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January 13, 2020

Don’t hate the player, hate the game! The ABL game has changed.

Yet the players remain the exact same.  There have been many changes to the middle-market ABL industry over the past decade, but none more seminal than the dramatic shift in underwriting methodology to include enterprise value. But what about the assets?  Liquidating middle-market businesses with at least ABL net funds employed of $10+ million, and majority much higher, can be a difficult task. Specifically, when dealing with heavy-inventory situations as well as loans against non-working capital assets, such as M&E, RE and IP.  It constrains internal resources, has serious risk of not returning capital and is not the preferred path to go vs. running a sale process.  ABLs understand the risks and have had to adjust underwriting to factor in enterprise value as part of determining whether to get aggressive or even propose.  This is much more prevalent in today’s competitive market with ABLs being asked to take on more risk for lower rates.

Why is this the case and how did we get here?  Increased risk, aggressive structures and way more competition and complexity are the simple reasons, but this shift has been a long time coming as the ABL industry has transitioned to a mainstream product.  The ABL industry has proliferated in terms of dollar size, number of firms and sophistication, among other things.  Like many industries, the ABL industry became subject to competitive pressure, margin compression and consolidation as it grew and became widely adopted by banks and non-banks alike.  The shift to becoming more mainstream created product expansion, split-lien (and other) structures, comfort with different collateral and more risk.

It’s also important to be clear that this article really pertains to ABL facility sizes starting at $10 million (on the low end) and up. Smaller companies, on average, do not typically have the liquidity or EV to merit an aggressive structure based on enterprise value. Today’s middle-market ABL landscape is the result of a lot of capital, significant non-bank entrants, years of product adoption and vastly increased private equity usage.  This has forced ABL firms to adapt the product to partner with and compete with traditional cash-flow lenders as well as credit funds and BDCs. To that end, the private equity industry has had a meaningful impact on the EV-based lending shift as many ABL deals are done in support of private equity buyouts.

ABL firms now regularly provide a one-stop solution to finance not only working capital, but also M&E, real estate and even IP.  Gone are the days of just financing the working-capital assets.  In addition, split-lien deals with larger term lenders, SBICs and credit funds are much more prevalent as partners in deals.  More complex structures and the harder-to-finance and liquidate assets create obstacles to liquidating.  A sale vs. liquidation starts to become an attractive option when ABLs are in split-lien deals with meaningful non-working capital assets such as M&E. On one-hand, an ABLs has financed a lot of non-working capital assets that clearly lose value if sold piecemeal-mail and on the other hand the ABL might be in a split-lien deal and therefore might not have access to the general intangibles in a liquidation.  These are just a few reasons why the industry trend for middle-market deals is to push for a distressed sale rather than a liquidation.  It should also be noted that even a distressed sale does not mean either party is going to get out whole.

In today’s market, ABLs compete more so on structure than pricing if you had to point to one or the other. If you are going to compete on aggressive structure, then you need to have the sophistication to understand enterprise value as well as the distressed PE and credit market. It’s a symbiotic relationship.  To compound this point, many investment banks are catering to this market by now conducting a dual-track process that includes both debt refinancing and sell-side options in case a refinancing is not feasible.  This is becoming more mainstream, given the amount of investment banks who have started, expanded or spun-out of the larger firms the past several years including Configure Partners, Armory, Focal Point, Livingstone, G2 Capital Advisors and Carl Marks to name a few to compete with the existing leaders Lincoln and Houlihan Lokey, among others.  The turnaround industry has experienced the same growth as the big firms – FTI, Alix, etc. have grown bigger and many of the middle market firms such as Conway Mackenzie, Phoenix, Silverman, Sierra Constellation and Winter Harbor, among others, have expanded as well.

It’s a fact that fewer middle-market ABL deals are done now without the ABL getting comfortable with the business having a reason for being and enterprise value.  Simply put, the new “new” conforming ABL structure is way more complex and wide-ranging than in the past and a sale as a going-concern is a much better path out than a liquidation other than in specialized ABL niches, such as retail.  Increased borrower sophistication has helped with this trend as boards of distressed businesses realizing that a sale (in or out of chapter 11) may not only get the senior out, but is much more advantageous to other constituents such as employees, management, junior lenders and, of course, the PE firms themselves.  ABLs would much prefer to include a bigger availability block to provide optionality to run a fast-sale process.  The challenging part of this change in methodology as it remains untested in a downturn.

ABL organizations, especially the underwriting function, have changed as well.  The situations, deal structures and collateral pools have exponentially proliferated.  While ABLs now have to lend against non-working capital assets and consider lending against EV or EV assets, e.g., trade names, patents, and customer lists, most ABLs don’t have the expertise to do it properly. This is creating a real competitive differentiation in the market and also material point of difference for non-bank ABLs who portend to have the sophistication, but at the same time are still reliant on lender financing to be able to execute on these aggressive structures.

The real test of underwriting sophistication will surely come in the next downturn.  Most ABL shops simply over-depend on third-party valuation firms to appraise the EV assets and simply take a discount to the value when including it in the borrowing base.  It’s unclear yet whether they know how to include the third-party analysis with their own.  It’s a slippery slope getting this right as the difference between right and wrong is classic debt vs equity risk for low-margin debt returns.  Furthermore, many new ABL shops have started at the end of the cycle as they and their investors believe now is the time to start with a clean portfolio to take advantage of other ABLs’ aggressive underwriting assumptions that might not hold up.

ABLs have not historically viewed the sale of a business as a true exit option, however, this has fundamentally changed over the past several years as the middle-market ABL product and structure has become more complex – one could say it’s a different game.  We are also in the early stages of ABLs having enough outcomes to understand their EV underwriting track record given we are still in a good economic cycle.  The prevailing sentiment is that it is untested whether ABLs as an industry know how to independently value businesses or how to estimate equity interest/value in a business, especially in a distressed or tight-liquidity situation.  We are in a market cycle where very few underwriters or PMs can speak to this topic or risk from experience. Many are flying blind and are relying on third-party analysis that clearly does not take into account a major market correction.

ABLs should start to be less exuberant about these EV loans even if many are made to sponsor-backed businesses.  We are entering a brave new world where EV lending is starting to be the norm. The question remains whether it will revert back after the next downturn. The game has changed over time, yet the returns have not and the players certainly have not.  When the tide goes out, and it will, we will all know who the winners are in the age of EV underwriting.  Just remember, let’s all blame the game and not each other as players in a game, when the tide goes out to shore.  Remember to bring a bathing suit.

Link to full article here.