It is not hard to understand why, given that since the bursting of the tech bubble in 2001 there has been a liquidity explosion — a ‘wall of cash’ readily available for struggling businesses, with an ever-increasing number of players willing to provide it.
However, everything that expands will eventually contract. This universal truth will surely apply to the current credit cycle. With further interest rate rises expected, many are predicting that the credit crunch is just around the corner. The notable collapses in the
The recent import into Europe from the US of ‘covenant lite’ loans in leveraged finance transactions may even turn out to be not just a symptom of a market that is overheating but also the cause of a new wave of restructurings, perhaps even insolvencies. With less ability to monitor borrowers, it may be too late to save businesses when they finally implode under the weight of unserviceable debt. Given this uncertain environment, developments in how companies in trouble are financed are worth exploring.
Development of ABL
There are generally two phases to any restructuring (ignoring the initial stage of denial). The first involves stabilising the company by a combination of standstill arrangements, waivers of defaults and possibly some form of bridging finance. The next stage will play host to the actual restructuring — structural, operational and/or financial. At both stages, the financing available to the company is clearly a major concern.
Developments in leveraging the capital structure over recent years have led to a range of products now available to satisfy investors’ varying appetites for risk, contributing to the liquidity explosion mentioned above. This has also provided opportunities for companies in trouble to raise extra cash through a variety of means with less reliance on the traditional clearing banks. One form of financing that has seen growth recently — and which is particularly suited to a company facing the prospect of a cash crunch — is asset-based lending (ABL).
Put simply, ABL enables a debtor to borrow against its assets, in contrast to a vanilla loan typically based on earning multiples. While sharing similarities with other non-traditional lending, such as invoice discounting and factoring, ABL differs in allowing a company to unlock ‘hidden’ value on its balance sheet by borrowing against its receivables, stock, plant and equipment, property and other assets.
Lending on this basis is clearly of use to a company facing financial difficulties where cash flow is likely to be an issue. There are specialist ABL lenders familiar with the demanding timelines for distressed corporates. In fact, most high street clearing banks also offer ABL products. For example, the MFI group (now re-named Galiform) put in place ABL facilities in February 2006. These enabled the group to prepay its traditional loan facilities and provided the breathing space to formulate a group restructuring that eventually saw the loss-making retail business sold off and the profitable trade joinery side of the business continue.
A particular feature of ABL is that a lender will place less reliance on restrictive financial covenants and will instead require a high level of information flow. Quarterly testing is replaced by weekly (or possibly daily) monitoring. This reflects the nature of the assets being lent against — the bulk of which, typically, will include the company’s sales ledger. On MFI, the ABL providers obtained broad access to the company’s IT systems so that they had an early warning system of any financial difficulties.
Another common feature that differentiates ABL facilities from vanilla loans is that cash coming into the business might be required to go through a blocked account. Much like a residential ‘off-set’ mortgage, this will ensure that interest and principal are repaid immediately, before any cash is released to the business. It is also essential for the purposes of the lender obtaining critical fixed-charge security.
ABL facilities are not suitable for all types of business. Service sector companies, for example, are likely to be asset poor, in contrast to retail, manufacturing and distribution businesses. The next downturn will inevitably impact heavily on these sectors, already facing challenges from the internet, rising oil costs and stiff competition from abroad. As a result, growth in the use of ABL facilities in the refinancing/restructuring market can be expected.
Debtor-in-possession financing
While companies may be successfully restructured outside of a formal court-driven process, it is not always possible to avoid going into some form of insolvency procedure. A voluntary filing may even be used as part of a pre-packaged solution, such as where the company’s business is essentially viable but its capital structure needs an overhaul.
It is vital for a successful restructuring that the debtor has sufficient working capital during the insolvency process, as employees and suppliers will need to be paid. In some jurisdictions, when a debtor commences insolvency proceedings, it is able to draw on a form of financing known as debtor-in-possession (DIP) financing. This allows an insolvent debtor to borrow new money and, importantly, give the lender ‘super priority’ over the company’s existing creditors — in some circumstances, even secured creditors. This is the case in the US, for example, where a Chapter 11 debtor may obtain secured DIP financing under the auspices of the US Bankruptcy Court, provided secured creditors are adequately protected — essentially, where the secured creditor is over-secured.
Historically, DIP financing has been provided by asset-based lenders, since the vast majority of DIP loans are advanced against inventory and accounts receivable. Nevertheless, during the past decade or so, traditional commercial lenders have become involved in DIP financing and the debtor’s pre-petition lender may even offer the DIP financing to protect its position. This form of financing is often heralded as a key component in successful restructurings in the
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