Borrowing the name of a well-known inventory management concept, FILO loans are loans that are "first-in, last-out" in funding and payment. This loan structure is growing in popularity with senior lenders and mezzanine lenders alike, and is seen in an increasing number of transactions. Under the right circumstances, a FILO loan can be a good supplement to a senior loan, as well as a preferable alternative to mezzanine financing.

Structure of a FILO Loan

A FILO loan is always part of a larger lending transaction. Most often, FILO loans are found in asset-based revolving credit facilities. Though FILO loans have many of the same characteristics as mezzanine loans, FILO loans are most often part of senior credit facilities.

In a proposed credit facility, the senior revolving lender may have agreed to make an asset-based loan to the borrower with advance rates at a somewhat lower level than the borrower expected or needed. To increase the advance rate, the senior lender will bring in another lender that is willing to loan against a portion of the additional asset value in the company. For example, if the senior revolving lender agrees to advance funds against up to 65 percent of the value of the company's inventory, the FILO lender might advance against an additional 20 percent of the inventory, for an aggregate effective advance rate of 85 percent.

A FILO loan is set up as a separate tranche within the revolving credit facility. More like a term loan than a revolving loan, the FILO loan is funded in full at the closing (i.e., "first in"). Once repaid, the FILO loan funds cannot be re-borrowed. In keeping with the concept that this part of the loan is "last out," no prepayments are required.

Principal payments that do come in prior to maturity will be subject to a strict payment waterfall, and will go first to the lenders under the senior revolving tranche, and then to the FILO lender. If there is ever a need to foreclose on collateral, the proceeds of the collateral are paid out in a similar waterfall—first, to cover expenses, fees, interest and principal on the senior revolving loan, and only, after these are paid, to repay the FILO loan.

FILO loans are attractive to hedge funds and mezzanine lenders because the loan pricing often is similar to that of a mezzanine deal. But better than in a mezzanine deal, the FILO loan is part of the senior credit facility and receives the benefit of a first lien on the company's assets.

Borrowing Base

Unlike a typical asset-based revolving loan, the borrowing base calculation on the FILO loan is performed only at closing, when funds are advanced. If, after the closing, the borrower's assets decline in value and the outstanding amount of the FILO loan exceeds the FILO borrowing base, no prepayment of the FILO loan is required.

To protect the FILO lender, there is a requirement in some deals that the senior revolving lender establish a reserve against its borrowing base in the amount of any shortfall in the FILO borrowing base, so that the total funds advanced under the facility do not exceed the aggregate borrowing base amount for both tranches. A floor may be established for some amount of decline in value before the senior loan reserve will be triggered.

The FILO borrowing base will be based on a separate subcategory of assets from those used to calculate the senior revolving tranche borrowing base (i.e., the excess value of the inventory or receivables).

First Lien Security Interest

Having a first lien security interest can be tremendously valuable to the FILO lender. Many of the lenders interested in FILO loans are normally in second lien or unsecured positions in their other loans, and they appreciate the added value of being a first lien creditor in a bankruptcy.

Because a FILO loan is part of a larger facility for which another lender serves as the administrative agent, the FILO lender is not usually permitted to take separate action with respect to the collateral. The administrative agent, however, will have rights to the collateral in its capacity as agent on behalf of the lenders (including the FILO lender). Thus, it is important to work with an agent that the FILO lender respects and trusts to carry out this role appropriately, since the FILO lender will not be able to take action on its own.

Having a first lien puts the FILO lender ahead of most creditors, other than the other lenders in its own facility, if the borrower files for bankruptcy. Coupled with a borrowing base—particularly one where reserves are established in the revolving loan for overages on the FILO borrowing base—the FILO lender is better protected in the event of a downturn than it would be in a mezzanine loan.

Agent Reliance

For lenders used to having to do all the work on a deal themselves, being able to piggyback on the work of an administrative agent can make the transaction easier and more attractive. The agent will handle administrative matters relating to the loan from start to finish, and will work with the borrower to resolve many issues, thus avoiding the need for the FILO lender to spend time doing so.

Hearing another lender's views about the borrower, both before and during the deal, can be valuable to the FILO lender. The FILO lender's interests, however, are not completely aligned with the agent's interests. Because the agent is usually the largest holder of the senior revolving loan, its portion of the loan always will be paid in full before the FILO loan. This risk can be addressed in part by the addition of special voting protections for the FILO lender.

Voting

It is important for the FILO lender to have a right to class voting, so the FILO lender is the only one that can vote on matters that affect the FILO loan. For example, if the FILO loan comprises 25 percent of the overall facility, the FILO lender will not be able to control a majority vote by itself, and will need protection to ensure the majority lenders cannot vote for changes that would negatively impact the FILO loan.

In addition to the customary list of issues that would require a 100 percent lender vote, the FILO lender will want a veto right over any changes to the revolving loan borrowing base and advance rates, to ensure that the protections the FILO lender has negotiated up front remain in the deal at all times.

Senior Lender's Perspective

For senior lenders, FILO loans can be helpful because they permit the lender to maintain a smaller hold position in the loan—selling off a part of the loan that perhaps could not have been sold to other senior lenders. The existence of the FILO loan permits the senior lender the greater comfort level of being able to maintain lower advance rates, while permitting the borrower to obtain the funds it needs at an overall advance rate that it finds satisfactory.

The senior lender still enjoys a senior position in that it is always the first to be paid, even though it must share its collateral with a lender that is otherwise junior. Under the right circumstances, a FILO loan can be a good fit with a senior loan, and a good alternative to mezzanine financing.