Sponsored Article – Will ABL repeat its US success in Europe?

A number of major financial institutions, many from the US, have established asset based lending operations in Europe in the past four years. Why? Because within North America, asset based lending (ABL) has witnessed dramatic growth when compared to traditional lending, and the opportunity to export the product into Europe is seen as highly attractive – both to appeal to indigenous European companies and to support US clients expanding into Europe. This article, by use of a hypothetical case study, discusses the opportunities for this type of lending to enjoy similar growth within Europe. When will it emerge as a widely used, viable alternative to traditional cashflow lending?

The recent growth level in the European high yield market demonstrates how quickly Europe can embrace US financing mechanisms. The weight of private equity raised by US institutions demonstrates their appetite. However, there may be more uniquely European jurisdictional factors that may get in the way of ABL’s growth, so the article will also touch upon some of the legislative constraints that currently prevent the same level of ABL finance being available to European businesses compared to their US compatriots.

In the US, at December 1998, ABL outstandings totalled $254.2 billion, having increased by 24 per cent over the prior year. To put this in context, it is estimated that ABL players accounted for 21.3 per cent of all new short-term lending in the US that year.

ABL loans represented 27 per cent of total US commercial bank loans. However, in terms of short-term funding activities, total US commercial bank loans only represented 28 per cent of ABL loans made during that year, the most recent set of annual data from the Commercial Finance Association. Whilst banks remain the largest providers of long-term debt financing to the business sector, the short- to medium-term financing activities of the ABL players substantially exceed that of traditional US banking institutions. The quantum and trend in the US is clear as ABL dramatically increases market share.

In assessing why these trends are occurring in the US and their relevance in Europe, let’s examine a scenario to compare the availability of finance from a traditional cashflow lender and from an ABL provider.

Case study

An overseas forestry owning business sees an opportunity to purchase a distribution arm with operations in three European countries. They foresee a consolidation in the sector and therefore a potential inability to sell their product into some of the largest European markets. Their resources are stretched in terms of equity infusion, as this will be their third acquisition this year. The vendor is looking for at least e100 million for the business. Therefore, their need is for as much debt as can be raised.

The uneven earnings in the historic performance were down to the market having been at the bottom of the construction cycle during the previous 24 months. There has been some restructuring of the business last year. Given the performance, how much debt can be raised?

Cashflow approach

The cashflow lender will be looking to analyse the level of debt that can be serviced by future cashflow. In judging the multiple to be applied to trailing and forecast EBIT, he will be comparing EBIT as a proportion of sales ranging from between five per cent and 14 per cent historically, forecast at eight per cent next year. This is the nature of an industry driven by cyclical capacity issues. Given the fluctuation, what level of sustainable EBIT can be taken and what multiple?

If we assume an average EBIT / Sales of eight per cent, then sustainable EBIT should be e24 million on forecast sales. However, how achievable is the volume growth? Is the business at the bottom of the cycle? With a multiple, say, of 4x on historical earnings, this could release e40 million to the company, by way of an amortising acquisition facility. 5x would release e50 million. The need for so much additional working capital facility to fund expansion may reduce the appetite of a cashflow lender. Will they need more than forecast as the forecast assumes a reduction in stock and debtor days? Leverage of the balance sheet may be an issue. Equally, the need for amortisation of the facility will be taking cash out of the business.

ABL approach

The ABL approach would be to look at the underlying assets of the business.

The business is rich in working capital assets and whilst the debt turn is higher than one might wish to see for this type of business it would be very suitable for ABL given the simplicity of the receivable and the commodity nature of the inventory i.e. the wood product. This type of business, after allowing for some slow paying customers and some old stock should be able to raise say 75 per cent to 80 per cent on debtors and 60 per cent on stock, a sum of circa e70 million on working capital assets, based upon the most recent historic balance sheet. Any payroll or other government creditors would need to be fully reserved against. Acquisition debt from an ABL lender could be at least e20 million more than from a traditional lender. If extra monies were needed, a further e6 million may be financeable on fixed assets, by way of a term loan. This portion would depend upon the robustness of the cashflow.

The ABL provider would be able to get comfortable with financing the foreseen growth of the business. Again, the satisfactory working capital performance would mean that circa 75 per cent of the growth in accounts receivable and 60 per cent growth in the stock should be able to comfortably support extra debt of up to e30 million if sales forecasts are met. With year-end debt levels of circa e100 million (acquisition and working capital), the business should still be in a position to service debt over two times, if projections are hit.

European jurisdictional issues

In the US, this level of debt could be confidently projected. In Europe, with its greater emphasis upon protecting the rights of a much broader range of creditors, it is unlikely that the level of debt advantage from ABL (vs. a traditional lender) will be so marked but, dependent upon the jurisdiction, advantage will still be gained.

For example, in the UK, the issue of retention of title may result in the level of finance from the inventory being less. The ability of the supplier to retain title to the goods supplied until paid for means that the ABL provider protects themselves from such suppliers’ rights by offsetting their payable balance from the finance against stock. Often, retention of title clauses are successfully defeated due to inability to identify goods, poor clause drafting or modification of the product. However, the uncertainty of the situation means that the financier will generally reserve a sum to protect against the possibility of loan dilution due to retention of title. Clarification of this issue by requiring suppliers to register such clauses at a central body would greatly assist the due diligence process. In some European jurisdictions, retention of title may extend through to the receivable.

In mainland Europe, the wide range of jurisdictions means that different security instruments have to be taken in different countries. For example, on a pan-European receivables and inventory financing, it may be that in one country the receivables need to be purchased whilst in another an un-notified charge will suffice and in the third the charge must be notified and registered.

For the inventory, in the UK a lender is able to lend protected by the benefit of a floating charge. In some mainland European countries inventory, subject to retention of title constraints, the law is similar to the UK; in others effective control of the inventory must be demonstrated by placing it under the control of a third party warehouse.

Summary

The benefits that ABL can bring to businesses experiencing high growth, high leverage or uneven earnings are clear. Equally, it can be a vehicle for enhancing shareholder value in certain types of acquisitions and buyouts. In the secondary buyout arena or with “public to privates” ABL can enable an exit or partial exit route for the institutional investor or private equity sponsor.

Within the UK, the law allows for much of the vast and fast growing ABL product offering to provide a real alternative to traditional lending. In mainland Europe, local jurisdictions, as a generality, enable fewer of the advantages to be offered currently. However, detailed due

diligence is being undertaken on a country by country basis by some of the new entrants and ways of expanding the ABL offering throughout Europe is likely to be seen over the next five years.


Acquisition of an importer and distributor of timber products

Income statement and balance sheet

Emillion Forecast Actual (1) Actual (2) Actual (3)

Sales 300 200 160 100

Ebit 24 10 12 14

Cash (30) (14) (4) 4

Debtors 85 62 46 30

Stock 55 36 32 20

Creditors 70 56 44 28

Fixed Assets 12 12 10 8

Net worth 52 40 40 34

Actual (1), (2) and (3) are prior three years’ results. Forecast is plan for next year.