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Tighter credit and bigger deals are making asset-based loans more respectable.
Tim Reason, CFO Magazine
November 1, 2003
For Stephen Forsyth, 2001 was a one-two punch to the gut. In the spring, the CFO of Stamford, Connecticut-based Hexcel Corp. saw an unprecedented drop in the global electronics industry wipe out $100 million—two-thirds of the annual revenues from the composite-maker's electronics business. Then the terrorist attacks of September 11 decimated Hexcel's commercial aerospace business, slicing annual revenues there by $150 million, or 30 percent. In 10 months, the company, with annual revenues of $1.1 billion, had lost a quarter of a billion dollars, with little hope that the aerospace business would recover before 2006.
Forsyth's team quickly recapitalized the company, raising $125 million from private-equity sponsors, contingent on the company's ability to refinance its senior debt. To do so, Hexcel issued $125 million in senior secured notes and arranged a $115 million asset-based credit facility with Fleet Capital. "The equity investors wanted to be comfortable that we had structured senior debt that could take a few more bumps in the road," he says. "That's what took us to the ABL [asset-based lending] market in the final analysis."
A few years ago, ABL wouldn't have made investors comfortable; it would have sent them running for the exits. But this method of borrowing against balance-sheet assets—which long carried a stigma as "rescue" financing or "lending of last resort"—has since been legitimized, both by borrowers of Hexcel's size that value its flexibility and by an increasing number of very large companies that are boosting the size of ABL loans.
In May 2001, CFO reported that the "stigma once associated with asset-based lending—that it signified a company down on its luck—has all but disappeared." That report focused on midsize companies—the traditional market for ABL loans ranging from $50 million to $100 million—that didn't have enough cash flow to get an unsecured loan. But as the economy sank further into recession—and some industries, such as retail, saw the worst deflation since the Great Depression—the number of large companies seeking credit from asset-based lenders soared. That, in turn, has made ABL a far more respectable proposition.
Of course, fallen angels (large, well-known companies whose bond ratings have slipped below investment grade) are down on their luck. But their names—and the size of the loans involved—have pushed ABL even further into the mainstream of borrowing alternatives. This year alone, Kmart, Goodyear, RiteAid, and Levi Strauss all took out asset-based loans worth well over a billion dollars each (see "Good Old-fashioned Debt" at the end of this article).
The typical ABL facility is a revolver, secured by liens against such working-capital assets as receivables and inventory. In recent years, arrangers have added term loans, secured by such fixed assets as property, plant, or equipment, to ABL packages. The Levi Strauss deal is one such example—the financing consists of a $650 million revolver coupled with a $500 million senior secured term loan.
What is not typical about Levi Strauss's financing is the size of the term loan. Smaller, more-traditional ABL offerings typically limit the term loan piece of an asset-based financing to no more than 25 to 30 percent of the size of the revolver. "[Term loans] were more discouraged in the past, simply because it was harder to predict what the ultimate value would be for equipment and real estate," notes Jim Connolly, president and CEO of Fleet Capital.
Asset-based lenders have long been experts at determining how much of a company's receivables or inventory they can recover in the event of a default, and the size of the revolver they offer fluctuates according to that "borrowing base." Moreover, a revolver secured by receivables is, in effect, a series of small loans paid down each time receivables are collected. It is more difficult for asset-based lenders to liquidate real estate or equipment, or even gauge what their liquidation values might be. "But," says Connolly, "we, the ABL industry, have gotten a little more sophisticated about calculating a company's ability to pay its term debt out of its cash flow."
Here again, the influx of larger issuers has had a profound affect on the ABL market. As the size of the total financing packages has grown, the term-loan portions of ABL packages, and even tranches of the revolver, are increasingly funded by institutional investors attracted to the security and fat returns. "At a certain point, you reach the end of the money that banks can put up and you have to look at institutional investors," explains Steven Miller of Standard & Poor's in New York. This year, S&P reports, institutional investors put up $2.6 billion in asset-based loans through August alone. That's almost as much as the $1.6 billion for all of 2002 and the 2001 total of $1.1 billion combined. As a result, some of the largest recent deals have seen the term-loan portion equal as much as 75 percent of the revolver, or have even seen the total portion of the financing provided by institutional investors exceed the bank portion.
