Gaining ground rapidly

Asset-backed financing of MBOs is set for a bumper year as small companies struggle to attract funding, while mid-market private equity houses at the upper end are also switching on to the asset class. David Rothnie reports

While the venture capital and private equity communities race up the transaction value chain and struggle to match opportunities with investment, the gap that is opening up below is proving lucrative for asset-backed finance lenders, who are experiencing a deal flow VCs can only dream of. “We completed 30 deals in 2002, which is a 100 per cent increase on 2001. We have been growing at this rate since we started four years ago, and at the moment are looking at two or three deals a week,” comments John Bagley, deputy managing director of NMB Heller.

Rather like early stage VC investing, asset-backed lending is heavily regionalised and requires firms to have a strong presence on the ground with which to react to referrals from corporate finance advisers. Because of its suitability for traditional manufacturing firms with plant, machinery and property, the Midlands accounts for a large proportion of deal flow in the UK market.

But the suggestion that asset-based lending is aimed at equity-starved local manufacturing business is misleading. The natural evolution of the market, together with a tough funding environment means lenders are moving up the transaction value chain. Lloyds TSB’s largest single credit line is for £60 million and the firm will seek to replicate this in 2003. James Cullen, regional director at Lloyds TSB Commercial finance, says: “The great change in our business is that we are funding larger transactions. We are looking at deals with a debt funding requirement of £100 million, which we could pursue alone or as part of a syndicate.”

This willingness to do larger deals could provide a useful fillip to a private equity market that is already showing signs of stirring. Cullen estimates that when the final figures for 2002 come in, the firm should have matched its 2001 total of 43 deals in the UK: “Since the start of Q4 last year, we have seen an uplift in activity. When I look at our work in progress going into January, we have a healthier deal flow than we have had for the last two to three years.”

Lloyds TSB’s staple deal flow remains between £1 million and £20 million in terms of debt funding, while NMB Heller’s average funding is £5 million, with its maximum credit line currently at £20 million. On a couple of occasions last year, it even provided seed capital and start-up facilities, respectively, to a steel processing plant and a manufacturer of conservatory roofs. These deals were done because NMB Heller either knew the management teams, or were recommended to them. Bagley insists this is an exception rather than the rule. “We occasionally back companies from day one, but they have to have the right introducer, the right management team and, ideally, the management team or individual would have to commit their own money to the deal.”

The main other players in this space are Gmac and GE Commercial Finance, with Burdale Financial and Bank of America operating at the higher end of the spectrum. There is clearly room for all of these participants to continue growing their businesses.

The asset-backed finance industry has come a long way in terms of reputation and application since it arrived in the UK five years ago. For many years it was regarded as a second-rate form of finance, only used by companies in trouble and with nowhere else to turn.

A lot of that negative image was down to the major clearing banks mis-selling the product in the 1980s as a way of de-risking their portfolios. One asset-backed financier explains: “[asset-backed] finance was used in situations where a company had got into difficulties.

Its funding was switched into a factoring product in the knowledge that the factor is closer to the asset and therefore in a better position to recover more of the investment if the business failed.”In the US asset-based lending, including factoring, is the major form of finance for growth businesses and has been for several years. In broad terms, finance is provided against the value of current and fixed assets such as stock, freehold property and plant and machinery. Both the buyers and the target company’s assets can be used to finance the purchase. It is becoming equally dominant in Western Europe. The UK, where the traditional overdraft has long reigned supreme, is finally catching up.

As a broader asset class away from the MBO market, asset-backed finance is looking like an almost perfect solution for worried borrowers, bankers and investors. While other debt markets are paralysed by bouts of extreme price volatility, the asset-backed market is one channel of funding that is still open. According to Deutsche Bank figures, there was €92 billion of new asset-backed debt sold in Europe alone between January and October last year.

The rate of issuance does not seem to be slowing. At the end of last year, Abbey National launched £4.2 billion of bonds backed by residential mortgages. As well as deals backed by mortgages and credit card portfolios, issues linked to other consumer cash flows are doing well, according to analysts. French vehicle maker Renault is in the driving seat, launching a debut €1.4 billion securitisation of loans made to its customers, leading on from Fiat of Italy’s successful loan-backed deal in July.

Although corporate treasurers may find debut asset-backed deals expensive and time-consuming to set up, repeat borrowings are usually more cost-effective. Not every borrower has the right revenue streams to complete a securitisation, but a greater range of companies than ever are now attempting to tap the market. For example, Scottish whisky distiller Kyndal will use securitisation to refinance last year’s management buyout from Jim Beam. The £188 million bond sale will be backed by barrels of maturing whisky, including the Whyte and Mackay brand, in a deal that will echo a French champagne-backed bond issue two years ago.

These big ticket issues illustrate the extent to which asset-backed lending has entered the corporate mainstream and is a leading indicator for the rest of the market. According to the Factors and Discounters Association (FDA), which represents factors, invoice discounters, and other asset-based financiers, the invoice finance sector as a whole has grown considerably over the past 12 months. Funds provision is up by 15 per cent to over £7 billion compared with a year earlier. The first quarter of 2002 also showed that the value of transactions handled grew. FDA member turnover rose to a new record of £24.3 billion (an increase of 15 per cent from March last year).

Underlying this growth is a rise in the numbers of companies using the services of FDA members to over 30,000. Also, ever larger businesses are also turning to invoice finance. The number of businesses with sales in excess of £10 million using invoice finance is 51 per cent up on the same period last year. Commenting on the figures, Tony Cox, FDA chairman, says: “Ten years ago the sector provided funding to just over 9,000 businesses, today it provides funding to over 31,000. After more than 12 months of economic uncertainty, it is very encouraging that the factoring and invoice discounting industry continues to demonstrate such significant growth.”

