LIBOR transition: government proposes legislation to deal with 'tough legacy' contracts
Out-Law Guide | 28 Jul 2020 | 2:05 pm | 11 min. read
The concept originated in the US and was once a form of financing only available through certain speciality banks. However, ABL is gaining in both availability and popularity as businesses seek to boost their working capital and fund major corporate transactions.
Written by projects expert David Kennedy of Pinsent Masons, the law firm behind Out-Law.
ABL is particularly helpful to seasonal or cyclical businesses with asset-rich balance sheets and, unlike cash flow lending, can be structured to suit a borrower's business and operational needs. In the US market and increasingly in Australia, ABL takes the form of revolving lines of credit and term loans, and has been provided in conjunction with 'term loan B's (TLBs), capital markets offerings and various other long-term debt instruments.
The advent of the 2009 Personal Property Securities Act (PPSA) has helped in making ABL more common in the Australian market and accessible to foreign financial institutions. The PPSA is in part based on Canadian and US equivalent laws, with which off-shore institutions are familiar. Foreign financial institutions therefore understand and have structured ABL transactions under similar regimes to the PPSA and are increasingly looking to structure such ABL transactions for Australian borrowers. US financial institutions provide ABL as a regular debt product.
In contrast to receivables financing or factoring products, which are sized based on the value of a borrower’s receivables (only), ABL facilities combine all inventory, receivables and plant and equipment into one aggregated borrowing base. This significantly increases debt available to a borrower.
The borrower will calculate and report on this borrowing base monthly so that ABL financiers can monitor their exposure, i.e. whether the borrower has borrowed more than the value of the borrowing base.
While typical ABL borrowing bases are comprised of receivables, inventory and/or plant and equipment, it is possible to include real property in the borrowing base to increase borrowing capacity. ABL facilities have also been based on receivables owing to a borrower under intellectual property licences and reserve-based loans, which include oil and gas field reserves or mineral resources in the borrowing base.
Asset-based lending is a burgeoning market in Australia, and can provide flexible capital to the right corporate groups if structured correctly.
A borrower’s borrowing capacity under an ABL facility is affected by the quality, value and adequacy of the assets comprising the borrowing base. Quality, value and adequacy of assets is assessed by the ABL financiers prior to entering into an ABL facility and, typically, annually thereafter by way of appraisal and field examination. These appraisals and field examinations may be conducted by a third party valuer appointed by the ABL financiers or by the ABL financiers themselves. Appraisals will identify what credit risks exist in lending against particular assets, what types of inventory, equipment and receivables to exclude from the borrowing base and how to value those assets. Ultimately, this will inform what the borrower's borrowing capacity is and what the borrower's monthly reporting requirements will look like. The stronger a borrower's cash management systems, payment terms and inventory management, the better position a borrower will be in to maximise its borrowing capacity under an ABL facility. Most financial institutions offering ABL debt products will assist borrowers in developing robust reporting and cash management systems as part of the appraisal and field examination process in order to maximise the borrowing base.
Historically, only speciality banks had the expertise and capability to offer and monitor ABL facilities. However, more and more lead arrangers and underwriters with ABL transaction expertise are syndicating ABL facilities to financial institutions that otherwise would not offer them as standalone debt products on a bilateral basis. For ABL facilities syndicated in the US, for example, the 'lead-left' arranger will often negotiate the terms of an ABL facility and act as facility agent to monitor ongoing compliance, reporting and field examination and appraisal obligations of the borrower. In this way, financial institutions that are more familiar with ABL can offer larger debt products to their customers without taking on the risk of a large revolving credit facility alone.
ABL facilities are typically cheaper than cash flow based revolving credit facilities, as the ABL financiers will take first-ranking perfected security over the assets comprising the borrowing base. These assets are generally the most liquid assets, and are assets which the ABL financiers have thoroughly diligenced and are quickly realisable in the event of borrower insolvency.