Breaking the Covenant
By far the most touted benefit of ABL is freedom from the restrictive financial covenants that typically accompany unsecured loans based on a multiple of cash flow. "The covenants and structuring of an asset-based lending give you more flexibility than the traditional cash-flow market," says Hexcel's Forsyth. "We wanted to set up financing so that if there were another bump in the road, we weren't immediately running back to our banks and needing their help and relief."
That freedom was also attractive to William H. Carter, CFO of Borden Chemical Inc., in Columbus, Ohio. Unlike Hexcel, Borden wasn't going through major changes, nor was it in need of recapitalization. But Carter thought an ABL facility—which also had lower interest rates than unsecured debt—would help the company cope better with the ups and downs of the chemical industry. "Creditors in traditional credit facilities can get very nervous when you have significant cycles in an industry," says Carter.
"In an unsecured facility, especially for a leveraged company," he says, "you're always measuring yourself against the covenants, whether you have $5 million borrowed or $200 million borrowed." So Carter replaced Borden's unsecured facility with a $175 million ABL facility from Fleet Capital. In addition to lower interest rates, the ABL facility came with just one financial covenant—an EBITDA-to-interest-coverage ratio that kicks in only if availability under the line drops below $75 million. In the second quarter of 2003, says Carter, the company had no covenant test.
The big question is whether large ABL facilities of $500 million and up will remain as popular if the economy improves and credit markets loosen. Already there are fewer of the fallen angels that lent new respectability to ABL facilities. According to S&P, the number of fallen angels had increased every year since 1996, but peaked in 2002 and is now declining. As of September, the number of companies demoted from BBB-minus or higher to BB-plus or lower was 44, compared with 55 in the same period last year.
"I don't think this [large ABL borrowing trend] is over at all," argues S&P's Chris Donnelly, pointing to the recent deal signed by Levi Strauss. "ABL is here to stay," agrees Daleep Akoi, middle-market news editor for Loan Pricing Corp. in New York. "But it may have reached its cyclical peak." Most new ABL financings, he says, are $500 million or less. But that's still as much as 10 times the size of the traditional midmarket ABL facility, and the borrowings haven't slowed.
Fleet Capital's Connolly hopes that trend will continue even after a recovery. "We want to show that this is a good alternative financing technique," he says. He argues that companies that got a taste of how quickly the market can change may gain newfound appreciation for the consistency of secured lending. "We tend not to respond to changes in the capital markets—we're comfortable lending in a tough economy, and we are certainly comfortable lending in a good economy," he says. "We are hoping companies don't race back to the unsecured markets, because those markets are very fickle and subject to change."
"At least until 2004, you will continue to see companies coming from cash-flow loans to ABL," says Akoi. "The market is just littered with unsecured issuers that had to come back and secure themselves." ABL is likely to remain particularly popular among retailers and equity sponsors, he says. Any improvement in the economy, Akoi posits, is likely to cause companies with ABL facilities to draw more on their revolvers. That, in turn, means more interest for lenders. "At least for the next year and a half," he says, "things look pretty good for the asset-based market."
Tim Reason is a senior writer at CFO.
Good Old-fashioned Debt
Not all fallen angels—companies whose credit rating has slipped below investment grade—turn to asset-based lending. Rick Dobson, CFO of Aquila Inc., in Kansas City, Missouri, found another way to get free of restrictive cash-flow covenants when his company's $400 million unsecured revolver matured last April.
Put in place when the utility-turned-energy-trader was still investment grade, the existing revolver was inexpensive and had few restrictions. But Aquila took a series of devastating financial blows after the Enron scandal, slipping below investment grade while its stock dropped to a low of $1.07. It soon became clear that renewing the revolver with a 19-bank syndicate would hamper the company's effort to revert to its utility roots.