Invoice discounting and asset-based lenders have always gone where traditional banks and private equity providers often fear to tread: they will look at turnarounds and bankruptcies, as well as small, old economy companies, both of which are not at the top of the pitch lists of traditional lenders. For example, in November last year, NMB Heller provided working capital finance to Grays of Cambridge International, the world’s leading specialist supplier of quality cricket and hockey equipment, to acquire James Gilbert, the world’s leading rugby brand, from its receiver, PricewaterhouseCoopers. Because the firm was in receivership, the firm’s existing bank would not fund the acquisition.

Paul Gray, finance director of Grays, explains: “We had an excellent 15 year relationship with our bank, so we were extremely disappointed when our bank classified the deal as highly leveraged and insisted on full accounting and legal due diligence the afternoon before the receiver’s deadline for final offers.”

Most asset lenders have developed their product offering beyond that of traditional invoice discounting, enabling to ‘stretch’ the transaction. Cullen says: “It is increasingly rare for us to do a pure invoice discounting deal. We tend to stretch into lending against stock, plant and machinery and property.”

For its part, NMB Heller has a trade finance arm, Strenham-Heller, which enables it to broaden its product offering. At the beginning of January, Projects Distribution, the UK’s premier surf, skate and snowboard distributor, received funding from NMB Heller to launch its own brand of skateboards and clothing. An invoice discounting line means that as soon as the company invoices its retail customers, it can immediately access up to 80 per cent of the value of those invoices from NMB Heller. Given that Projects Distribution sources most of its stock from overseas suppliers, NMB Heller was able to use trade finance to provide letters of credit, to a value approaching £1 million. Projects Distribution had previously used Lloyds TSB, but switched because it does not provide trade finance in the way it required.

Paul Beveridge, managing director of structured finance at Venture Finance plc, which provides working capital for medium sized enterprises, has come up with a five point guide to asset-backed finance. “Typically a business will consider a loan or an overdraft when looking to expand, but this may not be the best option. There is evidence that banks are becoming more reluctant to extend or grant overdrafts. Figures from the British Bankers’ Association show a 68 per cent fall in bank overdrafts to SMEs in the past decade. And as most loans are secured against the value of commercial property, this can be particularly risky if property values start to fall, as has happened in previous recessions.”

Beveridge says a candidate for asset-backed funding should have a minimum turnover of £5 million; be currently profitable or projecting future profitability; have sufficient balance sheet assets to provide funding against; and require funds of between £1 million to £10 million. Most sectors are open to this funding. Manufacturing and distribution sectors tend to be the most suitable, although service sector businesses can also be successfully financed.

The benefits of this form of finance are clear. Because funding is asset-based, the facilities maximise the working capital and term loan to the target. Also, as assets from both the buyer and the company being acquired can be used to finance the purchase, this reduces the need for large values of external equity, allowing the management team to remain as sole shareholders. Furthermore, asset based finance negates the need for directors to provide personal assets, such as property, as security. Finally, because facilities are committed for an agreed period, business owners have no need to continually re-negotiate limits with their bank.

;The beauty of asset-based funding is its flexibility,” says Bagley. “Private equity firms provide share capital for which they receive preference shares and also a ratchet, whereas we can look at funding options using the assets of the target company. We also provide cash flow loans.” It is also categorised as senior debt, which makes it less expensive than high yield.” This has a more benign impact on the cost of money. Bagley estimates that the safest form of asset-backed lending – against the debtor – costs 1.5bp to 2bp over Libor, rising as it extends to stock, plants and machinery, with cash flow lending costing around 3bp over Libor. The real money is made on management fees, with lenders agreeing arrangement and success fees at the outset of the transaction.

Apart from its superior size, the US market differs from its UK counterpart in terms of process and hierarchy. In North America, the provision of asset-backed finance is handled

by the lead private equity investor, which decides the level of asset-backed financing on a transaction and invites bids from the industry. In the UK, deal flow generally originates from mid-market corporate finance advisers which in the main means accountancy firms. Bagley estimated one fifth of all of NMB Heller’s deals were executed in conjunction with private equity providers, while Cullen places the figure for Lloyds TSB at 50 per cent. The UK could well follow the US model, given the increasing interest shown by private equity firms in working with asset-based lenders. Cullen explains: “One of the attractions to private equity providers of teaming up with an asset-based lender is that all of our debt is revolving, so it does not have to be formally repaid. We are a source of permanent debt, whereas a private equity house would have to repay the cash flow lender at a fairly early stage after the deal completes.”

It is both an indicator of the growing acceptability of the asset class, as well as the lack of willingness of PE firms to invest in smaller buyouts, that some invitations to tender include a specific request for asset-based lending. Bagley confirms: “Often the business plan of the company will stipulate that asset-backed finance will be used, because they know it will be difficult to attract VC investment.

We are currently looking at a couple of PTPs, whereby the management teams have specified the inclusion of asset-based financing.”Another positive feature of the asset-backed market for MBOs is that it is increasingly applicable across Europe.

A more stringent regulatory climate prevents lenders from more sophisticated forms of lending against plant, machinery and property, but the market for pure invoice discounting is showing potential. During the second half of last year, Lloyds TSB established a joint venture with Bertelsmann in Germany which will provide invoice discounting to the local market, while NMB Heller’s Dutch operation has been doing a similar thing for some years.