As published in ABF Journal on July 21, 2022.
By Robert Dinozzi, Chief Growth Officer, Second Wind Consultants
For decades, private equity investors have taken distressed assets through a process to divorce them from subordinate liens. An analogous, lender-initiated process (the UCC Article 9 restructuring) clears up the traditional bottleneck in bank-to-ABL transitions, ultimately leading to the next evolution of the take-out relationship.
In the latter stages of the business lifecycle, the marketplace for asset-based lending take-out financing often operates within the context of under performance or distress. As such, for every bank referral to an asset-based lender, there are credits banks would ideally exit but cannot because subordinate debt exists on the balance sheet, either prohibiting the asset-based lender from taking a senior lien or otherwise challenging the viability of the business.
Looking ahead, and by taking a cue from the distressed investment community, this traditional bottleneck in the take out marketplace can be overcome.
The Take-Out Ecosystem
Conventional and borrowing base lenders operate synergistically within a credit ecosystem, facilitating businesses’ transitions through the various stages of their lifecycles. In this ecosystem, businesses come to life, grow and then come to an end, with each stage characterized by different credit requirements and different underwriting.
After the birth of a business through venture or seed capital, it typically enters into a higher growth stage, most often facilitated by asset-based lending. As the company’s borrowing base grows, it has access to more capital to fuel further growth. Ideally, the business will eventually graduate from this stage as the rate of growth slows and stabilizes and ratios become bankable. At this point, the ABL has served its purpose and the business will move to conventional finance.
Toward the end of the business cycle (outside of an initial public offering or successful exit), the business may become underperforming or distressed; that’s where banks and asset-based lenders meet again, as the bank, in lieu of selling its non-performing note, will look to be refinanced out by an asset-based lender. In the ideal situation at this stage, the asset-based lender would enter and help the company finance a turnaround or, alternatively, be in a better position to collect in the event of liquidation.
This ecosystem, like any other, is characterized by an equilibrium between all parties serving themselves while also serving the efficient functioning of the whole. This two-way take-out bridge between conventional and borrowing base lenders facilitates the efficient movement of credits between the different forms of underwriting associated with each stage in the business lifecycle.
Overcoming The Sub-Debt Bottleneck
However, more often than not, that bridge does not get the business from bank to ABL. The seemingly insurmountable problem is that whatever circumstances led to underperformance also led to the existence of various forms of sub-debt on the balance sheet, which precludes the asset-based lender from being able to take a first-position lien. Therefore, it is no surprise that the “clean” deals available for ABL take-out at this stage of the lifecycle represent just a fraction of those positions banks hope to exit. For those credits the banks would like to exit but can’t, when the asset-based lender doesn’t get the referral, it usually goes to workout or special assets.
Sub-debt can act as a barrier in the takeout relationship and it also represents an inefficiency for business in general, leading to untapped business for asset-based lenders and often a last-resort transition to workout or special assets instead of a transition to new, alternate underwriting. This can result in otherwise avoidable destruction of business value, jobs and economic activity.
However, the sub-debt bottleneck to bank take-outs does not need to be accepted as insurmountable. In fact, the solution to unlocking the greater potential of this synergy can already be seen operating within the world of private equity and distressed investment.
For decades, distressed investors have used a particular restructuring process (the Chapter 11 363 sale) to acquire the going-concern assets of a business while shedding them of all subordinate liens and liabilities.
On the other side of this process, it is not uncommon for equity investors to seek take-out financing from asset-based lenders so as to redeploy their capital into their next transaction. In this situation, from the asset-based lender’s vantage point, business is conducted as usual, as the distressed assets have previously been resolved and are subject to customary ABL underwriting.
In the context of such an ABL take-out of private equity, the 363 sale can be viewed as an intermediary process, resolving those previously distressed assets prior to the asset-based lender’s entry. The ABL take-out is made possible because the 363 process stood in between a distressed business on the one hand and an unencumbered asset base on the other. This allows the asset-based lender to finance the same asset base on the other side that it could not have before. The important idea is that of a “process” standing between previously distressed assets and unencumbered, financeable ones.
The historical conundrum is that, unlike private equity investors, asset-based lenders are typically not in the business of purchasing notes. In lieu of the investor-initiated 363 process, there has traditionally been no ABL-driven process to resolve excess debt whereby an asset-based lender could then take a senior lien post transaction. In fact, without a relevant analog to the 363 sale process, excess debt in the lending ecosystem is all too often resolved through the destruction and liquidation of businesses.
The good news is that there is a relevant analog that can facilitate an evolution of bank ABL take-out synergy beyond just “clean deals.” Much like private equity investors can initiate a 363 sale process to purge assets of excess liabilities, asset-based lenders can initiate an analogous process centered around a going-concern UCC Article 9 asset sale and restructuring. More precisely, an Article 9 restructuring is a process that divorces a company’s debt from the assets. It is analogous in some ways to the 363 sale but is transactional in nature, not judicial, and does not require deviance from ABL business as usual. Equally as important from an originations standpoint, this transactional process can be completed in a couple weeks, rendering it a viable ABL business development tool and by result, a streamlined solution for banks.
