of Business at Concordia University, recalls the industry took off in Canada about 1996, when GE Capital and a few ABL divisions of major US banks came into Canada. That explains why the same major players are found here and south of the border: GE Capital, Congress Financial, ABN Amro (operating through its subsidiary LaSalle Business Credit in the US) and GMAC; the only one that hasn’t ventured north is Fleet Capital. Bruce Jones, CFA executive director, estimates that the large players in the US account for US$300 billion of the US$326 billion in outstanding loans. (One significant factor distinguishes the two markets: the US has some 1,100 ABLs in addition to the giants, whereas Canada has only 10 or 12.)

Viable alternative
Of course, the stereotype of ABLs being exclusively involved with companies in trouble isn’t totally false. “People associate us with distressed debt because the ABL financings that get into the news are usually about companies in financial difficulty — Irwin Toy Ltd., Eaton’s, Air Canada, Stelco Inc.,” says Wayne Ehgoetz, president of Congress Financial of Canada in Toronto. But in fact, only 30% of the companies his firm does business with fall into that category. “The other 70% are strong companies, private and public, that have needed an alternative to traditional bank financing,” he says.

One of the main reasons companies seek this alternative is that they’re active in sectors that banks are not comfortable with, and therefore refuse to lend to. Such retailers represent Congress’ largest portfolio segment, at 15%. One such company is John Forsyth.

“Even though most banks we approached had an ABL arm, they didn’t want to lend to an apparel company,” says Hester. He remembers going with colleagues to a meeting at a bank where they were put in a room in which there weren’t even enough chairs for everyone. “You get a clear impression that banks will lend to you only if you don’t need it.”

ABLs in a nutshell

Pros •  An asset-based loan will usually provide     more leverage than a bank loan •  The lender is more familiar with your     business model and stands as a partner •  Clients enjoy more consistency of financing     during unstable cash-flow periods •  ABLs impose fewer covenants than bank loans •  Interest rates and closing fees are often     comparable to tier-one banks •  Facilities are committed, not on demand,     usually for three- to five-year agreements •  The larger players will readily do crossborder     financing, something Canadian banks are     reluctant to do •  The borrower/lender relationship is more     individualized. Manager-to-accounts ratio is     usually 15-to-1, compared with 100-to-1 in banks

Cons •  The detailed due-diligence process can prove     cumbersome •  Monthly administration costs are higher,     essentially because of audit procedures •  Collateral reporting is more frequent than     with banks — usually bi-weekly for inventory,     daily or weekly for receivables •  Appraisal and audit updates can be time     consuming for clients •  An asset-based loan ties long-term finance     to short-term assets, which contradicts general     prudent accounting rules. However, a certain     amount of inventory can be considered a     long-term asset; individual units can turn over     rapidly, but the general level remains stable

ABLs have been moving well beyond their traditional base of clients. “We find them involved in frozen fish companies, flowers, car services — practically every field,” says Jones. They’re even in high tech. For example, Hexcel Corp., a Connecticut-based manufacturer, saw a drop in the global electronics industry wipe US$100 million — a full two-thirds — from its 2001 revenue in its composite elec- tronics business. Then, the 9/11 terrorist attacks chewed away 30%, or US$150 million, from its aerospace business. In just 10 months, Hexcel, which had revenue of US$1.1 billion, lost nearly a quarter of that — and is still waiting for the aerospace business to recover.

To survive, the company managed to raise US$125 million in private equity, but investors demanded that Hexcel find another US$115 million from a lender with the stamina to withstand the trying period ahead. Hexcel turned to ABL financing, signing a deal with Fleet Capital.

The economic downturn of 2001 also brought into the ABL fold a slew of large corporations whose sudden drop in credit rating singled them out as “fallen angels.” Traditionally, ABLs focused on mid-size companies whose cash flow was insufficient to get a bank’s unsecured loan and whose financing needs ranged from US$50 million to US$100 million. But the recession caused the number of large companies seeking ABL credit to soar, with players such as Goodyear, RiteAid and Levi Strauss stretching out their hands for loans of US$500 million to US$1.5 billion.

