1.         Introduction

One of the more noticeable developments on the Dutch debt market during the past year was the incorporation of an asset-based lending or 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. A term facility can be made available by one or more commercial banks or by direct or alternative lenders, for example in the form of a traditional term loan or a unitranche financing. An ABL facility is usually provided by commercial banks or specialised asset-based lenders, as direct or alternative lenders generally cannot extend revolving credit or overdrafts and certainly not an ABL facility that requires monitoring to a certain extent.

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. For other lenders these structures are indispensable given their inability to provide working capital facilities. Also, these structures are attractive for commercial banks since direct and alternative lenders are generally not pitching for the so-called side business of the borrower.

However, negotiating and putting in place an ABL/term facility structure without a clear set of intercreditor principles can be a time-consuming and costly exercise and may result in complex, conflicting documents. Even worse, getting the intercreditor position wrong could have adverse implications for recovery by the term lenders (see for instance Standard & Poors: Leveraged Finance: How Asset-based Loan Facilities Can Limit Recovery For Investors In Some U.S. Speculative-Grade Companies) and for the transferability of the loans under the term facility. The challenge is to eliminate the frills that have found their way into ABL documentation over time to accommodate a 'lender of last resort', and to get ABL lenders comfortable with relying just on their core rights and powers necessary in a regular financing. Given today's competitive marketplace, demanding borrowers and savvy advisors, this is probably inevitable in any case. Indeed, in the US, ABL has already started moving in this direction. Hopefully the Netherlands and the rest of Europe will follow suit. After all, the aim should be to provide ABL lenders with as much flexibility as possible, in order to prevent them from having to take drastic measures, and give term lenders as much comfort as possible, in terms of the availability of working capital, and a realistic possibility to pursue going-concern restructurings, if and when necessary.

This article briefly discusses the nature of ABL in general before turning to one possibility for putting in place and documenting an ABL/term facility structure.

2.         What is asset-based lending?

2.1       How does ABL work and why is it attractive?

The term asset-based lending is generally used to distinguish this type of financing from so-called cash flow-based lending. For the latter, the maximum amount of financing is generally a multiple of the company's EBITDA. In contrast, for ABL, the maximum level of financing is generally based on the company's borrowing base, which is determined by multiplying the value of certain assets deemed acceptable to the ABL lenders as collateral by a percentage (the 'advance rate'). The borrowing base in ABL is likely to consist primarily of working assets, such as accounts receivable and inventory (stock), that meet certain pre-agreed eligibility criteria. The advance rate generally ranges from 70% to 90% for eligible accounts receivable and from 50% to 65% for eligible movable assets.

Conceptually, an ABL facility does not require amortization. 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 with the borrower's business and grow if the business picks up again (usually subject to a pre-agreed maximum available amount under the ABL facility).

ABL generally has two principal advantages for the borrower, the first of which is pricing. Indeed, an ABL facility is generally cheaper than a traditional, cash flow-based revolving credit line. Looking at the risk factor only, 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, at least in theory, an ABL facility requires fewer financial covenants and thus gives the borrower more flexibility. Financial covenants aimed, for instance, at controlling leverage or capital expenditures are not considered necessary for the purpose of monitoring exposure under an ABL facility and the value of the borrowing base. For instance, in the US, it is not uncommon for ABL lenders to require no financial covenants at all or only a fixed charge coverage ratio that is tested on a springing basis if the available facility drops below a certain threshold, e.g. 10% to 20% (a 'soft block'). In addition, an ABL facility typically requires fewer non-financial covenants such as negative or restrictive covenants on mergers and acquisitions, additional debt, distributions etc., which may provide even more flexibility. In this way ABL financing could also follow the trend of borrowers being able to get more 'cov-lite' financing.

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 (often on a daily basis) through an interface between the ABL lenders' risk and credit management systems and the borrower's accounting and inventory control systems. This interface allows the ABL lenders to monitor developments in the borrowing base, the collection of receivables and the available facility. The 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 issue to the term lenders 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. In all ABL facilities the ABL lenders have the right to require regular appraisals and field examinations.

2.2       How is an ABL facility structured and documented?

ABL facilities come in all shapes and sizes, and an ABL facility may be documented in a variety of ways, as there is no generally accepted market practice. On one end of the spectrum, the ABL lenders' standard (in-house) documentation is used. On the other end, the ABL facility is carefully negotiated on the basis of Loan Market Association (LMA) documentation. In between, there is all kinds of semi-tailored (standard) documentation. The obvious advantage of standard documentation is that it is brief, easy to put together and cheap since no external lawyers are necessary. However, the disadvantage is that such documentation tends to be very lender-friendly and is often uncommitted, meaning that the lender has discretion to lend or refuse to lend, and the outstandings must be repaid on demand ('until further notice'), or benefits from extensive grounds to accelerate. Moreover, such documentation provides the ABL lenders with discretion to adjust eligibility criteria, advance rates, reserves, exclusions, franchises, maximum turns, dilutions, concentrations and payment terms, or otherwise to reduce the borrowing base or available facility. The borrower may be comfortable with this situation given its personal relationship with the ABL lenders or the affiliated bank, but this certainly does not apply for the direct or alternative lenders stepping into the ABL/term facility structure and relying on the availability of working capital financing.

2.3       Exit scenarios for ABL lenders

There are basically two ways an ABL lender can exit an ABL facility.