Through the Article 9 restructuring, the assets of a business are sold as part of a going concern transaction that passes the business operation from the old operating entity to a new unencumbered one, separating the assets from the old company’s liabilities so the asset-based lender can take a senior lien.
“This solution allows more bank-to-ABL transitions. FSW Funding has been able to finance businesses in a way that would otherwise not have been possible,” Haze Walker, director of sales at FSW Funding and Lawrence Financial Group, says. “FSW Funding can now underwrite assets without regard to current liabilities; this allows us to facilitate new transactions as an alternative lender.
Article 9 Restructuring
As we covered in a previous article, when a bank wishes to exit and an asset-based lender would otherwise underwrite the transaction if it were able to take a senior lien, an Article 9 restructuring can be initiated by an ABL transactional partner, such as a turnaround and restructuring firm or a trusted advisor.
The Article 9 restructuring process stands in between incumbent lenders and incoming asset-based lenders as an intermediary step, shedding subordinate liabilities through the process. Rather than the traditional one-to-one take-out, the asset-based lender can leverage the transactional partner to facilitate a third-party note purchase from the bank, at asset value, into a special purpose vehicle (SPV).
“I was able to originate a $3.5 million take-out facility for an exiting bank by leveraging a transactional partner and the Article 9 process. We entered fully secured, taking a first position lien despite there previously being almost $5 million in subordinated liabilities,” Joseph Upson, a business development officer in the equipment finance industry, says. “The refinance would not have been possible without the process standing between incoming and exiting lender in order to cleanse the assets.”
The “purpose” of the SPV is to conduct the Article 9 restructuring as the new first-position creditor. The SPV purchases the first-position note, anticipating the desired ABL take-out through the Article 9 process. From the first position, the SPV initiates a friendly pre-packaged foreclosure, a 10-day noticing period and a UCC Article 9 asset sale to the new operating entity, which is financed by the take-out ABL.
In short, a bank is taken out by the asset-based lender, which is one step removed, in the form of a note purchase. The transactional partner has pre-packaged borrower consent to the Article 9 going-concern asset-sale to the new company. The SPV now friendly-forecloses on the assets and conducts the UCC Article 9 asset sale to the new operating entity, which is financed by the asset-based lender that initiated the two-step transaction in the first place.
When a senior lender is an asset-based lender, rather than a bank, the process provides for a streamlined transition. Here is an example from an existing asset-based lender’s standpoint.
Gino Clark, executive vice president with White Oak Commercial Finance, had a positive experience with an Article 9 restructuring while working with a seasonal apparel company that missed its primary spring season when COVID-19 closed down the U.S. economy in March 2020.
Although White Oak’s asset-based credit facility was flexible enough to help support some of the cash flow issues created by the first wave of the pandemic, as the global economy continued to experience chronic supply chain disruptions and extended supplier shutdowns in 2021, the apparel company was no longer able to satisfy its obligations. As the company was faced with a dire situation and limited options, an Article 9 asset sale proved to be a powerful tool. It enabled a new buyer to purchase the company’s assets and continue satisfying orders. White Oak then collected on the outstanding receivables with very little dilution, satisfying the outstanding debt obligations as well as providing funds to help satisfy other creditors. According to Clark, the process was efficient and at a low cost, resulting in the highest possible settlement for White Oak and protection of the personal guarantees of the principals.
“Here was a good company that was experiencing circumstances completely outside of their control, namely COVID, and they got overleveraged,” Clark says. “Through the Article 9 sale process, a new company was able to purchase the assets and take over the existing business, and we were able to collect the highest potential volume on the debt. This can be an effective process for giving good companies with good business models an opportunity to breathe new life.”
A More Efficient Ecosystem
By taking a cue from the private equity world, asset-based lenders can reconceive the traditional one-step take-out as a two-step process vis a vis the bank in order to resolve sub-debt through the transaction.
In this evolution, the ABL take-out becomes more flexible and the take-out ecosystem becomes more efficient. Asset-based lenders can overcome the bottleneck of sub-debt precluding a first-position lien while circumventing the fact that, by covenant, most asset-based lenders are not in the note-purchasing business like private equity investors.
In addition, by inserting the Article 9 restructuring process at the center of a desired takeout, both lenders can achieve their desired outcomes. The asset-based lender can offer the bank a more flexible product while helping the distressed business’ operation avoid special assets while financing its turnaround.
“With the increasing awareness of the Article 9 restructuring process, the financial industry can now resolve overleveraged assets pre-transaction,” Walker says. “Alternative lenders like FSW Funding can continue to be competitive by offering their referral partners this expanded scope of take-out opportunities.”
In any ecosystem, adaptation is the key to thriving. By offering referring banks a more flexible scope of viable take-outs, asset-based lenders can generate more business, create efficiencies for banks (both in freeing their reserves and avoiding liquidation) while giving viable business operations a chance at success they would otherwise not have.