If your loan is too risky for a bank, an asset-based lender may be willing to provide the cash -- but it won't come cheap
An asset-based lender (ABL) may not be the first place a cash-starved small business would look for financing, but it shouldn't be shunned as a source of working capital, either. In the past decade, commercial finance itself has evolved, and with it the reputation of ABLs, which use borrowers' assets to underwrite risk. Once derided as a bunch of bearded buzzards, asset-based lenders have earned a modicum of respect. After all, anyone willing to finance high-risk leveraged buyouts, as asset-based lenders have been doing by the dozens, can't be that bad.
Most of the independent ABL operations have been acquired by banks, and some banks have even started their own divisions. But some independents remain. Foothill Capital Corp., for one, is self-described as the nation's largest independent asset-based lender. The Los Angeles company originated in 1968 as a venture capital firm and gradually evolved to its present status.
Independent ABLs such as Foothill can lay claim to filling an important gap in capital structure by extending credit -- especially to small and midsize businesses -- in the face of pro formas that horrify traditional lenders. And they can accept as collateral tangible assets that would give the willies even to banks' own ABL divisions. Foothill recently made a substantial loan to a small business that rebuilds automobile carburetors. The company's most valuable possession was something only '78 Camaro owners could love: grease-caked old carburetor housings. Although there was no immediately apparent market for them, Foothill ventured a number. So what if the appraisal fell well short of the owner's estimation -- with empty carburetor shells, who could argue?
Rushing in where other financiers fear to tread, aggressive "hard-money" lenders often find themselves standing bravely between a shaky business and its extinction. If the liquidation value of the collateral doesn't build in a substantial margin for error, a secured lender can take a mighty cold bath should the fiscal climate change. Indeed, just such as unexpected reversal badly reddened Foothill's income in 1982 and 1983, when hard times in the oil-patch states decimated what once was rock-solid collateral. The freeze was so severe that Foothill's own credit rating wilted in the commercial paper market.
In consideration of gambles that could wipe out their own businesses, ABL money comes relatively dear. Four to six points over prime is common -- and that's not to mention a litany of fixed and variable add-on fees (loan origination, collateral management, packaging, auditing, and closing among them) that can effectively tack on several more points. An ABL's annualized target yield for a risky deal is apt to be in the high 20s, all told.
Not that it can't be advantageous for essentially healthy businesses to use high-priced capital from time to time. The Los Angeles Lakers Inc. and Los Angeles Kings Inc., whose ephemeral assets, like those of many professional sports, confound traditional lenders, recently tapped Foothill's understanding for $12 million. The advance helps tide them over barren cash-flow cycles until the turnstiles click again in season. And when MacGregor Sporting Goods Inc. needed cash recently to acquire a manufacturer of souvenirs, Foothill spotted them $6 million.
But lest we get overly rapturous, it should be understood that working-capital financing such as Foothill readily performs can also hasten a sickly business's slide into default. Usually, some creditor or other has legal divvies on the struggling company's checkbook, grabbing incoming cash just when it's needed for servicing the high-ticket loan. And that purse-holding creditor, of course, can well be the ABL itself.
The maximum Foothill is willing to go is calculated on the price at which its team of liquidators estimates the collateral pool can be quickly moved (less costs for insurance, rent, and other handling charges). If the asset is clearly going to be hard to dump on the open market, as a large computer or a CAT scanner might be, Foothill will try to get a put, an arrangement by which a prospective buyer is entitled to purchase the item at a predetermined bargain-basement price, if and when it is liquidated. In MacGregor's case, the collateral consisted of receivables and inventory, part of which was some 12,000 souvenir baseball hats. "If the company were to go out of business," emplains Peter E. Schwab, president and chief operating officer of Foothill Capital, the lending subsidiary of The Foothill Group Inc., "we'd call every concessionaire in the country and tell them, 'We've got your hats.' We're in [the hats] at so low an advance rate against their real value that we could say to the customers, if you'll take them tomorrow, we'll sell at our purchase price. Of course," he acknowledges, "it might not be so easy right after the World Series."
