Can asset-based lending and cash flow lending work together?

It is becoming increasingly common to see an asset-based lending (ABL) facility (usually provided by a bank or a specialist ABL provider) sitting alongside a more traditional cash flow based term loan facility (provided by a bank or an alternative lender, such as a debt fund) in the borrower's capital structure.  

This kind of arrangement, in which two lenders both take security over the same pool of assets, is known as a 'split-collateral' structure and can provide the borrower with an efficient funding solution. 

Such structures used to be quite rare, due to the difficulty of agreeing intercreditor arrangements acceptable to both the ABL provider and the term lender, neither of whom wanted to give up their usual 'super-senior' position. 

More recently, ABL providers and term lenders have started to work together to find compromise solutions which enable these two financing products to co-exist. 

Why ABL

ABL can offer the borrower an attractive alternative to a cash flow based revolving credit facility (RCF).  Firstly, ABL is usually cheaper than an RCF, since the ABL provider takes first-ranking security over the borrower's most liquid assets (receivables and inventory) and carefully measures its exposure against them.  

For the same reason, the ABL facility agreement is likely to contain few, if any, financial covenants.  This means that an ABL facility can be more flexible than an RCF and potentially allow a borrower  to access higher levels of funding. 

Competing interests  

An ABL provider and a term lender have very different priorities and exit strategies in such a split collateral structure.  These competing interests need to be carefully considered and then balanced in the intercreditor agreement (ICA) between the two lenders.    

This process can be made much easier if both sides in the negotiation have a clear understanding of what is most important to the other lender in such a structure and why.    

What is important to the ABL provider? 

The ABL provider makes its decision to underwrite the deal mainly on the basis of the borrower's assets.  

For this reason, in a distressed situation, the ABL provider needs to be able to move quickly in order to protect the value of the assets which make up its collateral.  

In addition, the ABL provider will want to retain a wide discretion (usual in ABL facilities) to significantly reduce the funds available to the borrower if there is any sign that the borrower is becoming or may become distressed.  

Why are these things so important for the ABL provider? Because the easiest way for an ABL provider to safely exit from an ABL facility is to:

(i) stop the borrower from continuing to draw under the facility; and 
(ii) collect in the outstanding receivables until the ABL facility is fully paid down.  

If the ABL provider does this, its exposure will reduce quickly as the outstanding receivables are paid, which means that ABL provider is less likely to have to become involved in an enforcement process.   

What is important to the term lender?

The term lender's concerns are different.  Firstly, it is less concerned with the value of the borrower's assets and much more focused on preserving the value of the business as a whole, so that it can be refinanced, restructured or sold as a going-concern.  

Secondly, the term lender does not usually have the benefit of first-ranking security over the borrower's receivables and inventory so it cannot simply reduce its exposure and wait for its facility to 'self-liquidate' (as the ABL provider can when it reduces availability under the ABL facility and collects in the debt). 

Refinancing, restructuring or selling a business all take time.  A term lender's primary concern in a distressed situation is to keep the borrower afloat while it finds a willing buyer for a sale or a new funder to provide financial support.  The term lender will be concerned that a dramatic reduction of availability under the ABL facility would create an immediate cash flow problem for the business, hinder a going concern sale / restructuring or, worst of all, trigger an insolvency.  

In addition, the term lender will be aware that any potential buyers or funders of the borrower's business will be deeply concerned about proceeding with a transaction where there is a current ABL provider who could terminate the ABL facility (as a result of an event of default under the ABL facility agreement), collect in the receivables and enforce on its security in order to sell the inventory.  

Finding a solution

Since there is no generally accepted market practice for harmonising the concerns of the ABL provider financing the working capital with those of the term lender funding the core assets of the group, each situation will require a bespoke solution.  

However, there are some common themes which emerge from deals where the balance between the ABL provider and the term loan lender has been successfully achieved.

Priority – usually the ABL provider and term lender will both take security over the same pool of assets (typically in the form of all-asset debentures).  

The ABL provider's security normally ranks first over the assets it has financed (e.g. receivables and inventory) and the tem lender will rank first over all other assets (e.g. shares, IP, real property).  

The security of each lender will rank second over the other lender's priority assets i.e. the term lender's security will rank second over the receivables and inventory and the ABL provider will have second ranking security over shares, IP, real property and other assets.  

However, the lenders may agree that, if the term lender enforces its first-ranking security to effect a going concern sale or restructuring, the proceeds of such sale or restructuring shall be applied in repayment of the ABL liabilities first and then in repayment of the term loan liabilities.     

Drawstop – as mentioned above, the term lender will be uncomfortable with the ABL provider retaining its broad discretion to reduce availability dramatically or to stop funding altogether whilst it is trying to co-ordinate a going concern sale / restructuring.  

It may, therefore, be agreed that the ABL provider can only do this if the amounts outstanding under the ABL facility actually exceed the value of borrowing base (i.e. there is a shortfall in relation to the collateral, thereby placing the ABL provider at immediate risk) or if there has been a Material Event of Default (see below). 