The first, and easiest, way for ABL lenders to exit the credit arrangement is by refusing further use of the facility (a 'draw stop') and by collecting receivables and applying the proceeds to repayment of the facility; in this case, the ABL facility basically self-liquidates. In theory, the ABL lenders should be fully repaid once the current business cycle is complete, i.e. all inventory has been sold and all accounts receivables that make up the borrowing base have been collected. In this scenario (if an appropriate bank account structure has been put in place), there is no incentive or requirement for the ABL lenders to notify debtors of accounts receivable and/or require possession of and/or sell inventory. As a result, this scenario is relatively undisruptive (compared to enforcement), but it will cause serious and immediate liquidity issues. The borrower will then need to obtain financing for new business cycles from another source. And the fact that it cannot offer first-ranking security interests in its working assets until the ABL lenders have been fully repaid, could pose a serious obstacle in this regard. However, the ABL lenders have an interest in ensuring that the borrower can continue trading as a going concern since its working assets will then continue to generate going-concern value (as opposed to liquidation value), and the ABL lenders will continue to benefit from their security interests in future accounts receivable and inventory.

The second way to exit is by way of enforcement. This scenario is obviously very disruptive to the borrower as it will likely entail negative publicity. Moreover, finding another working capital financier will probably be impossible in that situation. For the 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 the ABL lenders. Dutch bankruptcy law is very secured creditor 'friendly'. It does not impose an automatic stay and secured lenders can basically exercise their rights as if no bankruptcy exists.

3.         Intercreditor arrangements

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. Despite the separate pools of security ABL lenders do not have 'limited recourse'. This means that they can exercise the same rights as ordinary creditors against all of the borrower's assets and, most importantly, they can apply for the borrower's bankruptcy.

The challenge for an intercreditor arrangement lies in the opposite interests of the ABL and term lenders. In financial distress, the term lenders, given their security position, will probably wish to pursue going-concern refinancing, restructuring and/or sale of the group or a substantial part thereof 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 the outstandings under the ABL facility. However, a ABL lenders taking action (or having the authority to do so) is likely to jeopardise potential solutions and may be highly disruptive for any refinancing, restructuring or sale.

The key issue facing the market is how to reconcile the ABL and term lenders' position. Since there is no generally accepted market practice, 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 the borrowing base. The borrowing base allows the ABL lenders to make an almost real-time analysis of their credit risk. The point for departure should therefore be that the ABL lenders are required to continue financing for as long as the ABL facility is reasonably expected to be in formula (i.e. in line with the limits agreed upon for the ABL facility).

3.1       Drawstops, quasi-drawstops and acceleration/enforcement rights for ABL lenders

The first question is under which circumstances the ABL lenders should be able to rely on a drawstop. Obviously, they should be able to do so in the case of a borrowing base deficit. However, considering the potential adverse consequences of drawstopping for the borrower's business, it could be argued that not just any deficit should give rise to a drawstop event. For the term lenders and borrower, it is important to ensure that the borrowing base deficit can only trigger a drawstop if it has resulted solely from a decrease in the value of the borrowing base, and not from a discretionary adjustment of the terms of the ABL facility. The ability of the ABL lenders to make such adjustments should not in fact act as a quasi-drawstop. In addition, the borrowing base deficit must not be the result of a loan in excess of the maximum available facility (an 'over-advance').

A second question is when the ABL lenders are authorized to take enforcement action, more specifically, when they are authorized to accelerate the ABL facility and enforce the ABL security interests. Not every borrowing base deficit should give the ABL lenders the right to take such action; there should be a serious structural issue in the borrowing base, e.g. a deficit in excess of a certain threshold that has continued for a certain period of time or a higher (peak) deficit at any point in time. The term lenders must ensure that, outside a structural borrowing base deficit, the ABL lenders do not have an unfettered right to take enforcement action. Given the potentially catastrophic effects of such an action, the ability to exercise such rights should be tied to a limited number of carefully agreed acceleration events, such as fraud in relation to the borrowing base, an inability to determine the borrowing base, insolvency proceedings, non-payment, cessation of the business or a change of ownership.

If the ABL lenders wish to terminate the ABL facility other than in the event of a material event of default, they must observe a standstill period, the duration of which depends on the nature of the event of default. Once the standstill period ends, the ABL lenders are authorized to take enforcement action if that event of default is still continuing. Whether the ABL facility can be so terminated, must be agreed on case-by-case basis. If ABL lenders are comfortable with their core rights and power, there should probably not be a reason for "nice to have" events of default. And otherwise such events of default should arguably trigger a much longer standstill period.

Moreover, it is important that ABL lenders cannot trigger events of default by adjusting the terms of the ABL facility (see par. 3.2 below) and, likewise, that events of default cannot be upgraded to acceleration events.

The foregoing means that, as is the case in a unitranche/super senior RCF structure, generally enforcement is primarily controlled by the term lenders. However, given their position, the ABL lenders definitively have a seat at the table in the case of financial distress.

3.2       ABL adjustments

A final point to consider is that the term lenders should be wary of allowing the ABL lenders to make discretionary adjustments of the terms of the ABL facility without restriction, as this could effectively undermine the carefully agreed arrangements regarding drawstops and acceleration/enforcement rights. The ABL lenders could, however, argue that the authority to make such adjustments gives them more flexibility to keep the ABL facility in formula without having to take draconian measures. A possible middle ground is for the term lenders to allow the ABL lenders to make such adjustments if a material event of default occurs and continues, but only if the adjustments remain within certain agreed limits.

3.3       Other issues

A number of other issues may need to be addressed in the context of an ABL/term facility structure. For example, amendments and waivers, purchase options, consultation periods and the possibility for term lenders to extend cure loans. Furthermore, the term lenders must be able to release any guarantee and residual claims and, if applicable, any second-ranking security interests by the ABL lenders in the case of a going-concern restructuring. If the term of the ABL facility is shorter than that of the term facility (which is likely in a unitranche facility), refinancing of the ABL facility must be permitted under the term facility. Finally, allocation of mandatory prepayments between the term lenders and the ABL lenders as well as the position of hedge counterparties needs to be considered.