M&A Blog #09 – debt (Part V – asset based lending (ABL) and seasonal ABL)
For those of us who have borrowed money based on collateral, this blog post will feel familiar. If you have listed your car or savings account in your mortgage application, you are essentially trying to get a loan based on your current asset(s). The concept can be extended to M&A. Thus far, we have discussed many aspects around capital structure and debt financing, including how debt levels are determined by a company’s cash flows, enterprise value, and asset values. In this post, we will look deeper into asset values - specifically how asset-based loan (ABL) is determined and we will calculate a company’s ABL borrowing capacity with an Excel spreadsheet. We will then take a step further in our ABL analysis by factoring in seasonality in the calculation - specifically for businesses like retailers whose inventories and account receivables fluctuate around major holidays like Christmas, etc. This post is the last one of our debt discussion.
Asset Based Lending (ABL) loan is important because it is often one of the cheapest-cost loans for a company. It is usually the easiest to get and doesn’t come with restrictive covenants that other types of debt comes with. ABL is fairly accessible event to companies with poor credits, and it is usually used to finance a company’s working capital. ABL can exists alongside other types of debt (revolver, term loan, etc.) as a part of a multi-tier capital structure.
Debt lenders analyze balance sheet for specific tangible asset that they can easily sell when the borrower is unable to pay back the loan from cash flow; asset such as inventory and account receivable. Debt lenders typically conduct a detailed analysis based on historical experience, industry norms, and current market conditions in loan assessment. A typical ABL borrowing capacity calculation is shown below:
The steps to this analysis is fairly straightforward:
Goal: to determine the available borrowing base for the ABL loan
For both A/R and Inventory, determine the gross amount, ineligible, and eligible amounts available
From the eligible amounts, working with an ABL lender or through one’s own assumption, determine ROA that should yield the available-for-borrowing base
The total available-for-borrowing based is then discounted with any reserve requirement - such as dilution reserve (typically a percentage of A/R) - to yield the total borrowing base
The outstanding revolver is then subtracted from total borrowing base to yield excess availability for the company to borrow against
The sample file for this exercise can be accessed here.
Additionally, for businesses with high fluctuations around certain times of the year (holidays, Christmas, etc.), it can be difficult to determine the available borrowing capacity. A retailer or a consumer electronics manufacturer see significant sales around those times of the year to use much more financing capacity. Both the borrower and the lender should factor in seasonality in the analysis to determine a consistent level of availability.
The steps to this analysis is also fairly straightforward:
Get records from the past 3 years on Cash, A/R, Inventory, Prepaid Expenses, Notes Payable, Accounts Payable, and Accrued Expenses - by month
Calculate the monthly Average A/R and Average Inventory
Make some assumptions around monthly Advance Rates for A/R and Inventory (or better yet, check with your ABL lender). An advance rate for an asset is the rate of which your lender will allow you to borrow against. The rates are different for different asset types.
Use the Average A/R, Average Inventory, and the advance rates to calculate the monthly total availability of borrowing
Calculate the monthly Average Net Debt for the past three years and subtract these amounts from the monthly total availability of borrowing to yield the monthly Net Availability
Make an assumption for a cushion (we don’t want to borrow all we can borrow) that can be used to absorb shocks - call this “Surplus Capacity” in the analysis above - and subtract this amount from Net Availability to yield the amount Available for Transaction
To be conservative and err on the side of the lowest month, we pick the smallest amount the monthly Available for Transaction. This will generate a safe amount to borrow for the M&A deal that we are considering.
The sample file for this exercise can be accessed here.
In conclusion, ABL is a cheap, simple way to finance an M&A deal - especially for companies who have the A/R and Inventory to support such borrowing. Calculations to determine the amount that we can borrow is straightforward, even for companies with seasonality in their businesses. This post wraps up our discussion on debt-financing for M&A. Hopefully, it succeeded in shining a light on why debt-financing is so important for a deal and the various aspects an acquirer ought to consider when it comes to debt-financing. In the next post, we will discuss equity-financing, specifically how to gauge if it is good or bad for the acquirer.
