We have advised on a number of significant asset-based lending transactions in Scotland in the past 12 months. This article considers the benefits of an asset-based lending structure and the key themes for lenders and borrowers to consider as against more traditional forms of secured lending.
Asset-based lending is a specialist form of secured lending where the loan is more closely tied to the borrower's assets than is customary with a typical secured loan. The lender advances funds to the borrower based on an agreed percentage of the value of certain types of assets, most commonly receivables, but often multiple asset classes are used including inventory, real estate, machinery and equipment. As greater focus is placed on collateral and liquidity than cash flows, asset-based lending facilities may provide greater headroom and debt capacity for certain corporate borrowers.
Maximise facility headroom for your business?
The UK lending market continues to evolve and one of the key themes we see is an increasing willingness for businesses to consider a broader range of funding solutions and to take more of a "package" approach to their financing needs. Whilst balance sheet management has undoubtedly become a real focus for lenders (and asset-based lending ticks many of the boxes in this regard), this has not only involved a reduction in certain exposures, but also a desire to improve the quality of loan books and to consider a fuller range of lending products. Against this backdrop, asset-based lending has come to the fore and we are seeing an increasing number of transactions funded by banks (in addition to the specialised "commercial finance" companies who have traditionally funded deals of this nature) through asset-based lending structures or combining asset-based lending with traditional secured lending models as part of the "package".
How does it operate?
The arrangements around asset-based lending facilities can appear complex and mechanical at first sight, but will be well understood by borrowers with the benefit of some specific legal advice. The nature of the arrangements means that there are some common legal issues arising on asset-based lending transactions including:
The Borrowing Base
The borrowing base is a formula that is used to determine the maximum amount of money that the borrower can borrow at any point in time, based on the value of the agreed asset pool. Often this appears as a rather lengthy definition in the loan agreement and, given its importance to the overall mechanics of the facility, can involve extensive negotiation between the parties.
Borrowing Base v. Collateral
It is important for all parties to remember that in asset-based lending, the borrowing base which supports the loans is not the same as the collateral that secures the loans. The borrowing base is simply the formula used to determine the amount of the loans that the borrower can borrow under the loan agreement from time to time. However, the collateral securing the asset-based loan will often extend beyond those assets that are in the borrowing base (and may indeed extend to all of the assets of the borrower) providing an additional collateral safety net for the bank in an enforcement scenario should it wish to sell the collateral to recover the loans. Borrowers can often be surprised that lenders wish to have any oversight on elements of the business beyond those assets forming the borrowing base!
Security and Liquidity
For lenders it is crucial that in a default scenario it has the tools to take control of the borrowing base assets and convert these readily into cash to obtain repayment of the loans. The solutions here will vary depending upon the asset classes in question and, of course, the approach to security is quite different between Scottish and English transactions.
Lender Control of Assets
In asset-based lending the lender generally exercises more control over the borrowing base assets than lenders typically exercise over collateral on other secured loans. This leads to negotiations regarding (1) the frequency of borrowing base reporting to lenders, (2) the extent of other financial information that the lender should receive beyond simply that relating to the borrowing base, and (3) occasionally clean-down requirements to reduce the outstanding loans to zero for a brief period before reborrowing in accordance with the borrowing base.
There is an operational impact for borrowers in having to monitor the fluctuations in the asset pool and a cost associated with the lender carrying out the required diligence in respect of the assets. However, this may be an acceptable price to pay for borrowers to increase their facility headroom and should not be an inconvenience for those already operating robust models for monitoring inventory levels and so forth.
Will it work for your business?
An asset-based lending structure will not work for everybody but may operate particularly well for borrowers with greater financial leverage and marginal cash flows.
We have been involved in a number of asset-based lending transactions featuring a full range of companies across a variety of sectors, but it seems to lend itself particularly well to those operating in the food and drink industry (particularly whisky distillers), manufacturing, tool hire and supply businesses, and others driven by substantial inventory and receivables books.
Asset-based lending as part of the finance "package"
The popularity of asset-based lending continues to increase as a means to improve cash flow and raise working capital, but also as a means of funding acquisitions and restructuring. In our experience, private equity houses and other investors like the financial discipline that it brings to a business. This is encouraging in a market where availability to finance remains a central topic for discussion. However, legal advice is paramount for borrowers in ensuring that the mechanical nature of the facilities is understood, and for lenders in ensuring that appropriate controls and enforcement options are in place.
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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.