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May 24, 2016

Hand-to-Hand Combat and the Need for Second Lien Financing

Published in ABF Journal:

As credit tightens, middle market companies are being squeezed from all sides. Lenders offering short-term second lien or stretch loans can work with ABL lenders to help these companies stay liquid.

Asset-based lending in the middle market conjures up images of hand-to-hand combat between borrowers constantly pushing up against availability limits and account managers dodging frequent requests for additional capital. These weekly tussles with the cash-tight companies that comprise most of the industry plague ABL professionals. This tension is the combined result of macro trends, bank-owned ABL consolidation and general difficulties in planning a sub-$100 million revenue business.

Borrowers are in the midst of an economic cycle where banks are tightening credit and trade suppliers are constantly pressuring companies to stay within credit terms. Never before have middle market companies been squeezed from all sides — terms from suppliers and collections from customers. Longer cash cycles and bank credit tightening have helped to bolster general migration to asset-based lending. These circumstances create constant capital needs and put a lot of pressure on even experienced ABL professionals, which leads to ongoing friction with the borrower.

Second lien loans, or over-draft capital, can offer a solution for strapped mid-market firms. A product that is subordinate to an ABL, second lien capital is subject to an intercreditor and is traditionally provided in the form of an amortizing loan with a term that ranges from six to 30 months.

Stretch Loans Provide Liquidity

These stretch loans create a unique, but previously hard-to-solve opportunity, as the weekly struggle for deserving companies can be reduced via partnerships with firms that specialize in providing second lien capital. This capital effectively provides extra liquidity and ensures that companies are not redlining their respective credit facilities as borrowing bases are fore-casted to become more conservative over time, based on industry trends and tighter scrutiny. The resulting push-and-pull relationship is the result of the confluence of factors that leave ABL professionals feeling like they are in a weekly battle with their clients.

The process for raising second lien capital is well served for two groups. Companies with less than $10 million in revenue (typically needing less than $500,000 working capital) can obtain this capital from the new internet lending industry. Also well served are companies with more than $50 million in revenue (typically needing $5 million or more) that generate strong EBITDA. But a large number of companies have limited options and little means to obtain capital other than what is provided by senior ABL lenders.

Super G Funding recently completed a deal with a well-known national ABL. Super G and the ABL worked collaboratively to finance a decades old manufacturer from a bank-to-ABL structure. The borrowing base under a competitive market rate accounts receivable and inventory formula was still too tight to effectuate the transition and would have put the company in jeopardy of having insufficient liquidity. Super G was contacted during the underwriting process and quickly structured an 18-month, $1 million subordinated term loan with staggered amortization. The amortization had to be staggered to enable the company to complete its turnaround, catch up with vendors and return to a regular cash cycle. Without the second lien loan that enabled the transition to an ABL structure the company could have faced a sale or liquidation from its former bank as it was approaching the end of its forbearance period and needed to exit.

The timing was weeks, the structure was flexible and the capital need was under $3 million and, of course, subordinated. The second lien loan docs were simple and Super G had a pre-negotiated inter-creditor in-place, which enabled a streamlined and efficient process. These transactions come about quickly as the second lien need is not apparent until late in underwriting and this scenario speaks to the broader opportunity to create a national partnership program with each major ABL group.

Several new funds are popping up to fill this credit void, but there will be others given the white space in this market. This niche is going to grow as current trends proliferate. To succeed, second lien capital providers need a strong understanding of the ABL business and national relationships. The opportunity is to create a national brand supported by senior level ABL relationships and a proprietary underwriting and execution model.

Air Ball Execution

A second lien capital provider that focuses on a niche strategy of financing the risk that ABLs can’t or won’t finance needs to have a strong capital base with cash on hand at all times and a unique execution strategy. The “air ball” execution needs to happen flawlessly as the need typically arises during underwriting when a client is being on-boarded or during a business cycle that creates a capital need. In either case, the second lien lender needs to be able to react and close within two to three weeks in order to solve the need and provide speed and flexibility.

The true market for this capital is mid-market companies that generate less than $8 million in EBITDA and have subordinated capital needs between $500,000 and $5 million. Companies can solve capital needs smaller and/or larger than that due to market efficiencies, but there is a void when it comes to financing in this window. This capital is not meant to be long-term or to compete with traditional mezzanine financing, which is usually accompanied by a financial sponsor. Most companies in the U.S. are non-sponsor backed and generate less than $8 million in EBITDA, so the market and corresponding need is quite large. Again, a company might use second lien capital to get through a tight working capital period in order to obtain traditional mezzanine, which is typically five years in term and requires covenants and warrants.

Super G, for example, arranged a loan for an audio/ video equipment importer after it triggered an inventory sub-limit issue with its bank-owned ABL and was put in technical default. A major port strike held up needed inventory, adding to the company’s stress. The company was structurally sound, generating around $50 million in revenue with standard margins and was a victim of timing. Super G provided a second lien term loan that enabled the company to pay suppliers, work through old inventory and catch up on its sales cycle to return to growth.

The migration from banks to ABL firms should only increase as credit continues to tighten and regulatory hurdles remain a concern. The fact that many ABLs are bank-owned will most likely cause continued cash pressure on many companies, given that average bank-owned ABLs are lower priced but tend to provide less availability. This trend should only continue as traditional banks continue to consolidate independently-owned ABLs or start their own groups.

Second lien capital providers who can fill the void and understand how to work with ABLs should be rewarded as bank-owned consolidation continues and larger macro issues create a tightening of credit and corresponding conservative borrowing bases. The second lien product in the lower middle market is poised to grow and succeed as a great alternative for ABL clients requiring a backstop or extra liquidity.

CHARLIE PERER is a director and credit committee member of Super G Funding, a committed debt fund focused on filling the credit void in the lower middle market with fully amortizing terms between 12 and 36 months. He is responsible for originating and structuring transactions across all loan products and corporate development initiatives.