One ABL is known to have accepted unbagged charcoal briquettes as part of a collateral pool, and Foothill itself has been willing to rent freezers to store the perishables that one client was able to put up as security. "The hardest asset [to evaluate] is inventory; you're guessing on its resale value," says veteran loan maker Alan Jacobs, a Foothill vice-president and western regional marketing manager. "One of my prospects is a winery -- what do I know about wine?" Partly for that reason, a loan secured by inventory alone is deemed too risky; ABLs feel better when a pledge of receivables goes along with them.
Foothill is comfortable not only with exotic collateral, but also with unorthodox business setups. The resale value of forprofit hospitals, for example, has to be determined through formulas that don't apply to conventional structures, leaving potential for error. The standard for evaluating a medical facility presently is around $120 per bed. Provided the bed is legitimately filled: a lender was recently confronted with an enterprise that, when the ABL's appraisers came to visit, stuffed its empty beds with staff members posing as patients, so that the occupancy rate would appear reassuringly high.
When a bank couldn't put a package together for one legitimate health-care establishment, Foothill didn't hesitate to loan $12 million -- at prime plus four, plus three points. Secured by real estate and equipment, the obligation was interest-only for the first year, then amortized over a seven-and-a-half-year average life. Needless to say, Foothill gave itself plenty of recovery room, discounting the per-bed formula by 50% to $60 each, for starters. The entire package was structured and signed within three days.
While bankers are used to knowing exactly with whom and with what they're dealing, the trench-fighter heritage of independent asset-based lenders seems to goad them into taking on tougher challenges. Foothill marketing manager Jacobs tells the story of when he was working for another ABL and accepted new cameras as collateral for an advance to a company that ran retail photo-equipment concessions in department stores. The Nikons and other top-of-the-line cameras were "real good stuff -- a cinch as a collateral pool," he remembers thinking smugly. "I was in for only 50% of cost -- how could I lose?" Yet some Mean Street instinct told him to move the inventory into a public warehouse where he could keep an eye on it. He instructed the people there to count the cameras as they came and went, and to send him a computer printout every month. Sure enough, one day the owner left town, literally never to be seen again. Jacobs rushed over to the warehouse armed with his latest list. The crew had dutifully counted every camera; all were there, as reported. The hitch was, not a single one had a lens.
A rude awakening for you and me, maybe, but to a hard-bitten ABLer like Jacobs, no catastrophe. He rounded up "the cheapest lenses possible," and personally screwed them in. "On some of those cameras," he recalls with unexpected remorse, "it was a crime." Be that as it may, he placed the lot on distress sale, and the loan was recovered within a year.
Time is money to many an ABL applicant. Because lenders are a breed who don't say no quickly, usually a lot of time has been spent in shopping among prime-plus-two or -three loan possibilities before a needy borrower is willing to go to prime-plus-four and beyond. By then, circumstances have likely worsened. "Ninety-five percent of the time, we've got to get going quickly," says Jacobs, who has wrapped up many a deal in one weekend's nonstop work. "We're used to it; the rush atmosphere goes with the territory."
Not infrequently, that territory is staked out within a few feet of the bar, Foothill being among the few staunch lenders knowledgeable enough to escort a company into and back out of Chapter 11. One of its most notable round-trip tours took place in 1983, after Foothill's original $4-million line of credit to United Press International Inc. (UPI) was eaten up by continuing losses. At that point, as a major creditor Foothill could have elected to liquidate the company and recover its well-collateralized loan. Instead, it opted to let UPI file for court protection and reorganization, and to continue to finance the company through its travails once new management was installed. The procedure was agreed to by UPI before going in, and endorsed by the court. Explains Schwab: "If there's a reasonable possibility of the company surviving, as a lender it's always better to finance. We had faith in the new management. There was a chance for this company to emerge, either through a turnaround or by selling it."
The fresh financing -- at about five points over prime -- allowed UPI to pay back salaries and benefits to thousands of employees, and to be able to negotiate new contracts with unions. Emerging from Chapter 11, the wire service was, indeed, sold, and in 1986 Foothill's loan was paid back in full. "It shows what asset-based lending really can do," beams Schwab, who put Foothill on the line. Nonetheless, it can never make everyone happy. "Someone had to get a haircut somewhere," Jacobs suspects. "When a company goes into Chapter 11, even if it emerges, the old creditors usually don't get a hundred cents on the dollar."