Many of the companies turning to ABLs may have fallen on difficult times, but in most cases they are far from dying. They simply don’t fit well with banks because their cash flow has temporarily dried out or their leverage ratios have gotten out of line. Often, the loan-seeking company finds a much better ally in an ABL. “Since we first signed with Congress Financial,” says Hester, “it participated in all our acquisitions, sometimes with extraordinary financing. It has been a true partner to us.”

Closely connected
Of course, to a large extent, ABLs have no choice but to be partners to their clients since the very structures of the loans they sign require it. Contrary to popular assumption, asset-based loans do not exact outlandish interest margins. Compared to banks, at ABLs all-in pricing is probably 50 to 75 basis points higher, says Patrick, who is party to many deals with a large variety of lenders. That’s a combination of fees and interest rates.

One key advantage of ABL loans is that they impose few covenants, if any (a frequent one is an EBITDA-to-interest-coverage ratio). Banks, on the other hand, protect themselves with many covenants, such as debt-to-equity or debt-to-cash-flow ratios since they do not generally secure their loans. In more difficult times, financially managing the company can therefore become a juggling exercise.

ABLs protect themselves with collateral and by closely monitoring its value. “Banks work with month-old reports on inventory and receivables,” says Rick Lomas, executive vice-president of CIT Business Credit Canada in Toronto. “We’re more proactive in determining collateral value of inventory.” That means reports may be required weekly, or even daily.

Such demands may seem excessive to many financial officers, but when a company has the adequate IT systems, as is the case with most mid-sized and large firms that have implemented ERP financial modules, the necessary reports are easy to cough up. In most cases, IT systems are already in place. And those who have gone through the process often welcome it.

“Some might find the reports and the audits onerous, but we find them helpful,” says Hester. And, he adds, since they’re done electronically, they don’t eat away any time, yet they do point to potential weaknesses and impose an excellent discipline on the company. “After all, if you have inventory of more than one year, shame on you.”

Typically, ABLs will not do a stand-alone term loan and will extend one only if it is attached to a working capital loan, which they are equipped to monitor. That means they do not simply follow collateral, they execute simulations and projections; for example, to see how its value will evolve in changing business environments.

Because they are so close to a company’s daily operations, ABLs come to better understand a client’s business model and the industry it works in. That’s why you’ll see them readily extend extra financing if their client wants to do an acquisition, and when the economic climate darkens, they’ll stay the course. “We’re ready to go into more troubled waters than banks are,” says Lomas.

The bottom line is that asset-based loans are more intrusive and more costly than bank loans in terms of interest charges and administrative fees. Those fees can run up to $20,000 or $30,000 a year for an average borrower, says Ehgoetz. Yet ABLs impose minimal covenants compared to the unsecured, cash-flow-based loans of banks. And their higher costs are offset by the advantage of delivering higher leverage. “If you can get more financing with us — say, $4 million or more — the fees are not significant,” Ehgoetz says.

Usually, an ABL finances up to 85% of receivables and 80% net orderly liquidation value. Ehgoetz says at the outset banks seem to go almost as high, giving 80% on receivables and 55% on inventory, but they cap it. For example, on an inventory value of $1 million, they will cap the loan at $400,000. “But we will leverage up to $650,000, even $700,000,” he adds.

So, how to value a company’s inventory? First, ABLs call on auditors, appraisers and field examiners to determine quantities and ensure the inventory is in good condition. And auditors, usually employed by ABLs, sometimes have to deal with fraud. For example, Jones tells of a company in bankruptcy that had to liquidate vast quantities of salad dressing stored in huge vats. Auditors dipped sticks into the vats but didn’t check the substance too closely. When the time came to liquidate (literally in this case), they discovered that 75% of the “dressing” was just water.

Next, liquidation specialists are called in. “There is no rule of thumb for evaluating assets,” says John Jefferson, vice-president of Hilco Appraisal Services LLC in Toronto. “Perhaps companies A and B make the same product, but A might have a better market position than B, and a better product. And some inventories are easier to sell — in the retail sector, for example, compared to manufacturing.” The final value hinges on many factors: are clients readily available? What are the quantities to liquidate and in what time? Do products require special transportation expenses? Costs linked to the selling of the material, such as advertising and salaries, must also be taken into account.

