Expert Q+A: Asset-based Lending in the Mergers & Acquisitions Landscape

Michelle Laitinen, managing director, sat down with expert Richard Hatley to explore how inflation and economic uncertainty are impacting mergers and acquisitions (M&A) and why the topic of lending matters more than ever for businesses today.

Cash flow lending allows lenders to assess the recurring cash flow of companies and offer to lend based on a multiple of that cash flow. Asset-based lending (ABL), an alternative for some businesses, leverages the value in the assets that a company owns to create liquidity.

As a business advisor, share how you guide companies during the lending process.

At Riveron, we work on behalf of both lenders and borrowers during the origination, monitoring, or amending of asset-based loans or cash flow loans. Our work on asset-based loans for these parties includes conducting initial and recurring field exams to evaluate the quality of assets that will become collateral, including accounts receivable, inventory, machinery, and equipment. We also perform assessments on the quality of earnings when cash flow lending is more appropriate. In both cases, we work with our clients to maximize liquidity while mitigating credit risk.

How has inflation impacted lending, borrowing, and deals?

As companies increase their borrowings or expand credit lines, they are asking for more capital in an environment where inflation has no clear end in sight. The past eighteen months of post-pandemic market re-entry and historic M&A activity have created an inherent uncertainty for lenders trying to understand the current and future capital needs of their borrowers.

The main impact that inflation has on transactions is that it creates uncertainty surrounding the true level of cash flow for companies and the timing of that cash flow. For instance, it has been well discussed that there are major supply chain issues. The disruption to production timelines has been compounded by the increase in material costs, and this disruption changes how much third-party liquidity is needed and how long it must stay in place. Also stemming from the current environment is wage inflation. Many companies are paying their people more in order to incentivize retention, which increases the operating expenses of these companies.

The confluence of everything costing more and changes in the timing of when capital is needed now requires companies to find more liquidity with more flexibility in order to finance their operations. Imagine a company that manufactures trailers. In the past, materials were paid for and arrived in 30 days, a trailer was built and sold in another 30 days, and proceeds were collected 30 days later, resulting in a 90-day cash conversion cycle. In the current environment, costs have risen by 20%, some of which have been pushed through to customers, material lead times have grown threefold, production lines take 45 days due to labor shortages, and accounts receivable are stretched by customers dealing with the same issues. The cash conversion cycle has lengthened significantly, and the capital need has grown, resulting in both a lender and a borrower trying to figure out how much capital is needed and what the timing of cash flow will be.

Why are asset-based loans (ABL) becoming more attractive in this setting?

When companies are experiencing strong cash flow, borrowers may choose a cash flow loan to take advantage of lower loan pricing, simpler reporting requirements, and reduced covenant structures. By contrast, in times of operating volatility, cash flow loans can become problematic as lenders try to discern the true recurring cash flows to support the financing. Variables such as employee retention, materials inflation, and supply chain volatility are potential detriments to a cash flow loan structure.

ABL borrowers are not as reliant on cash flows to support their borrowings and instead are utilizing the value of working capital and fixed assets to collateralize the loan. During a downturn, a company’s asset levels often fluctuate less than cash flow, enacting the product’s design of not being susceptible to cash flow instability. ABLs are structured to increase and decrease in size based on asset levels, in step with the company’s cash conversion cycle. As long as cash flow remains vulnerable, asset-based lending will continue to be more attractive when given the option. For these reasons, working-capital-heavy businesses are good candidates for ABL loans.

What are some risk expectations when it comes to defaulting on and recovery for each type of loan?

Defaults are going to occur among both types of loans, but the product’s design and covenants should provide protection when these events occur. From a lending perspective, a certain level of default risk is acceptable and factors into overall portfolio risk.

The difference between an ABL and cash flow loan defaulting comes in the recovery. When an ABL loan defaults, the lender’s primary form of recovery is to realize on—and liquidate—the company’s assets. This recovery approach is factored into the borrowing base to ensure funded debt does not exceed the recoverable value of the collateral. If a going concern sale is possible, the lender might consider it, but the primary source of payment is always the collateral. On the other hand, cash flow loans do not link loan fundings to assets, often resulting in an undercollateralized position in a default scenario. Cash flow lenders have a more complex fact set to assess and must consider multiple liquidation or restructuring scenarios. For this reason, the risk of loss to the lender in an ABL default is lower than during a cash flow default.

How do ABLs maintain market share in times when cash flow loans are a competitive option?

ABL structures can adjust to market conditions. When the market is saturated with capital, and cash flow or covenant light structures are popular, ABL typically responds with higher advance rates, advances on non-traditional ABL assets (i.e., unbilled accounts receivable, progress billings, etc.), and curtailed reporting, appraisal, and exam requirements. When the market gets volatile, though, lenders go back to core ABL standards.

In this climate of cash flow volatility, what is important for both borrowers and lenders to understand?

Coming off the heels of the pandemic, the market has witnessed a heightened amount of M&A activity. Deals were being done at an improbable speed, and some lenders took on atypical levels of risk. Toward the end of 2021, a number of variables contributed to bringing the marketplace into this climate of inflation, supply issues have not gone away, and while liquidity still remains in the market, lenders appear to be reassessing credit risk.

As a result, there is an expectation that the market will see an increase in ABL structures as a percentage of the broader market and a tightening in the cash flow space. The migration back to ABL after a market disruption has historically been the response to increased credit risk, with many lenders expecting the migration to have already occurred. However, the market has been saturated with capital from both lenders and government programs, which has likely caused the delay.

Regardless of the financing structure, during inflationary periods, it is critical that lenders work with their borrowers to understand the impacts specific to the company as well as the more macro view of its industry and confirm that the company has sensitized its capital and operating projections accordingly. This will be key in determining the appropriate credit structure for the company and whether it fits the lender’s credit tolerance. Consequently, borrowers must understand that lenders will be making these assessments, so being in command of historical and projected financial information as well as strategies for mitigating a volatile market’s operational risks will be important to maximizing their credit structure.

Working with so many lenders and borrowers alike, what are some of the trends you are observing?

Across the board, the market is experiencing increased inquiries to ABL groups. In a healthy market, that would mean companies are growing and need working capital. In the current market, it is more likely a response to the choppiness in the economy and concerns about the stability of cash flows.

There also seems to be less focus on guessing when supply chain issues will ease and more attention paid to what the capital impact will be—if the issues become an operational fixture over the near term. Similar to the dissolution of hopes that inflationary pressure could be transitory, the mindset that supply chain issues would resolve naturally to traditional timelines and price points is changing, and longer-term planning is becoming the norm.

Discussions about lending on more difficult asset classes such as in-transit inventory, unbilled receivables, and progress billings have become more conservative versus their treatment as recently as six months ago, with more extensive testing and documentation of policies and procedures to ensure the lenders have a comprehensive understanding of the credit risk.

Other topics bounce around the periphery, such as the long-term impact on commercial real estate and how it will manifest in occupancy costs and liquidity as lenders deal with troubled real estate loans.

Overall, the market over the last eighteen months has reset expectations and called for innovation—new ways to make deals work. As the market continues to evolve, so must expectations. And, if history is a good guide, there will be a general shift toward good basic credit discipline and an increasing role of ABL structures, where appropriate.