1.  

What is an asset-based loan?

An asset-based loan or secured loan is a loan secured by a company's accounts receivable, inventory, equipment, and real estate, whereby the asset-based lender takes a first priority security interest in those assets financed.  It is an alternative to traditional bank lending because asset-based lenders target borrowers with risk characteristics typically outside a bank's comfort level.

2.  

What types of financing do asset-based lenders offer?

Asset-based lenders are collateral lenders, as opposed to cash flow lenders.  They focus first on the collateral's cash conversion cycle for repayment and on cash flow second.  Asset-based lenders loan money to companies using two main types of credit facilities:

• Working capital facilities based on accounts receivable and/or inventory: Loans which finance accounts receivable and inventory are typically structured under a revolving line of credit or "revolver," without a scheduled repayment.  The lender advances funds against the revolver to carry accounts receivable and inventory and, when such assets convert to cash, the advances are repaid accordingly.
• Fixed asset facilities to finance equipment and owner-occupied real-estate: Loans financing equipment and real estate typically take the form of term facilities with a scheduled repayment usually equal to the fixed assets' useful life.  Some asset-based lenders will not take on term debt or limit their exposure to it, since such debt carries a higher degree of risk than revolving debt. Equipment finance companies, leasing companies, and mortgage bankers specialize in fixed asset financing and provide such financing on a transactional basis.

3.  

When does an asset-based loan make sense?

Good candidates for an asset-based loan have tangible or financeable assets that can be used as collateral, such as accounts receivable, inventory, equipment and real estate.  These companies may have high leverage ratios, as measured by debt to equity, typically over 5 to 1, or may be marginally profitable companies, companies with a recent history of losses, or with inconsistent cash flow.

But since the asset-based lender focuses on collateral, the borrower's eligibility for loan qualification is determined from an evaluation of the quality, liquidity, and sufficiency of the borrower's eligible assets.  The lender analyzes each asset class to determine its net realizable value in a liquidation situation.  It then uses this information to exclude certain assets from financing and set maximum advance rates. However, if it is determined through this analysis that the lender is unable to reconcile the quality, liquidity, and sufficiency of the assets that it is proposing to finance, an asset-based loan is not appropriate.

4.  

What is an asset-based loan typically used for?

• Leveraged mergers and acquisitions
• Turnaround/restructuring situations
• Liquidity events for family-held businesses
• Growth opportunities
• Capital expenditures
• Tight working capital
• Seasonal or cyclical companies
• Specialized industries
• Stock repurchase
• Public ownership to private ownership
• Debtor-in-possession (DIP)/confirmation financing

[

5.  

What's the difference between asset-based lending and traditional bank financing?

The primary difference between commercial banks and asset-based lenders is where they each look first for repayment:  The bank looks to cash flow for repayment first, then collateral; while the asset-based lender looks to collateral first.  Since banks underwrite cash flow as their primary repayment source, they typically require less collateral controls and monitoring but more financial covenants.

For companies that are "asset heavy," an asset-based credit facility may be able to make more funds available because the loan is not based strictly on the anticipated levels of cash flow.  Additionally, the structure often requires fewer covenants, thereby providing more flexibility for many borrowers.

6.  

What is typically included in an asset-based loan agreement?

A typical loan agreement with an asset based lender provides protections, rights, and remedies for both parties and establishes guidelines on how the loan is to be administered and how expectations are to be met.  In addition, the loan agreement may include a limited number of restrictive and/or financial covenants, but these are typically fewer than conventional commercial loan agreements.

7.  

How does the asset-based lender monitor its borrowers?

The level of controls and monitoring by the asset-based lender is directly related to the credit-worthiness of the borrower.  Typical controls include:

• A borrowing base formula that monitors the relationship between the value of the collateral available to secure the outstanding loan and the actual balance of the loan on a regular basis.  
• Funding controls (collateral monitoring) that may be administered daily, weekly, or monthly and range from submission of sales invoices/shipping documents to accounts receivable aging and listings/inventory listings.  The degree of reporting depends on the borrower's risk rating.
• Collection controls: The asset-based lender requires dominion (control) over cash by establishing a collateral account into which accounts receivable collections are deposited.  Access to this account is restricted to the asset-based lender.
• Ongoing audits are also used to monitor the account.  The asset-based lender will audit the borrower's books and records periodically to test the records' accuracy and validity and to substantiate collateral values as represented by the borrower.

