ABL mythbusters: The truth about asset-based lending

ABL has changed, as well as how businesses can leverage an asset-based loan. Read four ABL myths to understand the potential benefits of this effective, often cheaper financing option.

One of the most interesting developments in corporate finance is the increased appreciation of asset-based lending (ABL) as an effective, often less expensive option for financing asset-heavy businesses with seasonal or cyclical cash flow. These are not your parents' ABLs. They are well-collateralized, competitively priced vehicles to finance mid to large, successful companies. Yet decades-old misconceptions still cloud the understanding of asset-based loans and – worse yet – may still keep some companies from considering a loan instrument that could be their most effective option for financing.

Why do those misconceptions still exist? ABLs earned their reputation decades ago, when they were seen as creative financing for troubled companies that didn’t have the cash flow to support traditional loans. “Borrowers and their advisors would turn to ABL facilities after traditional, cashflow based, revolvers no longer provided adequate liquidity and/or covenant relief,” explains John Freeman, Head of ABF Sales and Originators at U.S. Bank.

Back then, most ABL deals were viewed as survival loans for “middle-market” businesses. But Freeman says relationship and investment banks, along with Private-equity sponsors, started using the asset-based lending structures for larger deals decades ago, which completely changed the perception of the industry.

That created a syndicated loan market for ABL deals. Relationship banks can arrange a large loan to a corporate borrower that’s backed by accounts receivable, inventory, equipment, real estate, and in some cases intellectual property,” he explains. “The lead bank can then sell-off loan participations to other like-minded asset-based lenders to spread the credit risk. The question becomes how much debt the borrower can support, and some very successful companies can support more debt with an asset-based construct vs. a traditional cashflow construct.”

How ABL has changed

Traditional loans are based on cash flow or multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). But ABL uses a different formula. As the name would suggest, asset-based financing is based on the value of the company’s assets, which become the loan’s collateral. As a result, a successful widget distributor with large inventory but low margins might have a much higher debt capacity with ABL.

“If you're trying to finance on a cash flow basis as a multiple of your cash flow or multiple of EBITDA, the borrower might be able to generate a large enough facility to execute their growth plans.” Freeman says. “But if the company leverages their working capital assets (A/R and Inventory) they often are able to generate a larger revolving credit facility through the use of the ABL construct.”

As a result, an increasing number of large, successful businesses have discovered the merits of asset-based financing.

“At the end of the day, ABL Lenders are looking to provide Borrowers with incremental liquidity that can be used for numerous purposes, including organic growth opportunities, acquisitions, dividend recaps, and turnaround strategies, etc. The product provides the ultimate flexibility to Borrowers.”

Still, despite its increased popularity, some of the concerns about ABLs continue to persist. So, changing that perception may require some ABL myth busting.

Myth: ABL is only a loan of last resort

Reality: ABL has evolved into another capital markets product solution. It’s simply a different way of financing a company that is more focused on the balance sheet than the income statement.

“For an asset-heavy company that has thin margins and doesn't really have large EBITDA levels, an ABL can be a better fit than for an asset-light borrower,” Freeman says. “It just really depends on the makeup of the company, but there is still some of that negative connotation out there for folks who just have never utilized an ABL. Their viewpoint is sometime perpetuated by conversations with their incumbent banker who is incentives to keep them in a structure that might not be the best fit of the goals of borrower.” 

Myth: ABL is not very popular with equity sponsors

Reality: Actually, asset-based lending is used quite often to help finance acquisitions for the same reasons that it has become popular for other financings. Although the people that buy companies tend to operate in multiples of EBITDA, savvy investors recognize the value of a well-constructed ABL.

“The Sponsor analysis if relatively straight forward,” Freeman says. “A hypothetical equity sponsor who buys a company for 10x EBITDA will seek total debt financing of 6 to 6.5x EBITDA and fund the balance of the purchase price with equity. That 6.5x debt financing could be 4 to 4.5x of senior debt plus a higher priced junior debt tranche. But ABL sizing is not driven by that same multiple of EBITDA so it may provide more of the total liquidity solution, at a much lower cost of capital.”

Read more: When is ABL right for your business?

Read more: Collateral options for ABL: What's eligible, what's not?

>> Learn more: Contact us to discuss how asset-based lending can fuel your growth strategy.

Myth: ABL is very high priced

Reality: Although they may have been expensive during the “loan of last resort” days, today’s asset-based loans are actually inexpensive because the historical recoveries are so high.

“The ABL product has evolved over the past 30 years and is now a core product which the vast majority of relationship banks offer. This allows banks to price the loan on a relationship basis vs. a loan-only basis. When pricing on a relationship basis banks will look at total client ROE, inclusive of ancillary share of the borrower’s total banking wallet, which will benefit borrowers.”

Myth: ABL requires high maintenance or extensive reporting

Reality: Although there is reporting involved with an asset-backed loan, it isn’t nearly as extensive as it was “in the old days,” because today's borrowers report electronically. You can set up reports on day one that automatically run for each reporting period. More importantly, the effort required to report the level and value of collateral is often far less burdensome than managing the restrictive covenants placed on cash flow loans.

“Modern ERP systems allow today’s ABL borrowers to easily generate and submit period reporting requirements. Gone are the days of cumbersome ABL reporting in which companies needed to add dedicated treasury staff to comply with the reporting requirements,” Freeman says.

When are ABLs appealing?

The flexibility of an asset-based loan makes it a desirable option for companies. Financing availability expands and contracts with the corresponding availability of a company’s assets, which means ABL is especially attractive for companies in the following situations:

1. Significant transition is occurring in the business (i.e., high growth, acquisition, sale or dividend recap)
2. Company’s Debt-to-EBITDA ratio is greater than 3.25 times earnings and it has a meaningful amount of working capital assets
3. Company utilizes a traditional cashflow revolver, may be operating with tight liquidity, but has a strong balance sheet with material healthy working capital assets
4. Company would benefit from a loan structure with minimal financial covenants
5. Company operates in a seasonal and/or cyclical industry (i.e., retail, distribution or manufacturing)
6. Company is either owned by or exploring a partial or full sale to a Private Equity firm
7. Company is a “fallen angel” which is currently, or is potentially, experiencing declining performance trends which could result in a cash flow revolver covenant breach.

At U.S. Bank, we’re here to help you decide if an ABL is right for your organization. Contact your relationship manager or visit usbank.com to learn more.