Intercreditor issues in asset-based and cash flow-based lending
July 2016 | PROFESSIONAL INSIGHT | BANKING & FINANCE
Financier Worldwide Magazine
A notable development on the Dutch debt market last year was the incorporation of an asset-based lending (ABL) facility into the borrower’s capital structure, in combination with a traditional cash flow-based term facility. In such a structure, the ABL facility is generally used for working capital purposes while the term facility is often used to finance an acquisition, a dividend recap or for capital expenditures.
It is likely that we will see more ABL/term facility structures in the future as Dutch commercial banks will continue to focus on deleveraging and limiting capital costs as a result of Basel III. ABL lenders will see their position change from more of a ‘lender of last resort’ to a ‘lender of first choice’ in those situations where an ABL facility is an option.
Negotiating and putting in place an ABL/term facility structure without a clear set of intercreditor principles can be time-consuming and costly and may result in complex and conflicting documents. Even worse, getting the intercreditor position wrong could have adverse implications for recovery by the term lenders and for the transferability of the loans under the term facility.
The challenge for an intercreditor arrangement lies in the opposite interests of the ABL and term lenders. In financial distress, the term lenders will probably wish to pursue refinancing, restructuring or sale on a going concern-basis, and will need time in order to do so. In contrast, ABL lenders generally wish to take swift action to reduce their risk (and are therefore not keen to accept standstill periods and allowing term lenders time as you would see in a more traditional senior or mezzanine structure). However, ABL lenders taking action (or having the authority to do so) is likely to jeopardise solutions and may be disruptive for any refinancing, restructuring or sale.
How does ABL work and why is it attractive?
Conceptually, an ABL facility does not require amortisation. Debt service consists solely of interest and fees. The principal under the ABL facility is repaid over time from cash received from the sale of inventory and the collection of accounts receivable (cash conversion of working assets). An ABL facility is basically self-liquidating in nature as it is linked to the borrower’s business cycle. Repayments under an ABL facility are available to be re-borrowed. And since an ABL facility is linked to the borrower’s working assets, it will organically shrink or grow with the borrower’s business.
ABL generally has two principal advantages for the borrower. Generally an ABL facility is cheaper than a traditional, cash flow-based revolving credit line. Focusing on the risk factor, it could even be cheaper than a super senior RCF. The reason for this being the lower credit risk associated with an ABL facility due to the fact that the ABL lenders advance funds against the company’s most liquid assets with a readily identifiable value and tend to actively monitor their exposure against the value of those assets. This results in lower loss given default (LGD) rates. A second advantage is that, theoretically but subject to the applicable advance rate (or ‘headroom’), an ABL facility requires fewer financial covenants and negative undertakings, giving the borrower more flexibility.
However, one disadvantage of ABL may be that ABL lenders require frequent and detailed reporting in addition to the usual financial reporting associated with other types of financings. Particularly in smaller to mid-market deals, the ABL facility tends to be closely monitored by the ABL lenders. This disadvantage is mitigated to a certain extent by technological developments and ‘real time’ online interfaces used by ABL lenders, but still do require information to be uploaded. This ABL facility is usually structured as an overdraft facility and often comes with a full cash dominion arrangement with a lockbox, requiring the borrower’s customers to make payments to a bank account controlled or owned by the ABL lenders. Payments received from customers are credited immediately against the outstandings under the ABL facility.
In larger transactions, the ABL facility may be more loosely monitored. The borrowing base is then primarily determined on the basis of borrowing base certificates which the borrower is required to provide at agreed intervals. Control may be tighter, and certain covenants may enter into effect on a springing basis. Such control may entail more frequent borrowing base certificates, appraisals, field examinations and (springing) cash dominion. This type of ABL facility is usually structured as a revolving credit line.
An ABL/term facility structure involves two pools of assets subject to security interests. ABL lenders typically have security interests in the borrower’s liquid assets. The term lenders’ position is less rosy: in addition to second-ranking security interests in accounts receivable and inventory, they generally only have a security interest in the borrower’s shares or real property. In some transactions the term lenders decide not to take security over shares. In this structure, however, any chance for a successful restructuring by the term lenders diminishes quickly if there is no share security. Despite the separate pools of security, ABL lenders do not have ‘limited recourse’.
Adjustment mechanisms and exit scenarios for ABL lenders
To get to an intercreditor position, it is important to see what adjustment mechanisms and exit scenarios ABL lenders have.
In the beginning, if an ABL facility starts to get ‘out of formula’ (because of, e.g., deteriorating asset quality, less creditworthiness of debtors of accounts receivable, increased non-payment of those (‘dilution’), etc.), ABL lenders will make certain adjustments to the terms of their facility in order to get it back ‘in formula’. This may include exclusions of certain assets or debtors, adjusting the advance rate, etc. By doing so, however, the availability of working capital is likely to decrease, which concerns term lenders depending on the borrower generating cash flows.
Another way for ABL lenders to either adjust or exit the credit arrangement is by (temporarily) refusing further use of the facility (a ‘draw stop’) and by collecting receivables and applying the proceeds to repayment of the facility. In theory, a borrowing base deficit or the ABL facility should be fully repaid during or by the end of the current business cycle. In this scenario (if an appropriate bank account structure has been put in place), there is no incentive or requirement for ABL lenders to notify debtors of accounts receivable or require possession or sell inventory. As a result, this scenario is relatively undisruptive (compared to enforcement), but it will cause serious and immediate liquidity issues.
Another exit scenario is through enforcement, an obviously disruptive scenario to the borrower as it will likely entail negative publicity. Moreover, finding another working capital financier will probably be impossible in that situation. For ABL lenders, disadvantages are that the working assets will probably generate liquidation value and that the ABL lenders may expose themselves to negative publicity too. In addition, enforcement will almost certainly result in the borrower’s bankruptcy. This, however, does not pose a threat to ABL lenders in the Netherlands (and is therefore no incentive to take other measures), since the Netherlands is a very secured creditor ‘friendly’ jurisdiction.
The way forward
The key issue facing the market is how to reconcile the ABL and term lenders’ position. Since there is not yet an approach that is embraced by the market generally, at least for the time being, implementing an ABL/term structure will require a bespoke approach. The key to finding a mutually acceptable intercreditor position is ABL lenders’ core rights, and we see a trend in the Dutch market (and which should not be limited thereto) toward this position as both ABL and term lenders realise the importance of an intercreditor arrangement (even in situations where the ABL and term lenders are affiliates). In short, this arrangement entails: (i) draw stops only in the event of a borrowing base deficit; (ii) adjustments to the ABL terms only within certain agreed limits or in certain specific circumstances; and (iii) enforcement only upon certain ABL events of default (in each case to be agreed upon on a case by case basis). This provides the term lenders comfort around availability of working capital and time for a workout as long as the ABL facility is essentially ‘in formula’, while giving ABL lenders the opportunity to act if the ABL facility is not.
David Viëtor is a partner and Marc Orval is a senior associate at NautaDutilh. Mr Viëtor can be contacted on +31 20 71 71 464 or by email: firstname.lastname@example.org. Mr Orval can be contacted on +44 (0)20 7786 9114 or by email: email@example.com.
© Financier Worldwide
David Viëtor and Marc Orval