8.  

What is a cash flow loan?

Cash flow loans are loans primarily underwritten by the cash flow (revenue) of the business rather than on the particular assets of the business.  The size of a cash flow loan and its repayment schedule are directly tied to the company's ability to service the debt, which in turn is based on its anticipated revenue stream.  Interest on these facilities can be fixed or variable, with rates dependant upon the credit risk and other structural features of the loan.  Cash flow loans are sometimes structured in conjunction with a sponsor group (also known as an equity or buying group).

9.  

How do cash flow loans work and what are they used for?

Lenders calculate a required margin of comfort in interest coverage -- "the safety factor.".   If, for example, the interest coverage requirement were one and one-half to one, a company seeking a loan on which the annual interest payments were $1,000,000 would be required to show the ability to generate $1,500,000 a year of earnings before interest and taxes (EBIT).

Cash flow loans are used for a variety of borrowing needs:  acquisitions, MBOs, growth, recapitalization, restructuring a company and capital expenditures.

10.  

What is a revolving credit facility?

Also known as a "revolver," this type of loan is designed to optimize availability of working capital from the borrower's current asset base.  Eligible assets commonly included in calculating the current asset base are finished goods and marketable raw materials, although valuations differ from industry to industry and will also differ on a company-to-company basis.  The term "revolver" is used because the amount the lender is willing to lend increases if the amount of the assets securing the loan increases.  Funds are loaned to a company based on a certain percentage of the appraised orderly liquidation value of the eligible account receivables and inventory.  Such loans are limited by the predictability of cash flow to service the debt.  A revolving line of credit typically has a term of one year with renewal provisions.  The advantage of a revolving credit facility is that the company can use current assets as collateral to secure a loan rather than wait until the collateral has been converted to cash.

11.  

What is a term loan?

A major component of senior debt is a senior term loan.  This is a loan based on a certain percentage of the appraised fair market value of the land and buildings and the orderly liquidation value of the machinery and equipment.  Loans against equipment and real estate are more often made in the form of term loans that include regular periodic payments of both principal and interest in order to retire the debt at a fixed maturity date.  Real estate loans have longer maturities than equipment loans because of the generally shorter economic life expectancy of equipment.

12.  

What is a Management Buyout (MBO)?

Sometimes referred to as a leveraged buyout or LBO, an MBO is an acquisition in which the buyer ("management") uses the minimum amount of equity to purchase a "target" company. The acquirer uses the target's assets as collateral for debt and uses its cash flow to retire the debt it accumulated to acquire the target.

13.  

What is EBITDA?

This term stands for Earnings Before Interest, Taxes and Depreciation and Amortization.  It is a financial tool often used to measure a company's cash flow and ability to service its debt.  It is a legitimate tool for analyzing lower rated credits, but less appropriate for higher rated credits.  There are some limitations to EBITDA.  To compute EBITDA, add back interest expense, depreciation expense, and amortization expense to pretax income.

14.  

What is LIBOR?

LIBOR is an acronym for London Interbank Offering Rate, which is the market interest rate charged by lenders and paid by borrowers for U.S. dollars outside the U. S. borders (commonly called Eurodollars).  LIBOR is quoted on a daily basis representing fixed time periods ranging from 30 days to 360 days.  The rate is set not by banks but by market forces in the supply and demand of Eurodollars. Interest rates on senior acquisition financing are normally based on a floating rate related to either the prime rate or LIBOR.

15.  

What is Debtor-in-Possession (DIP) and DIP financing?

DIP is a company that has filed for protection under Chapter XI of the Federal Bankruptcy code and has been permitted by the bankruptcy court to continue its operations to effect a reorganization.  DIP financing, which is new debt obtained by a firm during the Chapter XI bankruptcy process, allows the company to continue to operate during the reorganization process.  This is also sometimes referred to as confirmation financing.