Asset-Based Business Lending

thePoint
June 16, 2005

While they may not always be aware of it (or even want to admit it), community banks and other financial institutions that make commercial loans probably have entered the wonderful world of asset-based lending somewhere along the line, John Logan, retired director of asset-based lending at South Trust Bank, Birmingham, Alabama, tells Banker News.

Asset-based lending is the practice of making loans that use a company's assets such as receivables, inventory, and machinery as collateral for the loan. In asset-based lending, the quality of the collateral becomes pre-eminent in determining the creditworthiness of the customer.

"When financial institutions make commercial loans, included in that commercial loan bag are working capital lines secured by receivables and inventory," Logan says. "If an FI is making commercial loans—working capital loans secured by current assets—it is going to be in the asset-based lending business whether it wants to be or not. And that has everything to do with the balance sheet and the overall solvency, liquidity, and creditworthiness of their borrower."

Logan describes a scenario that often occurs when he teaches classes for financial services professionals.

He asks students, "Do you make asset-based loans?" and they always answer no. Then he asks, "Do you make working capital loans?" They answer yes. He tells them, "Well, you're in the asset-based business." They still insist they aren't. "Then you start to talk about it and they go, ‘Oh yeah, I guess I am,'" he says.

Logan explains that in a cash-flow loan, the principal source of repayment is cash, or earnings. In an asset-based loan the source of repayment is the conversion of the asset. "It's all about preservation of loan to value—yesterday, today, and tomorrow," he says.

"If you look at a credit package of any given financial institution, what you would see is there's always a principal source of repayment, Logan continues. “It will always say cash flow or earnings, something along those lines. The secondary source of repayment, if it were a secured transaction, generally would be the conversion or sale of that asset. Then you might have a third source—tertiary guarantees and things along those lines.

"If you saw the source of repayment of an asset-based loan, it would be reversed. It would be conversion or disposition, first, and cash flow or earnings second. Then third would be the tertiary source and guarantees. That is an absolute. The difference principally between an asset-based loan and a cash-flow loan is your primary source of repayment."

But, as financial professionals know, that primary source of repayment can change. That change can happen for a variety of reasons, both negative and positive.

"The obvious negative is that I've just lost a lot of money and my cash flow has been severely weakened," Logan explains. "But you also can have the cash flow severely weakened because a customer comes to the financial institution and says, 'I've just gotten this wonderful opportunity to increase my revenues by X number of dollars or 40%.' I don't know any company that can support 40% growth internally through sustained cash flow. It just leverages and stretches the balance sheet."

There are positive and negative reasons why the cash flow can be disrupted, but the bottom line is it is disrupted. "And when that happens, you no longer have a traditional [commercial and industrial] cash-flow loan," Logan says. "If you're financing working capital, you're now in the wonderful world of asset-based lending because your source of repayment has changed."

Logan sees several main issues interwoven into asset-based lending. They are:

Training. "There is a void in the training capabilities of given financial institutions in regards to asset-based lending for their employees, either initially or continually," he says. That's because institutions generally say they're not in the asset-based loan business so there is no point in providing training for such lending. What they fail to realize is they're going to be in the business anyway. They'll train their people on how to make working capital loans. And they'll make points of saying you've got to provide and file [Uniform Commercial Code] statements, etc. But when they're talking about managing risk in an asset-based loan environment versus a cash-flow environment, [training] generally doesn't exist."

Products. Asset-based lending products should be built around the dimensions of size and risk. "The products that you design have to fit the size that you're willing to go after in your marketplace and the risk profile that you're willing to take," Logan explains. "If you're in an institution that has a legal lending limit of a couple of million bucks, but your sweet spot is making loans in the $500,000 to $750,000 range, then don't build products that will allow you to go out and tackle $5, $7, $10, $15, $20 million loans. It's a water-and-oil scenario. And don't build products that that are bunker-mentality products that will maintain all kinds of risk when the profile of your customer is not high risk."

Understanding profitability and cost analysis at the customer and products level. "Profitability, has a lot to do, obviously, with competitive dynamics," Logan says. "If your hurdle rate and your return on equity internally that you want to get—for the sake of discussion is, say, 25%, 22%, or 18%--but in order to do that you've got to charge the customer eight over prime to get there because your cost structure is out of whack—and everybody around you is willing to charge prime plus two—fifty cents will buy you a cold cup of coffee. It's all about managing the revenue and expense, and profitability, and understanding your cost curve at the product and customer level."

This article was prepared by the staff at the Point for Credit Union Research and Advice and is published online at http://thepoint.cuna.org/. Reprinted with permission.