"When you deal with 19 banks, you deal with the lowest common denominator," says Dobson, "and the small banks would make it more and more punitive." In addition to requiring Aquila to conform to "extremely tight" covenants regarding debt-to-equity and other financial ratios, says Dobson, the banks also wanted first dibs on cash from asset sales. "Any proceeds from anything we sold in accordance with our repositioning would first go into the waterfall and get the banks out."
Dobson went through those negotiations with an alternative in his pocket—an asset-backed, three-year loan of $430 million, to be arranged by Credit Suisse First Boston and funded by institutional investors. Unlike asset-based financing, which typically involves a revolver secured by working-capital assets and a smaller term loan secured by fixed assets, this asset-backed deal was a straightforward term loan, with first mortgage bonds on utility properties serving as the primary collateral.
There were drawbacks. First, says Dobson, the loan was "not the cheapest in the world," with a coupon of LIBOR plus 5.75 and a LIBOR floor of 3 percent. The investors' return of 8.75 percent would drop to 8 percent once state utility regulators approved the deal, but upfront and advisory fees put Aquila's internal cost at 11 percent.
"We weren't thinking the revolver would be any cheaper," recalls Dobson, but for a utility whose working-capital needs rise in the winter to combat damage from storms, a revolver has advantages over a term loan. "We could run [a revolver] down and up during the year and probably save $30 million to $40 million in interest," he says. "A term facility is not as efficient, because once you borrow the money, it is outstanding."
But, as with asset-based financing, the absence of restrictive covenants was a big selling point. Aquila had to maintain a debt-to-total capitalization ratio of 75 percent for 2003 (and 70 percent for 2004 and beyond). "That was very flexible," says Dobson. "We didn't have to keep our eye on all these other covenants that could trip us up." Facing a major overhaul of the company and its business model, he opted for the less-restrictive term loan.
Virtually all of Aquila's capital structure was unsecured before Dobson signed up for the term loan, but that wasn't always the case, he says. "People have forgotten that a lot of the financing we did before the mid-'90s was asset-backed," he explains. "Then we had this stock-market exuberance and the spreads between secured and unsecured collapsed to 10 to 20 basis points, so we gravitated toward [unsecured financing] like the rest of the market." —T.R.
Not as Bad as It Seems
Asset-based lenders may not require borrowers to conform to strict financial ratios, but that's not to say they aren't keeping an eye on their money. In fact, the tight control they demand is probably the least attractive aspect of asset-based lending. To determine the borrowing base—the amount of receivables, inventory, or other assets a company can borrow against—asset-based lenders perform rigorous onsite due diligence. And if institutional investors get involved, the scrutiny can automatically double. "If institutional investors are just part of our [revolver] facility," says Fleet Capital president and CEO Jim Connolly, "they rely on us. But if they are providing the fixed-asset financing, then they always do their own due diligence."
Borden Chemical Inc. found the due-diligence process "certainly more work than an unsecured facility," says CFO William H. Carter. Still, he adds, "we didn't find it particularly burdensome."
Once lender and borrower agree which types of assets are eligible to be included in the borrowing base, the borrower must perform a monthly or weekly test to determine how much of the working-capital assets can be used as collateral, and report regularly to the lender. However, Daleep Akoi, middle-market news editor for Loan Pricing Corp., says ABL borrowers often find the calculation less onerous than expected. "It isn't really that big a deal once they get used to it," he notes. "Companies already have inbuilt mechanisms to track inventory and receivables."
"In the chemical business, we have pretty wild swings in raw-materials prices, which we pass through to customers, so our inventory and receivables can change pretty dramatically," says Carter. "Our borrowing base can move $3 million to $5 million from quarter to quarter." But, he says, "in hindsight, I don't think we've been surprised. The report process was what we expected."
Most ABL financings also require cash dominion; that is, receivables must be rerouted through the bank or financing company's lockbox. Again, however, the perceived burden is often worse than the reality.
"Strictly speaking, the bank gets your receivables, but the cash is immediately transferred over to meet your outgoings," says Hexcel Corp. CFO Stephen Forsyth. He adds that most companies use some form of lockbox arrangement anyway, so the only change is from one bank's lockbox to another's. "Once it's done, it's done," he says. "You don't notice the fact that the money flows in a certain direction once you have it organized." —T.R.