Seeking financing? consider asset-based loans: two bankers explain why, when the economy is down, asset-based lending is up. (Financing for Growth: Special Section).

Many financial executives considering financing options in today's market are turning to asset-based loans, finding them to be versatile and cost-competitive debt instruments that provide increased flexibility over other alternatives. Yet, despite these clear advantages, some still view asset-based loans as "the last resort for commercial borrowers," or imagine them to be an expensive financing option that imposes an excessive reporting burden.

The reality is quite the contrary, as asset-based loans provide a borrower with enhanced operational flexibility through all business cycles and, with the ubiquity of computers, reporting has become efficient and non-burdensome. Since asset-based lenders have the benefit of liquid assets to provide protection, they place less reliance on the borrower's operating performance, a condition reflected by the relatively small number of covenant requirements attached to their loans.

By contrast, cash flow loans typically come with stringent -- sometimes highly restrictive -- financial covenants, such as a leverage ratio maximum, fixed charge coverage, interest coverage and minimum EBITDA (earnings before interest, taxes, depreciation and amortization). These requirements can put significant stress on a company's ability to operate freely, especially during an economic downturn.

Asset-based lenders are concerned with a company's asset coverage, liquidity and, to varying degrees, the borrower's ability to service its debt. The leverage ratio itself is not material.

Demand for asset-based loans rising

Many factors have spurred the recent appeal that is driving the demand for asset-based loan structures, but three stand out.

1. The widespread presence of aggressively structured cash flow loans completed in the late 1990's. During this period, when many companies were executing leveraged buyouts, acquisitions and rollups, banks were delivering highly leveraged cash flow loans, which were based on a multiple of the borrower's trailing earnings. The shortcoming of this lending strategy was that many of these loans depended on continued improvement in the cash flows of these companies, as well as a strong capital markets environment, to provide an exit for the borrowers and lenders. Neither of these conditions held true, with the result that many of these companies are now struggling to meet covenants or to fulfill maturing debt obligations.

2. The economic slowdown's effect since 2001 on companies of all types, but particularly those that operate in cyclical businesses. As these companies' earnings have suffered, they have turned to the inherent value of their assets -- accounts receivable, inventory and fixed assets -- to deliver the operational flexibility and borrowing power their cash flows can no longer command. Beyond mere necessity, however, these companies generally find asset-based loans offer benefits beyond increased liquidity. Today's-loans are priced below cash flow loans and, as noted above, almost always come with fewer financial covenants attached to them.

3. The asset-based market remains steady and competitive in spite of large-scale bank consolidation that is currently affecting many other types of loan markets, especially the cash flow market. This consolidation, along with recent regulatory and shareholder pressures placed on lenders' portfolios, has caused many lenders to push under-performing loans out the door, an unfortunate trend made more commonplace in difficult economic times. By contrast, the asset-based lending market is more stable, a natural occurrence in that the borrowing power of a company's assets is characteristically more stable than its earnings. Besides making for more competitive pricing, the large number of lenders in the market means there is a greater pool of lenders competing for the syndication of larger asset-based loans -- such as the $2 billion credit facility provided to Kmart Corp.

Defining Assets

Unlike a cash flow loan, the borrowing capacity for an asset-based loan is based on the amount, quality and liquidity of a company's accounts receivable, inventory and fixed assets. Generally, the current assets of accounts receivable and inventory serve as the borrowing base for a revolving credit facility that can be drawn down and repaid. This structure can accelerate a company's cash flow by allowing it to borrow against the future value of its current assets that are expected to become cash in the near term, in turn, using the borrowed funds to finance working capital.

In addition, fixed assets (machinery, equipment, real estate) can be used to collateralize an asset-based loan. In contrast to its current assets, a company's fixed assets frequently serve as the borrowing base for a term loan credit facility, where the amount is fixed for a period of time, there is an agreed-upon payment schedule and amounts paid cannot be re-borrowed. There are also occasions where certain nontraditional assets (trade names and intellectual property) are eligible as collateral, but these assets are considered on a case-by-case basis. For the traditional form of assets, however, guidelines provide estimates for the value of assets as collateral in an asset-based loan.

For example, eligible accounts receivable typically include receivables from completed sales, whereas items like older receivables (over 90 days from invoice) and foreign receivables are usually considered ineligible. Also, eligible inventory regularly includes all finished goods and marketable raw materials, and most often does not include: works-in-process (WIP), slow moving or obsolete inventory, or inventory on consignment with customers.

Asset-based loan monitoring and reporting mirrors the strength of the borrowing company, and can be as infrequent as once per quarter. In any case, present day monitoring has been facilitated greatly by new technology, allowing customers to monitor their accounts and access real-time information online, a capability that eases the manpower burden on the asset-based borrower.

Versatile Structures

Beyond asset-based loans that are predicated entirely on the value of a company's assets lies the possibility for an "overadvance" or "senior stretch" loan. In this scenario, a lender will structure a loan that offers elements of both asset-based and cash flow by offering availability beyond the lendable value of current and fixed assets, if the company can demonstrate sufficient cash flows. In combination with funds lent on assets, the senior stretch product rewards companies with strong cash flows by providing a highly versatile structure that is generally priced lower than a pure cash flow loan.

As the banking industry re-evaluates its relationships with customers affected by the current economic dip, those offering asset-based loans are finding wide acceptance for their products. Time tested and versatile, the loans deliver strategic financing at competitive terms, allowing companies in all industries to achieve operational flexibility through the value of their assets.

RELATED ARTICLE: Why Consider Asset-Based Financing?

Companies employ asset-based financing for purposes ranging from funding traditional corporate restructurings to strategic acquisitions. Some examples:

* Weirton Steel Corp., an integrated producer of flat rolled carbon steel operating in a highly cyclical industry, refinanced its capital structure as part of an overall turnaround plan. The centerpiece is a $200 million asset-based credit facility that gave it much-needed liquidity and flexibility to cope with troublesome industry conditions -- as well as $35 million in additional availability.

Beyond restructurings, recent uses of asset-based financing include:

* The leveraged buyout of Igloo Products Corp. by Westar Capital, funded through a $75 million asset-based facility.

* The purchase of Precision Tube Holding Corp. by tubular steel products maker Maverick Tube Corp., using a $170 million asset-based structure.

Much of today's refinancing activity is generated by companies wanting to shed cash flow debt in exchange for an asset-based structure.

* Apparel manufacturer Russell Corp. obtained a $325 million refinance facility, which also included a $250 million senior note issuance.

* Electric razor manufacturer Remington Products Co. secured a $110 million facility to refinance its existing cash flow loan.

* Wesco Distribution Inc., a $3.9 billion publicly traded provider of electrical products, refinanced its cash flow facility with a $250 million revolving asset-based loan, using its accounts receivable and inventory as collateral.

Ira J. Kreft ([e-mail]) is Executive Vice President and Allan D. Allweiss ([e-mail]) is Senior Vice President of Fleet Capital Corp. Both are based in Chicago.