In a pro dealer universe with minimal collective profitability, cash flow-based loans have become largely irrelevant. But all pro dealers have “hard assets”—namely inventory; accounts receivable (AR); and rolling stock, other machinery and equipment (M&E). These hard assets can be used to obtain capital in today’s market via asset-based loans (ABLs). In fact, they’ve become the primary form of debt capital available today for pro dealers. Lenders’ ABL terms and availability can vary greatly. Understanding the nuances of ABLs can help you in lining up the right lender and loan for your business.
What they are. ABLs include “revolvers”—revolving lines of credit typically secured by a first lien on AR and inventory—and term loans, which are secured by a first lien on M&E. ABLs are provided by banks as well as non-bank lenders (often called “asset-based lenders” or “commercial finance companies”) to businesses of nearly all sizes.
Banks offer lower-cost ABLs than non-bank lenders and can have total annual cost of capital as low as 5% to 7% of the loan’s balance. They will require higher profitability (i.e., the ability to service interest payments) and lower debt-to-equity ratios. Reasonable expectations are that your pro forma earnings before interest, taxes, depreciation, and amortization (EBITDA) are double your interest expenses and your debt is no more than shareholders’ equity.
Non-bank asset-based lenders can lend to businesses with lesser profitability and higher debt capitalization, but these loans’ costs will be higher; today they can range from 7% to the high teens. Additionally, all asset-based lenders charge fees, but non-bank ABL fees tend to be higher. Closing fees, annual commitment fees, unused line fees, collateral monitoring fees, and field audit expense fees are the norm. These need to be understood in evaluating a loan’s total cost of capital, as they can be as much as—or even exceed—the stated annual interest cost.
Advance rates charged for ABLs vary by lender and largely determine your loan “availability”—how much liquidity/loan amount you will gain. Typical advance rates today are 70% to 80% of so-called eligible AR and 40% to 50% of eligible inventory book value. Some asset-based lenders will also lend against M&E, often up to 50% of the rolling stock and equipment’s orderly liquidation value. Eligible AR typically covers those accounts receivable that are less than 90 days outstanding from invoice date and that also are related to customers who are more than 90 days outstanding on less than a quarter of their total AR balances. Eligible inventory typically excludes “slow-moving” (aged more than 6 months), damaged, or work-in-process items.
Covenants. ABLs typically have fewer covenants than cash-flow-based loans in the loan documents. However, as with all loans, the covenants must be understood and conservatively negotiated up-front. Covenants represent the key threshold that, if crossed, can result in punitive and costly measures enacted by the lender. Among those punishments you’ll find rate hikes, advance rate reductions, availability blocks, additional fees and, in a worst case, the effective forced liquidation of your business. Typical ABL covenants include Fixed Charge Coverage ratio (the relationship of EBITDA to interest, principal payments and capital expenditures) and Minimum Tangible Net Worth (minimum shareholder’s equity excluding intangible assets such as goodwill). Understanding and negotiating these covenants carefully up front is imperative to your business’ long-term health in a borrowing relationship.
Other ABL features. Most asset-based lenders will require customer deposits be sent directly to a bank account set up by the lender. Customer checks are received into this lock box and used to pay down the ABL’s balance. Your loan availability is then accessed via periodic—as often as daily—loan funding requests. Once an ABL is in place, lenders will typically require clients to have reviewed annual financial statements, conduct periodic field collateral audits and require submittal of collateral/financial reports (known as “borrowing base reports”) at least weekly.
Matt Ogden is managing principal of Building Industry Partners LLC, a building products-focused private equity investment and M&A/debt advisory firm that is a co-founding equity sponsor of US LBM Holdings. E-mail: email@example.com. 214.550.0405