Published in ABL Advisor: http://www.abladvisor.com/blogs/8704/financing-the-bank-to-abl-transaction
Asset-based lenders have become the bedrock debt capital partner for any business's rise to bankability. The product is high touch and requires daily/weekly service and responsiveness from the ABL capital provider given the fluid nature of many of their clients. ABLs are focused on serving clients given the underwriting, servicing and ongoing management required to service companies and ensure success. The product was in-part created to finance companies through most situations or transformational periods by creating a structure to leverage assets.
ABL providers are situated in the middle of the credit spectrum with a higher credit quality grade than factors, but lower than a bank. This strategic positioning ensures that this product will play an active role in financing companies through business cycles and credit changes. Industry consolidation, macroeconomic changes, supplier issues and industry change are all factors that lead to changes in the business fundamentals of middle-market companies. In addition to economic factors, interest rates and bank regulation play a role as well. These factors should lead to an increased velocity of companies transitioning from banks to asset-based lenders.
Financing the Bank-to-ABL transaction offers a unique paradigm as it is typically not driven by one factor, but many and is meant to serve a company through whatever business cycle or issue that is transpiring. ABLs find themselves at a seminal intersection and play a pivotal role in helping transition companies to-and-from banks and other commercial lenders. The underlying companies are typically trying to get to a bank, or at some point in this life cycle will be asked to leave a bank, thus creating a need to transition to a borrowing base. This creates a dynamic opportunity, but also creates inherent risk and constant need for monitoring and capital.
In anticipation of this, most major national and regional banks have acquired ABLs or started their own groups. The same also holds true for other large non-bank lenders such as BDCs and private debt funds that seek to fill voids or finance riskier credits turned down by bank-owned ABLs. In just the past few years, asset-based lenders such as Marquette, First Capital and Presidential have been acquired by banks and non-bank lenders in order to serve this current and future financing need. The same confluence of circumstances that has led to this trend has also led to tighter credit standards creating a need for gap or stretch financing as part of financing these types of transactions. Financing the stretch piece in a bank-to-ABL transaction requires different underwriting given the increased risk, and necessitates having a strong relationship with the ABL who manages the account.
This opportunity also exists at a time when competition from traditional and alternative lending sources is at an all-time high, while at the same time, underwriting standards and regulatory hurdles remain challenging. The scalable opportunity is for asset-based lenders to generate more business and take less risk by seeking firms that seek to provide incremental subordinated financing to facilitate a transition to an ABL structure. New business models and subordinated debt products are coming into the forefront to generate new ABL clients and finance the risk that ABL firms do not want to take.
The business model entails being both a capital provider to businesses, but a service provider to ABLs by providing three essential services: 1. Onboarding clients via stretch financing, 2. Off-boarding clients via loan purchases or pay downs and 3. Retaining clients via second lien term loans that ABLs can’t or don’t want to provide. Consolidation of ABLs by banks and non-banks has created a unique opportunity to service ABLs and provide incremental capital to their respective clients.
The product termed “second lien debt” entails providing an amortizing junior debt strip subordinated to the ABL and subject to a standard inter-creditor agreement. Second lien financing is short-to-medium term in length and meant to position companies that want to obtain SBIC money from their existing ABL, permanent mezzanine capital or other long-term solution, but are not yet ready or able to obtain it. Typical terms range from 12-to-36 months and enable companies to position themselves for the right long-term capital event or solve short-term needs due to rapid closing times. The short-term nature of the product also makes it possible for ABLs to step in and provide their own term loan financing once the underlying credit has improved or once they have had time to get comfortable with the credit.
The ideal second lien borrower is a proven lower- and/or middle-market company with at least $10 million in revenue with sub-institutional subordinated capital needs ranging from $500,000 to $5 million. Companies have a range of readily available solutions for a several hundred thousand dollar capital need as well as a $5 million-plus capital need, but very few alternatives to solve for a few million dollar capital need that is subordinated to an existing lender. Firms such as Crystal Financial are market leaders when it comes to providing $5 million-plus second lien financing packages to companies generating greater than $8 million in EBITDA, but few firms are focused on sub $8 million EBITDA companies.
The real market need and opportunity is to partner with ABLs is to create a scalable partnership to solve for hard-to-find capital ($500,000 to $3 million subordinated loans) to smoothly transition clients to a borrowing base and provide for extra liquidity or a large opening reserve. Most companies that generate less than $5 million in EBITDA don’t have access to mezzanine capital or larger second lien players that write $5+ million checks. Second lien debt capital enables a smooth transition and most importantly provides extra liquidity, ensures an adequate closing reserve and sufficient working capital to finance operations. To do this requires providing flexibility to both the client and the asset-based lender as the goal is to not trigger a fixed charge covenant or other covenant that could trigger a technical default by the senior lender. This extra risk creates the need for aggressive or relatively structured amortization to mitigate the risk.