Supporting businesses growth through traditional lending practices often challenges both the company that requires funding and the bank asked to provide it with the lending facility.
The competing priorities of the borrower, who is looking for flexible and cost-effective pricing, often conflict with the amount a bank is prepared to lend, the conditions of the loan and the required return in advancing the loan. This situation has intensified in the post-crisis period and new demands placed on banks by the likes of the Basel III capital adequacy regime.
However, with the introduction of asset-based lending (ABL) many banks are now able to reconcile the competing differences by lending to companies at higher than traditional levels in a secure way whilst at the same time satisfying their customers with flexible conditions.
How ABL Works
ABL is a lending methodology whereby a bank lends against pledged assets, such as cash, inventory and receivables at a lending value that is higher than traditional lending values.
Unique structuring provides the confidence for banks to lend at higher levels based on a number of key characteristics:
- Typically ABL facilities are uncommitted, whereby the bank may elect not to provide any new financing.
- Financing terms are revolving in nature, for example weekly financing and revaluation of the assets maybe a condition of the ABL facility.
- Security against the financed assets may include full or partial control over cash.
- High level of monitoring by the bank.
- Regular inspections of the company’s storage facilities including auditing stock holders and company records.
- Banks can tap into industry experts who can provide informed decision on appropriate lending value especially on inventory that is highly specialised.
Diagram 1 below illustrates ABL’s application to a company’s supply chain.
This example shows a bank is able to provide a short term loan to a customer for $255, while under a traditional lending approach the bank may only be able to squeeze out $160 for the customer.
Another important component of the finance package is the dynamic correlation of how the financing follows the movement of the company’s assets through time.
Diagram 2 below shows how assets change between two months and how the financing also changes in conjunction with this movement:
Essentially, as asset values rise and fall in conjunction with the company’s trading activity the bank’s level of financing also rises and falls, benefiting the company whose business cycles are seasonal by nature.
Depending on the type of inventory, the bank and company will agree on appropriate financing and asset revaluation tenors.
For example, if the inventory under finance is commodity based, then shorter financing and revaluation tenors, say weekly, would be appropriate to ensure ABL values are aligned to the movements in commodity pricing. Inventory in the fast moving consumable goods category may have longer financing and revaluation periods of say fortnightly or monthly.
How ABL Financing is Structured
There are a range of options to apply when structuring a financing solution for a company, Diagram 3 illustrates this through a continuum.
On the left hand side finance could be structured with quite relaxed conditions, for an unsecured overdraft to a tightly controlled financing structure where by banks, through special purpose vehicles, purchase inventories from companies, often seen in structured commodity financing. ABL financing structures tend to sit in the middle of the continuum and structuring framework is centred on the key principles of:
- Asset valuation.
Rigorous reporting requirements are an important factor to ABL. From a bank perspective, in order to assign the correct lending valuations, the company needs to provide quite detailed and regular information on the asset portfolio. Other necessary reporting could be commodity price information to ensure assets values do not fall below the agreed thresholds on commodity prices. Also, detailed reporting to ensure the assets are of high quality, this could be in relation to a commodity grade or specification or overdue receivable payments.
Banks often integrate their operating platforms with market pricing feeds to ensure price risks are being managed and kept up to date.
Because ABL is aligned to specific assets, monitoring of the company’s trading activity is critical to ensure the quality of assets are maintained, for example, inventory not moving through a natural course of a trading cycle may point towards a problem with quality or stock obsolescence. The same applies to a company’s receivable book, past due receivables and receivables between related entities are generally excluded from ABL facilities.
Another element of monitoring is the need to conduct audits, this may include internal auditing teams within the bank or high specialised audit teams contracted by the bank to conduct a comprehensive audit of inventory and receivable records including sample checking to ensure the bank is not financing “fresh air”.
Whilst ABL values can be easily applied readily marketable soft and hard commodities, in the case of other general inventory types, across such industries of retail, automotive, chemicals and food and beverages and also inventory classified as work in progress often the question from credit committees in banks is “what makes this financed value correct?”
There are a range of methodologies to apply, from cost value to net realisable value to liquidation value. Prudent banks engage with industry specialists and appraiser firms to land on an informed decision of determining the right answer to the credit committee.
When it comes to ABL financing the old adage “trust but verify” often rings true.
Whilst ABL financing structures can appear on their face to be a nice, neat and tidy arrangement for the bank and their customer, there are risks to be aware of, and at times, when things go wrong banks can received an unwanted surprise.
One of the areas where banks can become unstuck is financing assets that were not intended to be financed.
A key concept in ABL is “eligibility criteria”, refers to the type of assets the bank has agreed to finance. For example, in the case of a commodity, the eligibility criteria could be set around the commodity specification, location of storage, type of transport used etc., similarly for receivables. Receivables which are 60 days past due maybe deemed ineligible and excluded from the asset value being financed.
Additionally, the credit quality of the company’s debtor is also a potential risk. If a large debtor defaults on a receivable payment, then the borrower may not have the financial means to repay the debt. Prudent banks seek to have a balanced portfolio of debtors and even deploy risk mitigation strategies such as credit insurance to mitigate the risk of non-payment from the buyer.
Overly aggressive advance rates on assets may mean, in the case of a default, the bank may recover insufficient cash, resulting in selling inventory in a distressed market, to liquidate the debt.
As with all forms of lending, it’s all about being selective in the target market, ensuring the customer is a healthy sponsor is a sound starting point and maintaining a balanced approach in monitoring and testing the asset quality in the ABL portfolio of assets.
The discussion thus far has centred on the basic structuring of the ABL.
While the opportunity to maximise the potential is largely limited to the imagination of innovative bankers, there are three apparent way to extend the value:
- Taking a supply chain perspective.
- Expanding the use of ABL.
- Collaborating with banking partners.
Whilst Diagram 1 illustrates the basic model of ABL, the value proposition can expanded into an integrated supply chain approach illustrated below in Diagram 4.
By taking a supply chain view of a company’s business, the level of complexity increases as well as the level of risk and in many ways the skill of trade banking is to incorporate risk mitigants and controls in order for banks to conduct this form of financing in a safe way.
Additional risk management properties incorporated into the above may include consigning transport documents to the bank in order for the title of goods be controlled through the banking system, legal agreements between the bank and third party storage providers including arrangements to segregate financed goods from other companies stock holding and using credit insurance to mitigate the payment risk of offshore debtors whose financial position may not be known to the bank.
Whilst the underlying customer need is finance, the use of ABL structures can be expanded by including other banking products, such as import letter of credit and standby letter of credit issuance, into the ABL facility.
Finally, banks generally need to maintain lending restrictions to corporates and as a consequence a single bank may not be in a position to extend finance to a company on its own.
Under this scenario it is now common for banks to collaborate through syndicated financing arrangements to extend ABL to the corporates who may have large financing requirements. Under a syndicated arrangement, the lead bank will be required to manage the asset base behalf of the banking group which will include frequent reporting and monitoring the asset quality of the underlying asset portfolio.
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