A major difference between ABL facilities and cash flow facilities is that ABL facilities do not require financial covenant compliance. Leverage ratios and debt service coverage ratios are less relevant to ABL financiers who calculate borrowing capacity based on a borrowing base of select assets as described above. This is very beneficial for borrowers with cyclical or seasonal businesses that rely on their working capital facilities when cash flow is limited. For such borrowers, testing financial covenants based on cash flow and EBITDA in low cash flow periods can lead to lenders repricing their facilities following financial covenant breaches and requests for waivers. This issue can arise even when underlying business metrics of the borrower are sound. In recessionary times, this can also lead to default interest, investigating accountants being appointed and enforcement.
Instead of ongoing financial covenant compliance, ABL financiers will require monthly reporting of the borrowing base together with related reports on receivables, inventory and/or plant and equipment. Such reporting can include detailed aging of accounts receivable and inventory lists which identify inventory in transit, on consignment, and so on. Only if the aggregate exposure under an ABL facility gets close to the value of the borrowing base (i.e. because the borrowing base shrinks) will additional reporting and covenant compliance be required.
If availability under an ABL facility reduces to between 10-20% of the borrowing base or commitments, then a typical ABL facility will require weekly reporting of the borrowing base, field examination and appraisals of borrowing base assets, compliance with a fixed charge coverage ratio of 1:1, and springing control over bank accounts by the ABL financiers. These springing covenants limit leakage of the borrowing base assets in circumstances where the aggregate exposure of ABL financiers is close to or exceeds the value of the borrowing base.
This is much more beneficial to borrowers who can use ABL facilities to fund seasonal changes in working capital without tripping typical cash flow facility financial covenants, and it can even permit such borrowers to make opportunistic acquisitions in these periods. So long as a borrower has sufficient borrowing base assets to cover the ABL financiers' exposure, it will have access to debt in low cash flow periods. This is particularly relevant during COVID-19, as asset rich borrowers will have access to working capital so long as the borrowing base value is maintained.
Given the heavy reliance on tangible and working capital assets, ABL facilities are best suited for borrowers with tangible asset-rich balance sheets, with a large proportion of working capital assets.
ABL facilities are also attractive solutions for corporate groups that operate in multiple jurisdictions because it removes the need for those corporates to have separate local working capital facilities in each jurisdiction on separate terms and pricing. As long as ABL financiers can take first-ranking security over borrowing base assets in a relevant jurisdiction, ABL can be extended to that jurisdiction.
For example, if a corporate has a presence in Australia, New Zealand and the UK, an ABL facility could allow that corporate to have one debt instrument which contains a borrowing base for each of those jurisdictions. Each borrowing base under such an arrangement would be comprised of receivables, inventory and/or plant and equipment owned by subsidiaries of the corporate in the applicable jurisdiction, such that there would be an Australian borrowing base, a New Zealand borrowing base and a UK borrowing base. These borrowing bases would be offered under one ABL facility, on the same terms, and would allow each operating subsidiary in a jurisdiction with a borrowing base to access directly a revolving facility up to the amount of the applicable borrowing base for that jurisdiction.
It is also possible for ABL facilities operating across multiple jurisdictions to have a global aggregated borrowing base, whereby the borrowing bases in each jurisdiction aggregate to one global borrowing base and each foreign borrower can access the borrowing base of a borrower in another jurisdiction. In the example above, this would mean that the Australian, New Zealand and UK borrowing bases would aggregate to form one global borrowing base, which borrowers in any jurisdiction could access directly. Whether a shared global borrowing base is possible depends on the guarantee and security laws in each relevant jurisdiction. However, regardless of how it is structured, global ABL facilities allow borrowers direct access to sizeable working capital facilities in each jurisdiction in which they operate, on consistent pricing and terms.
Another benefit to ABL borrowers is the flexibility ABL can provide in a capital structure. ABL financiers are extremely focussed on their ability to realise borrowing base assets. As long as that ability is preserved under appropriate debt arrangements, ABL facilities can co-exist with other forms of debt and leave residual collateral to be secured on a first-ranking basis to other lenders. This means that ABL facilities can co-exist neatly with other forms of long-term debt.
It is common in the US, for example, for large corporates to have both a TLB and an ABL facility as part of their capital structure. In this scenario, the borrower will grant an all asset security in favour of both TLB financiers and ABL financiers, with an intercreditor agreement that, among other things, gives ABL financiers priority over borrowing base assets and TLB financiers priority over all other assets, such as shares and intellectual property.
