Asset Based Lending Collateral Risks
Though considered more controlled than unsecured loans, asset-based lending (ABL) relationships still have potential risks attached to them. Issues such as markets, seasonality, internal controls and even a borrower's size can affect liquidity and the ability to recover a lender's advances.
Different collateral classes present special challenges. For the most part, however, a robust monitoring plan and straightforward due diligence provide a good amount of risk avoidance.
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Accounts Receivable
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Accounts receivable need monitoring, too. Accounts receivable are the most common ABL collateral. When receivables are fluid, all goes well. Advances are moderate, collections flow consistently, unused availability develops and disputes are at a minimum.
In contrast, if aging analyses become distended, disputes proliferate or documentation quality falters, then a lender's alarms should go off. Customers who normally paid within terms who now pay slowly might merit a confirmation call to verify terms of the original invoice. Disputes or claims surrounding an invoice may cause it to become past due. Absent or poor-quality supporting documentation might be an early sign of fictitious invoicing.
The best defenses against these risks are moderate advance rates, continued monitoring and proactive responses to the first signs of deterioration in collateral quality. If economic shifts or industry-wide risk patterns worsen, perhaps an entire class of invoices deserves a lower advance rate. Any shifts in individual customer payment patterns deserve analysis. Lastly, the need for an on-site collateral examination should be considered to assess borrower processes and ensure timely reporting.
Inventory
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Inventory has special challenges. Historically, many ABL lenders were very cautious about lending against inventory. Since the mid-1980s, ABL lenders became more aggressive about this asset. Cyclical and individual lender-driven adjustments have occurred since the early 2000s.
As a class of assets, inventories present a more challenging collateral issue with special risks. Inventories are not as fluid as receivables. Inventories might be in stages of assembly, the completion of which the lender might need to fund in order to convert to more liquid receivables. If the inventory is commoditylike, it may be available elsewhere, and customers can avoid dealing with a vendor who fights with its lender. Conversely, if the inventory is custom-made, the lender may need to court the intended customer to assure performance, product delivery and ultimate payment.
A further risk of inventory advances is the wider commodity marketplace for raw materials or, in some cases, mid-stage materials or components. The inventory may not be subject to a quick liquidation in an "as is" state. If it is, values might be affected by the liquidation and the associated wrong perception of low quality or lack of utility.
Proactive due diligence and specialized monitoring are the best insulation against inventory collateral risk. If the inventory advance is large or significant relative to the collateral mix, an inventory appraisal is in order before advances are made. On an ongoing basis, monitoring of inventory mix and level adjustments vs. the borrower's operating shifts is warranted.
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Equipment
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Equipment deserves caution. ABL advances against equipment as part of a loan package can present special risks. When considered as part of a collateral pool, values attributed to this asset class can cloak liquidity issues. Many litigation situations arose during the mid-1980s through the 1990s in which an overly aggressive advance rate against equipment endangered an ABL lender's chance to retain liens against other collateral.
In general, if an advance against equipment is required, an ABL lender might be in a better future position by documenting a separate term loan against this asset, even if that requires another lender or sharing the risk with a participant.
Comfort Zone
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Balanced advances are key. When providing ABL financing, risk appetite, monitoring capability and the borrower's situation are key elements of setting advance rates. In turn, this information also may determine which classes of assets the lender is willing to advance against.
For the most part, the borrower's needs or desires should be aspects that the lender's current monitoring infrastructure can handle without a lot of tweaking. Unless the prospective loan is the first of a series the lender intends to make to a new industry niche or borrower type that requires a specific change to its normal monitoring activity, the costs and risks of this advance may surprise the lender.
Appropriate due diligence, moderate advances and thorough monitoring are the best risk management tools when dealing with an ABL portfolio.
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