When the appraisers are done, they will have determined that the value of the inventory — which has, say, a book value of $100 million — is in fact worth $70 million. An ABL bases the 85% leverage of the loan against the net orderly liquidation value.

Cause for concern?
Considering that banks are increasingly aloof, treating loans as commodities that they securitize, it’s no wonder that companies are turning more often to ABLs. But the trend seems to concern Dodge. According to a Bloomberg report, in April he told delegates at a conference at York University in Toronto: “We may be seeing activity gravitate outside this regulated field [of banks], where the pressure is to use better risk-management practices, to non-regulated areas, and the potential for disaster may build up because more and more activities are done there.”

As Dodge and other Bank of Canada representatives declined to be interviewed, we can only speculate whether Dodge’s apparent concerns are called for. Of course, his claims cover not just traditional commercial ABLs, but lease financing giants such as Ford Motor Credit and GMAC. “I don’t know whether you call Ford Motor Co. a financial institution or a manufacturing company or an advertising company,” Dodge said at the York conference, “but it sure has a major presence in financial markets and can have a big effect.”

Take Ford Motor Credit’s outstanding debt of US$149.7 billion at the end of 2003 and GMAC’s US$176 billion. Add to that debts of other consumer lease companies, then pile it onto the CFA’s US$422 billion in outstanding ABL loans and factoring, and you end up with a heck of a lot of debt. Is disaster looming, as Dodge claims?

Jean Roy, professor of finance at HEC in Montreal, thinks the ABL industry as a whole poses no systemic risk. “I’m less worried than Dodge,” he says. “If a bank fails, it can have an effect on the monetary mass and contract credit. But no player in the ABL and leasing industry is so big that its failure would have a similar effect. If GE Capital, Ford Motor Credit or GMAC were to go bankrupt tomorrow, I believe most solvent borrowers would be able to refinance elsewhere.”

In fact, in the confines of the ABL business, most large players are owned by a major bank: Congress belongs to Wachovia, Fleet Capital to Bank of America, LaSalle to ABN Amro. Only GE is an independent, but it boasts a triple-A rating, better than any North American bank.

“As a subsidiary of a bank, we are required to have the same reserve levels, and we have the same risk rating and management systems,” says Ehgoetz. This was confirmed by a major US regulator. “Losses in the industry have not been significant, so it doesn’t command urgent attention,” a spokesperson says. “But we’re paying attention because it’s a significant sector.”

Still, many huge players in the broad industry of lease financing and asset-based lending lie outside any regulatory scrutiny. In Canada, most of the big players escape Dodge’s gaze as they are subsidiaries of US banks and are regulated by the US parent.

Unlike Roy, Kryzanowski thinks a crisis could very well develop, especially if one of the major lenders enjoys strong leverage with one or many banks. “Don’t forget the [Long-Term Capital Management] crisis in 1998,” he says. “They were unregulated, yet they were so involved with banks that the Fed had to bail them out to keep the financial system afloat.”

ABLs are not as diversified as banks, so they need to be closer to clients, says Kryzanowski. “Being close to clients is good, but at some point you can become too cozy — especially when times are good, and you stop asking questions. That happened to some of our banks that became cozy with clients like Dome Petroleum, the Reichmanns and Campeau.”

So, should Dodge flex his regulatory muscles? Kryzanowski doesn’t think so. “I would prefer that risk-taking be done in a non-regulated area, so taxpayers do not ultimately take the burden,” he says. “But I think it would at least be a good idea to have the industry report to regulators so they are not left in the dark and called in to clean things up if a crisis develops.”

Indeed, just as ABLs demand weekly, even daily, reports from clients, perhaps the logical next step — and the best for all concerned — is if ABLs were required to inform regulators just what heights their mountains of outstanding debt reach.

Yan Barcelo is a Quebec-based writer