Enforcement – the term lender will be keen to restrict the ABL provider's ability to accelerate or enforce its security.  For example, the term lender will not want the ABL provider to accelerate and petition for administration, to serve notice on the debtors in order to collect in the debts or to enforce its security over the inventory in order to sell it. 

The ABL provider, for its part, is likely to resist any restrictions on its freedom to enforce following a default under the ABL facility.   

If both the ABL provider and the term lender agree that the enforcement route will be via an administration, it may be possible for the parties to agree that the term lender will be responsible for appointing the administrator, provided that the administrator is selected from a list of insolvency practitioners pre-approved by the ABL provider.  

Another method of achieving a balance here is for the parties to agree that the ABL provider can only enforce (at least without being subject to a standstill period – see below) in certain tightly restricted situations, for example upon the occurrence of a "Material" Event of Default rather than just an ordinary Event of Default. 

Such an approach can help the term lender feel comfortable that the ABL provider will not enforce at the drop of a hat i.e. on the occurrence of an event of default that does not go to the core of the ABL provider's collateral (the receivables and other assets comprising the ABL provider's borrowing base).   

Such a solution means that the ABL provider will retain the power to enforce without undue delay where its priority collateral (e.g. receivables and inventory) is in jeopardy.

For example, if there is:

• a fraud; 
• a failure to pay the proceeds of receivables into the ABL provider's "trust account" (which can be indicative of a fraud); 
• a fundamental problem with the borrowing base (i.e. a borrowing base deficit caused by a decline in the value of the receivables rather than by a temporary adjustment to the ABL facility);
• an insolvency event; or
• a significant risk to the funded assets 

(each a "Material Event of Default"), then the ABL provider will need to be able to take immediate action to protect its position.

The term lender is likely to argue that, in the absence of a Material Event of Default, the ABL provider should not be permitted to enforce its security whilst the term lender is in the process of conducting a going concern sale / restructuring, since it is not at significant risk of loss.

Standstill – the parties may agree that, following an event of default that is not a Material Event of Default (for example, breach of a financial covenant), the ABL provider may only enforce after a certain period of time (known as a standstill period) has elapsed (for example, a period of six months following the breach). This time period should be long enough to enable a going concern sale / restructuring of the business to be completed.

In return for agreeing to sit on its hands for such a long time (and for being required to continue to fund the business), the ABL provider may request that the term lender is obliged to comply with certain 'milestones' (e.g. towards a sale) during the standstill period.   

This provides the ABL provider with the comfort that, although it cannot enforce its security for the standstill period, it will be able to apply some pressure to the term lender in a distressed situation.  This will give it more leverage in the ensuing discussions.   

Option to cure – if the ABL provider has implemented a drawstop or is considering enforcement due to a Material Event of Default, it could be agreed that the term lender can 'cure' the Material Event of Default by extending a short additional term loan.  The term lender would not, of course, be permitted to exercise such a cure right in cases of fraud.    

Option to purchase – on some deals, the term lender will have an option to purchase the debt owing to the ABL provider at par, for example following a Material Event of Default or upon the expiry of a standstill period.  This has the benefit of stopping the ABL provider from enforcing (as the ABL provider simply has its exposure paid down by the term lender).  

However, due to the monitoring and management that such a facility requires, it may be difficult (or even impossible) for the term lender to provide a working capital facility. The ABL provider may be content to be paid out by the term lender but the term lender should carefully consider the practicalities of actually exercising this option. Ultimately, the term lender may need to find another ABL provider to fund the working capital – however, since any new ABL provider would also need time to undertake due diligence on the business, this may not, in practice, be viable.      

Amendments /waivers – the term lender will want to put some parameters around the ABL provider's ability, in the absence of a Material Event of Default, to do any of the following:

• adjust the ABL facility, especially in relation to the ABL provider's discretion to (i) reduce availability under the ABL facility, for example by implementing reserves, changing eligibility criteria in relation to receivables or adjusting concentration percentages etc.
• increase the limit of the ABL facility; or 
• increase the fees, interest / discount charge payable on the ABL facility.

One way of approaching this would be to allow certain adjustments to be made within an agreed limit.

Similarly, if the term lender wishes to make an amendment to the term loan facility or waive a breach under the facility which does not directly prejudice the ABL provider or impact its priority assets, it will expect the ABL provider to give its consent to such changes.  

The term lender will not want the ABL facility agreement to contain a cross-default provision which would be triggered by a default under the term loan facility.  It will, however, want a default under the ABL facility to be a default under the term loan facility.       

A short summary of these main areas of focus and potential solutions is set out below. Each deal is different, so this briefing note should not be regarded as a substitute for transaction-specific advice. However, this table may serve as useful reminder of the things that are important to the ABL provider and the term lender, respectively.  

Conclusion

This is an evolving area.  Intercreditor positions vary considerably from deal to deal and a 'one size fits all' approach will not work.  There will still be situations where the ABL provider will expect to retain its 'super senior' position (e.g. where the quantum of working capital is much larger than the term debt).  

However, since ABL can offer considerable advantages for borrowers, those term lenders and ABL providers which work together to develop mutually acceptable solutions that can be implemented swiftly will undoubtedly gain a competitive advantage in the market.