Suddenly, assets are an asset

With cash flow-based lending on the wane, can asset-based lenders step up to the plate? Christopher Witkowsky investigates

Barry Siadat, co-founder and managing director of SK Capital Partners, works in sectors heavy on assets like speciality materials.

His firm, which will begin institutional fundraising for its second fund in the autumn, has relied on asset-based loans for its deals. Its most recent acquisition, the $50 million purchase of the nylon business of US speciality chemicals company Solutia, used asset-based debt from trusted lenders.

These days, private equity firms still looking to complete new deals have turned increasingly to the asset-based lending (ABL) market to stay active. Cash flow-based lending is all but gone, and the ABL market has shrunk as lenders have dropped out of the game.

Still, to make anything happen these days, the ABL market is the place to go to.

“The kind of deals we're doing, you can structure debt creatively,” Siadat says. “Our sectors, such as speciality materials, are very asset-intensive businesses.”

As the global financial meltdown permeated markets around the globe, many banks shut up shop and started to hoard cash. Leveraged loans were nowhere to be found, and are still hard to come by, according to Stephen Presser, co-founder and managing director of mid-market private equity firm Monomoy Capital Partners.

“Some time in the fourth quarter, the leverage lending machine just stopped, it just doesn't happen [anymore],” Presser says. “If you go to a bank today and have a perfectly lovely deal, and ask for two and a half times cash flow, they look at you like you have two heads.”

Amid this credit meltdown, however, the ABL market stayed resilient.

The Commercial Finance Association, a trade group for the asset-based financial service industry, reported only a slight decline of 1.9 percent in total credit commitments in the fourth quarter of last year.

For the third quarter of 2008 the association had reported a 17.1 percent increase in new credit commitments, following on from a 16.2 percent increase in the second quarter.

Asset-based debt is tied to the assets of a company, such as machinery, buildings and inventory. It takes account of the value of the assets to determine the size of the loan. Cash flow loans, meanwhile, are made against a company's cash flows and secured by covenants tied to earnings before interest, taxes, depreciation and amortisation, among other things.

“Asset-based lending represents a uniquely stable and viable source of funding for businesses of all sizes and industries. This stability is even more apparent in tumultuous credit scenarios like our economy is facing today,” says Andrej Suskavcevic, chief executive of the Commercial Finance Association.

“Our members are seeing a lot of activity, seeing a lot of potential deals,” he says.

“It's like there are only two girls left at the dance, but they're very popular,” says Presser. “There is an asset-based lending market out there; it's shrunk dramatically over the past eight months. It's the market we use, the market we've always used, but it has changed, it's tighter and more difficult than ever.”

The ABL market in Europe is also still active, according to Paul Beveridge, managing director of KBC Business Capital, an ABL lender in the UK.

“Most institutions in the UK that are currently lending and are active in the market are tending to use the ABL product set,” Beveridge says. “The capital shortages tend to mean people are being careful and cautious about where they lend. Banks are being more cautious about the use of capital and looking to use products that give them a reasonable return that are also fairly secure.”

The ABL market in the UK lent 8 percent more at the end of 2008 than at the beginning of the previous year, Beveridge says. “It's still a fairly small market in the UK, it has a long way to go before it becomes a terribly mature product,” he says. “If you were to map the 8 percent increase in ABL against other corporate lending, the graphs would be going in the opposite direction. 2009 will see a continuation of that outcome as ABL is used increasingly for refinancings or deals of any sort.”

While many private equity professionals lament the lack of lending, some lenders say they are active or ready to be active – the problem is the drying up of deal flow.

“There's so few opportunities in M&A, sponsors are focusing on their portfolios,” according to Daryl MacLellan, president of debt solutions provider CIT Commercial and Industrial.

Global M&A volume totaled $561 billion in the first quarter of 2009, down 32 percent from the first quarter last year and down 11 percent from the fourth quarter of 2008, according to data provider Dealogic.

One reason deal flow is moving so slowly this year is a continuing gap between sellers’ pricing and buyers’ expectations, MacLellan says.

But while the deal market generally is showing few signs of life, some ABL lenders are hearing about a lot of potential deals, according to Suskavcevic.

“There is a lack of deals happening, but a lot of people are moving toward ABL as the way to get deals done,” Suskavcevic says. “When you have the collateral for it, you know what you're getting. For the amount of deals happening, our members are telling us their phones are ringing off the hook.”

Presser's Monomoy has always used asset-based loans to finance its deals. The firm works in the US mid-market with companies in distressed industries like manufacturing and auto parts.

“It's the market we use, the market we've always used, but it has changed, it's tighter and more difficult than ever,” Presser says.

Asset-based loans are the perfect match for distressed companies, which are “fragile” already, Presser says.

“We don't like to put a lot of leverage on our companies … by definition they're fragile in some respects, and this is a really good match for the asset-based lending market,” he says.

Presser laments that the asset-based lending market has shrunk. A year ago, he says, there were 12 or 13 active asset-based lenders in the US, and now [in his opinion] there are just two – Wells Fargo and PNC Financial Group. “That's the entire asset-based lending world, with some occasional thought of competition from Morgan Stanley and Bank of America.”

“The banks we've built long, interesting relationships with” are out of the market, Presser says. Private equity firms benefitted from competition among asset-based lenders, but when there are only two or three players in the field, “you might have some deals you simply can't get financed,” Presser says.

The lack of lenders could become a problem once deal flow starts up again, he says.

“Not a lot of people are doing deals right now, so there's enough room in the system to finance the deals being done today,” Presser says. “That's going to change, and it'll change sooner than later. When we roll into the autumn and there's more robust deal flow activity in the mid-market, I'm not sure how only two or three banks will handle it all.”

With bigger, more traditional lenders out of the ABL market, some private equity professionals believe start-ups will fill the void when deal flow increases.

“We'll start to see some start-ups who are hungry and aggressive” come to the market, Presser predicts.

The few hedge funds that were involved in the ABL market probably won't be coming back, according to MacLellan. “It no longer fits their space since they can't get the necessary leverage to generate adequate returns ,” he says.