In the US market, ABL facilities are commonplace for manufacturers, wholesalers and distributors. It is even typical to see leveraged buyouts funded with TLB and ABL facilities, based on the value of the relevant target’s receivables, inventory and/or plant and equipment. The ABL in this structure acts as the target’s ongoing revolving facility and becomes part of the target's permanent capital structure, while the TLB is used to fund the target’s acquisition.
Any borrower with an existing ABL facility that is considering an acquisition will be able to include the assets of the proposed target in its borrowing base to obtain incremental debt capacity to fund the acquisition.
In Australia, secured parties with security over "circulating assets" are subject to certain unsecured creditors’ claims if an insolvency event occurs under the 2001 Corporations Act (Cth). For example, employee entitlements and certain costs of an administrator or liquidator, among others, will be paid out of proceeds from realised "circulating assets" in an insolvency, even if those assets are secured in favour of an ABL financier or other secured party.
"Circulating assets" include, among other personal property classes, receivables arising from providing services in the ordinary course of business, receivables that are the proceeds of inventory, authorised deposit taking institution (ADI) accounts and inventory.
Receivables, ADI accounts and inventory form the core of a borrower’s borrowing base in an ABL facility. Therefore, ABL financiers need to ensure that such assets are not treated as "circulating assets" because such treatment can expose those assets to statutory prior ranking claims from other unsecured creditors' in an insolvency. If any assets in the borrowing base are "circulating assets", ABL lenders will typically take a reserve in an amount equal to the amount of all statutory prior ranking unsecured creditor claims, which will reduce the borrowing capacity of a borrower.
Accordingly, borrowers and ABL financiers will seek to perfect security interests in those asset classes such that they are not "circulating assets". The PPSA provides a prescriptive regime under which an asset, which would otherwise be a "circulating asset", can be non-circulating and, therefore, be realised by the ABL financiers without having to account to any statutory prior ranking unsecured creditors.
Under the PPSA, "circulating assets" are not circulating assets if a secured party has:
The PPSA sets out how to affect "control" over each personal property asset class.
With respect to ADI accounts, the most common means to achieve control in accordance with the PPSA is to:
With respect to receivables, control is established by:
With respect to inventory, the secured party and the borrower should agree in writing that the borrower will appropriate the inventory to the security interest and the inventory will not be removed without obtaining the specific and express authority of the secured party to do so. The borrower’s usual practice should be to comply with such agreement.
"Control" over inventory is problematic in Australia because there is little guidance as to what degree of consent is required to any disposition before such inventory becomes a "circulating asset". Some ABL facility agreements attach pro forma sale contracts for inventory in which the secured party is required to consent before any disposition of inventory is made and other facility agreements that only require consent for dispositions of material inventory. In ABL facilities where it is not practical for the secured party to give express consent for each disposition, ABL facility agreements may treat inventory as a "circulating asset" and, accordingly, permit the ABL financiers under that facility to take reserves against the borrowing base for any statutory prior ranking unsecured claims in existence.
The intent of ABL is to allow the borrower to conduct its business in an unencumbered way until availability under the borrowing base reduces to an agreed level, at which time the ABL will spring specific covenants which allow the secured party to control proceeds of bank accounts and other borrowing base assets. However, each ABL security package will need to be tailored for the relevant borrower, as the approach to adequately securing borrowing base assets depends on the type of assets in the borrowing base, the account structure of the borrower group and the operating procedures of the borrower. There are also important structural considerations to consider with respect to "retention of title" arrangements and employee entitlement contributions potentially owed by a borrower. Importantly, however, the PPSA provides a regime for borrowing base assets to be secured on a first-ranking priority basis to ABL financiers to avoid them being deemed to be "circulating assets". This regime, as well as the structural and legal considerations described above, will need to be analysed to tailor a security package right for the borrower and the ABL financiers at the time an ABL facility is provided.
ABL facilities are a viable and, as yet, untapped debt option for many corporate groups in Australia. ABL is a burgeoning market in Australia, and can provide flexible capital to the right corporate groups if structured correctly.
LIBOR transition: government proposes legislation to deal with 'tough legacy' contracts