Despite the impact of COVID-19 on overall lending activity and the wider economy, we have advised on a number of asset-based lending transactions in Scotland recently. New credit appetite has remained strong in sectors such as whisky, and food and drink more broadly, as examples.

In fact, the particular characteristics of asset-based lending in focusing predominantly on the value of a borrower's assets as opposed to cash flow can also make it a very useful financing product in a period of market restructuring and business reset. This is because certain assets will maintain their value as collateral for the loan, even when the company may have been more challenged in terms of cash flow and earnings. We expect asset-based lending to continue to feature prominently as Scottish businesses recover and look for alternative options to maximise access to liquidity to finance that recovery and future growth.

This article considers some of the benefits of an asset-based lending structure and the key themes for lenders and borrowers to consider as against more traditional forms of secured lending.

Asset-Based Lending

Asset-based lending is a specialist form of secured lending where the loan is more closely tied to the borrower’s assets than is customary with a typical secured loan. The lender advances funds to the borrower based on an agreed percentage of the value of certain types of assets, most commonly receivables, but often multiple asset classes are used, including inventory, real estate, machinery and equipment. Inventory-only loans in the whisky sector are common. As greater focus is placed on collateral and liquidity than cash flows, asset-based lending facilities may provide greater headroom and debt capacity for certain corporate borrowers.

How does Asset-Based Lending work in practice?

The arrangements around asset-based lending facilities can appear complex and mechanical at first sight, but will be well understood by borrowers with the benefit of some specific legal advice. The nature of the arrangements means that there are some common legal issues arising on asset-based lending transactions including:

The Borrowing Base

The borrowing base is a formula that is used to determine the maximum amount of debt that the borrower can borrow at any point in time, based on the value of the agreed asset pool. Often this appears as a rather lengthy definition in the loan agreement and, given its importance to the overall mechanics of the facility, can involve extensive negotiation between the parties. There will be some standard reserves made against facility availability and the recent re-introduction of Crown preference in an insolvency situation has led to some adjustments in the approach here.

Borrowing Base v. Collateral

It is important for all parties to remember that, in asset-based lending, the borrowing base which supports the loans is not the same as the collateral that secures them. The borrowing base is simply the formula used to determine the amount of the loans that the borrower can draw under the loan agreement from time to time. However, the collateral securing the asset-based loan will often extend beyond those assets that are in the borrowing base (and may indeed extend to all of the assets of the borrower), providing an additional collateral safety net for the lender in an enforcement scenario should it wish to sell the collateral to recover the loans. Borrowers can often be surprised that lenders wish to have any oversight on elements of the business beyond those assets forming the borrowing base!

Security and Liquidity

For the lender it is crucial that, in a default scenario, it has the tools to take control of the borrowing base assets and convert these readily into cash to obtain repayment of the loans. The solutions here will vary depending upon the asset classes in question and, of course, the approach to security is quite different between Scottish and English transactions.

Lender Control of Assets

In asset-based lending, the lender generally exercises more control over the borrowing base assets than lenders typically exercise over collateral on other secured loans. This leads to negotiations regarding (i) the frequency of borrowing base reporting to lenders, (ii) the extent of other financial information which the lender should receive beyond simply that relating to the borrowing base, and (iii) occasionally clean-down requirements to reduce the outstanding loans to zero for a brief period before reborrowing in accordance with the borrowing base.

There is an operational impact for borrowers in having to monitor the fluctuations in the asset pool and a cost associated with the lender carrying out the required diligence in respect of the assets. However, this may be an acceptable price to pay for borrowers to increase their facility headroom and should not be an inconvenience for those already operating robust models for monitoring inventory levels and so forth. 

A useful tool for 2022

An asset-based lending structure will not work for everybody but may operate particularly well for borrowers with greater financial leverage and marginal cash flows. As businesses recover in 2022, many will face a sudden spike in activity due to the pent-up demand. To take full advantage, they will need access to funding which is flexible and allows them to scale quickly as activity increases. This may be more challenging in terms of cash flow lending until there is fuller evidence of recovery coming through in earnings performance, but an asset-based lending model may help unlock additional finance for those with more substantial assets and inventory and with a facility that allows availability to increase as trading accelerates. However, legal advice is paramount for borrowers in ensuring that the mechanical nature of the facilities is understood, and for lenders in ensuring that appropriate controls and enforcement options are in place.