The last resort?

Over a year on from the onset of the credit crisis, conditions in the global banking sector are continuing to deteriorate. In recent months several of the largest and most established financial institutions in the world have been brought to their knees as confidence in the sector has plummeted, prompting the US government to pass emergency legislation authorising a $700bn buyout of toxic assets – a move that represents the largest banking bail-out in recent memory. The knock-on effect of this turmoil has been a drying up of liquidity during the last twelve months across the whole economy, and nowhere is this more evident than in the private equity buyout market, with the value of European LBOs dropping by more than 60% year-on-year over the first three quarters of 2008 from €162bn to just €62bn.

In the midst of this, however, there has been a sharp rise in the value of asset based loan issuance, with figures released by the Asset Based Lending Association (ABFA) showing that, in the UK and Ireland alone, loans worth more than £17bn were issued during the first six months of 2008 – a 15% rise in comparison to 2007. And anecdotal evidence suggests that a similar trend has been recorded in the buyout market, as Gary Edwards, Head of Growth and Acquisition Finance at Investec, confirms: “There has been a significant rise in demand for asset based lending throughout 2008. We are seeing very high quality business propositions at the moment supported by strong management teams.”

Low risk factor

The main distinguishing feature of asset based lending in comparison to cash-flow based alternatives is the higher security offered by the method. An asset based lender will offer a loan that represents a percentage of the value of particular assets on a company’s balance sheet; typically 75-90% in the case of receivables, 75-85% for inventory, 70-80% against plant and machinery and approximately 75% for property. Crucially, not only is there clear headroom built into the valuation, but the loan is only secured against the liquidation value of the collateral and only in the case of eligible assets . “In many ways it is a formulaic form of lending; there are a strict set of parameters and if these are not met the loan will not be issued,” Jonathan Broome, Director of Close Brothers Corporate Finance Debt Advisory Group, explains.

The fact that there is less risk of the loan defaulting is particularly prevalent in relation to the Basel II accord, which became effective across the EU in early 2008 as part of the Capital Requirements Directive. The new regulations require banks to hold appropriate capital reserves to protect against the risks they expose themselves to through their various lending and investment practices. With banks currently starved of liquidity, lending methods which carry less risk are obviously subsequently becoming more attractive, as they require less capital to be held in reserve and therefore provide a more efficient use of financial resources.

However, it is important to note that the benefits of these regulations are yet to be felt by lenders in practice. "The idea of the Basel II accord giving banks practicing asset based lending greater access to liquidity or lower capital ratios is nice in theory but it is not as simple as it may appear, as the regulations do not yet distinguish each type of financing. The risk rating of asset based loans will most likely fall in the future as it is proved to be much more secure and prove robust loss ratios, but this will happen over time," suggests Edwards. But it is arguable that the theory itself is prompting more institutions to adopt the approach now, particularly those that have suffered as a result of write-downs against more traditional lending practices. “Basel II has helped because it has forced banks to look seriously at capital risk weightings and become more appreciative of the much lower risk associated with asset based lending,” says Kate Sharp, CEO of the ABFA.

Sponsor benefits

The asset-based approach to lending also has significant attractions for private equity sponsors. Notably, the majority of loans provided in this way are non-amortising, with all loans based on receivables and inventory, which represent the largest fixed assets on the balance sheet in most cases, being supplied as revolving credit lines that fluctuate according to the working capital requirements of the business. “As these loans are advanced against realisable assets there tends to be no amortisation and therefore fewer covenants in comparison to cash-flow based loans, which is potentially beneficial to private equity sponsors,” explains Broome. Furthermore, in the current market the pricing of asset based loans is becoming increasingly attractive compared to cash-flow equivalents. “If you market to where we are now it is significantly cheaper but it depends on what the loan is secured against. For receivables current pricing is around 2% and for stock is it slightly more, while traditional senior debt is currently priced at around 3-4%,” Broome continues.

Though this all suggests that asset based lending is a viable and potentially profitable option for buyout houses that have found their usual sources of financing severely restricted, there is a problem: the amount of capital that can be raised. With the value of fixed assets often far lower than both the cash-flow and the market value of larger businesses, asset based lenders are typically simply not able to fund large-cap deals and are much more suited to the small- to mid-market value ranges. And even in cases where a large business does have sufficient assets to raise the sort of debt required for an LBO, the small size of most European asset based lenders prevents them from being able to provide the financing. Indeed, Broome suggests that the ‘sweet spot’ for individual groups is around £30m per transaction.

By contrast in the US, where asset based lending has been a prominent form of leverage financing for much longer than in Europe, this form of financing has been deployed in some very large transactions. “Asset based lending came over to Europe from the US and in truth we are still around a decade behind - this is not a mature market here yet,” says Edwards. However, there is evidence to suggest that European lenders are steadily gravitating up the value chain. According to a member of the ABFA advisory board, this is a priority for the association: “Getting asset based lending more involved in larger deals is one of the main objectives of the ABFA. If syndicates of lenders share the risk on these transactions there is no reason why it cannot be used to finance deals in excess of £1bn in the future.”

One of the ways asset based lending is already beginning to be involved in deals at the higher end of the market is through hybrid structures, where an asset based loan is provided alongside a cash-flow based loan in a single package. The difficulty with these structures is that there are often conflicts when more than one bank is involved, as Broome explains: “The issue is that the asset based lender effectively occupies a ‘super-senior’ position because their loan is secured against the assets, meaning that the senior lender becomes subordinated.” Despite this, for larger banks that are able to provide both forms of financing this method does potentially provide a more secure way of providing adequate debt to facilitate larger transactions. Furthermore, it can also be used to alleviate the problem of a business having insufficient fixed assets to raise the required capital, in cases, for example, where the business in question has leased property but a strong inventory and steady cash flow.

‘The lender of last resort’

The benefits of asset based lending have obviously been highlighted recently by the sharp correction that is occurring in the wider debt markets, but it is incorrect to assume that its growing prominence is nothing more than a reaction to the current difficulties. Indeed, many argue that the industry has been growing quietly for many years and was merely eclipsed by some of the lending practices that have become common over the past three years. “Asset based lending wasn’t squeezed out at all it was merely not the preferred way to fund for obvious reasons, particularly because it can be administratively difficult as it requires certification on assets to be updated regularly,” explains Broome.

Indeed, despite the stereotypical perception that asset based lenders are ‘the lenders of last resort’, the approach has become a significant part of the wider debt market and its importance is growing. “There have been good incremental increases in demand over the last few years as the private equity community has realised that it is a good alternative to cash-flow lending. The industry also does well in difficult times because people see how careful and stable it is,” argues Sharp. Therefore, though asset based lending should not be seen as a quick fix to the current liquidity problems that are stifling the buyout market, it is likely to continue to be an important feature of the private equity landscape, particularly in the wake of the problems caused by the over exuberance of senior lenders in recent years. "In the past the banking sector told you what you could have and didn't ask what you needed but that is changing as it is increasingly recognised that debt structures need to reflect each businesses individual needs. The market will define future trends," concludes Edwards.

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