A high-risk lender appreciates dealing with the debtor-in-possession businesses that operate under Chapter 11, says Jacobs, because nothing is hidden. "You can see how much fat has been pared off the bone, where the real operating efficiency level is. The debt has all been pushed back below the line or forgiven or turned into stock, and you get a brand-new baby. That's not to say the first bump that comes along isn't going to kill it again, but you start out with an item that is unspoiled by human hands."
When housing starts sagged and a Tacoma, Wash., lumber company got into trouble, it sought Foothill support from within Chapter 11, to which its nervous primary banker had sent it scurrying by calling a $3-million loan. By definition, all creditors were stopped from exercising their rights, but the lumber company told the court it meant to hide only from the bank, not the suppliers; the company intended to replace its general manager, find a new lender "real quick," and thence to carry on. For six months it sought financing, but was turned down until finally Foothill's Jacobs trekked up to the Washington woods. There he determined that the situation looked turnaroundable, that new financing could be safely covered by lumber stocks, and that the fluctuating commodity-market value of the inventory could be watched closely. So Foothill agreed, in loan maker's parlance, to "take the other lender out." Cutting sales expenses by 10%, within 10 months the lumber company was released from Chapter 11 and on its way toward paying off all the creditors.
The opportunity to grab significant ownership from grateful businesses must be tempting, but Foothill turns it down on the grounds that as a lender it's not proper also to be in de facto control. But, admits Schwab, "if we seen we have the opportunity to share in the upside, we might take a little equity kicker -- maybe slightly less than 1%, maybe slightly more. That's only as a sweetener. It doesn't replace collateral. If we're not collateralized," he insists, "we will not take equity in lieu of collateral." But if the loan is defaulted, Foothill will step in. "Let's face it, at the level we deal, there is a high degree of failure," says Jacobs, "and the lender has to know how to run the business."
Death's-door rescues are, understandably, the most expensive of all. To shore up the lumber company, Foothill granted a 5-year equipment loan, a 10-year real estate loan, and a revolving line of credit that enabled the lumber company to borrow on receivables and inventory when needed. The price was prime plus six, payable monthly, plus a substantial onetime funding fee. Not exactly charity, but the cash-flow reversal has been so dramatic after Foothill's refinancing that, Jacobs predicts, "After a year they'll go to another bank, and that bank will take us out."
Even a growing business, expanding so rapidly that its working-capital needs outstrip income, can be let down by banks' cautious standards. Lacking ready capital, the business might have to forfeit opportunities such as an LBO acquisition, in which a bank might argue that the new debt-to-equity ratio would be too high when laid across both companies. No such worry plagues an outside ABL: "From our point of view," reasons Schwab, "the two businesses together might be even stronger."
Foothill will go as far out as 15 years with term loans secured by fixed assets, at a rate of three to six points over prime "all in" (a phrase that signifies that origination and other fees are included in the yield). On revolving lines of credit against receivables, interest is charged only on the portion that actually is used. But that portion is subject to being held open for a period of collection days after the invoice is paid -- a throwback to the old manual check-clearing system that today gives the lender free use of interest-bearing money for a week or more. Unlike a factor, who primarily buys invoices outright at deep discount (see Finance, "Factors to Consider," October 1986), an asset-based lender doesn't stand behind the credit; the business itself bills and collects directly, so that its customers are unaware the receivables are pledged as collateral. But high interest is not necessarily the cash-flow drain it may seem: a company borrowing on receivables to build inventory can use the early cash to take advantage of prompt-payment discounts from vendors, and thus pare a point or two from the effective rate.
Foothill claims it normally advances up to 80% of total receivables, but occasionally that ceiling is lowered. Even though textbooks teach that they're the asset closest to cash, receivables have a tendency to shrink through trade discounts, returns, and other unseen forces. One persistent drain comes when otherwise straight-shooting creditors find out an ABL has come on the scene. "Even the best companies will try to compromise the balance," a dismayed Jacobs has found. "To them it's good business practice to beat up on the lender."
Still, asset-based lenders are elbowing their way up the pecking order of respectability. Their unsavory reputation as lenders of last resort has been assumed by new loan makers, at whose basic 5% monthly charges even old-line ABLs now cringe.