Asset-based lenders: choice for small firms?

The economy has been rebounding swiftly, and--surprise -now is a great time to be a small- to medium-size enterprise (SME) looking for financing. Unlike the last recession, in which most local banks were slow to get back into the game, lenders this time around are well capitalized. As a consequence, credit markets have greater liquidity, and banks have begun to compete very aggressively for companies in the lower end of the middlemarket that are seeking to borrow $5 million to $20 million.

In addition, new lenders and investors are entering the fray. Several well-known private equity groups recently set up teams dedicated to serving SMEs. For them, this segment offers several advantages, including greater growth potential and better premiums than typically are found at the upper end of the spectrum.

Regardless of the reasons, the increased sources and availability of capital for SMEs is good news. These companies play a significant role in fueling economic growth. Through their ingenuity, product improvements and service developments, SMEs lay the foundation for myriad future business opportunities.

The SME Profile Borrowers at the lower end of the middle-market, by and large, are privately held businesses in which the majority shareholder is the president, chief executive officer and CFO. Frequently, they make a business decision first and worry about the financing later; board approval for finance decisions seldom is required.

SMEs are usually sales-driven and growth-oriented, and their entrepreneurial nature often results in earnings and enterprise value volatility that can preclude traditional financing options. Since most business owners are loath to relinquish equity, and junior secured lenders such as B tranches and mezzanine debt rarely serve this segment, senior debt is the primary form of financing.

SMEs tend to be more cyclical than larger companies because their businesses may be reliant on one product line or customer base. Financing typically stems from a variety of reasons, including equipment purchase, product or market expansion, acquisition, succession planning or change of ownership. Their first foray into financing is often an asset-based structure.

Since they often don't have fully developed finance functions in-house, the owners of such businesses rely heavily on external accountants or attorneys when they need to tap the bank market. These outside advisors typically play a pivotal role in identifying and contacting potential lenders, structuring the transaction and guiding the business owner through the financing process. While financing at the lower end of the middle-market is similar in some respects to deals at the higher end, in other ways it's very different.

How Deals Differ Wider Price Variations: In a syndicated transaction, which generally involves a group of banks underwriting in excess of $100 million, a primary driver for the deal is market receptivity. However, at the lower end--where deals are less than $20 million--a single lender usually provides all of the financing. Since each lender in a one-bank transaction is dealing solely with its own money, there's less consistency in pricing than in the broader syndicated market.

Although 20 years ago, all loans in this segment were indexed to the prime rate, pricing today typically includes an option based on LIBOR (the London Interbank Offered Rate). Currently, pricing on these deals usually exceeds larger, syndicated transactions by 100 basis points or more.

Straightforward Due Diligence: Financial statements for these companies often are not audited. However, trying to understand a company with $30 million in revenue is much less complicated than one with $1 billion. In addition, at the lower end, it's hard to separate the individual running the business from the company itself; so much of what the lender is underwriting are the individual's capabilities and commitment. Typically, the lender expects the SME owner to have something at risk, although a personal guarantee on the credit facility may not be required.

More Credit Components: Most middle-market, asset-based loans center on a revolving line of credit, usually for a term of three years. At the lower end of the market, borrowers expect the lender to satisfy all of their financing needs: working capital as well as property, plant and equipment. Consequently, the credit solution generally includes not only a three-year revolver, but a term loan in which real estate is amortized for 15 years and equipment is amortized for five to seven.

Fast Turnaround: SMEs, by their nature, are agile and expect the same agility from their third-party suppliers. Since responsiveness is critical, lenders to this segment focus on moving as quickly as possible on a specific opportunity.

Regional Relationships Rule While the lender/borrower relationship is always important, it takes on even greater significance when the business has just one lender. SMEs need a partner that understands their business and is close enough to act quickly. They tend to be more comfortable with local and regional lenders because those lenders have first-hand knowledge of local market conditions, which may explain why there are just a few national lenders at this end of the market.

In addition to capital, SMEs usually need a variety of other banking services, such as cash management and property and casualty insurance. They also like the convenience of a branch network. Given SMEs' limited internal financial resources, the lender becomes almost an extension of the enterprise, and they can become an extremely loyal customer base. Relationships of 20 years or more are not uncommon.

The lender relationship is never more important than during the deltas of the business, those periods of rapid growth and/or poor performance. SME owners are not necessarily versed in the business of turnarounds. Most are optimistic about growth and don't anticipate economic slowdowns or expect to lose money. When it happens, they tend to be overwhelmed.

This is where asset-based lenders can be particularly valuable. They know from experience what to focus on from the standpoint of planning, cash flow, preservation of capital and liquidity. They also have the ability to accurately project the time and cost required to affect a turnaround.

The same is true for rapid growth. SMEs generally are focused more on growing the business than on improving profitability and creating internal procedures and systems. Growth consumes a lot of capital, and companies experiencing rapid growth go through cash quickly. This can worry a traditional lender, which monitors the company by balance sheet leverage.

Instead, the asset-based lender evaluates the systems and controls required to handle the new business effectively. Credit procedures, inventory systems and the like may need to be implemented or modified as the mix of business and/or geographic service areas changes. By establishing the processes and controls required to manage the company's burgeoning financial aspects, the asset-based lender can free the business owner to focus on growth.

Completing the Lifecycle A final key distinguishing characteristic of lower-middle-market transactions is the need for estate planning. The entire net worth of many SME owners is tied up in the company, making succession issues and retirement planning critical. An asset-based lender can help the transition to the next generation by having either the company or the offspring acquire the owner's shares. This way, the business can be handed down and the founder can preserve needed retirement assets.

If there is no family-related heir, the asset-based lender can help with the sale of the company to a strategic or financial buyer. Lenders that support the business from its earliest stages through the final liquidity event are, in the truest sense, lifecycle lenders.

Given the nature of the SME, with its dependence on a single-source solution and its desire to grow without focusing on cash flow, asset-based lenders can be a natural choice. From the owner's point of view, the incremental dollars charged by the asset-based lender represent a relatively inexpensive way to ensure financing throughout the life of the business.

Sam Philbrick is Northeast Division President at Fleet Capital Corp., headquartered in Glastonbury, Conn. He can be reached at [e-mail].