Guest Post by John Klehm of SPECTRUM Commercial Services
Most acquisitions, a sale to a strategic partner, new entrepreneurial owner, or buyout group are financed by debt which is serviced via the cash flows of the company being sold. With unprofitable or otherwise distressed businesses, this may not be available. How does the sale of troubled companies get financed?
Even in distressed acquisition financing, ideally, the lender is looking for repayment from cash flows. When approaching the lender, the buyer will be presenting projections that show operational changes that lead to future profitability, from which the loan repayment will arise. In these cases, however, based on the historical operating performance, the reliability of those cash flows is in question.
Given the elevated risk that those projections don’t come to fruition, the lender will be looking for a very reliable secondary source of repayment, collateral coverage. In the event that the company isn’t able to repay the loan from future cash flows, there would be adequate proceeds from the sale of the assets to repay the loan in full. Typically, this type of financing is going to come from an Asset Based Lender (ABL), either an ABL division of a bank or an independent finance company.
In order to remain protected by collateral values, the ABL will want to be sure that the amount of the loan outstanding is always somewhat less than the liquidation value of the assets. The amount of credit provided is based on formulas applied to the different asset classes.
- Accounts Receivable is the easiest asset-class to lend against when done properly. Because it’s the lowest risk, lenders are comfortable lending upwards of 75-85% of the value of what they consider eligible AR.
- Inventory carries the most variation in how much a lender will advance against it because in many cases, inventory is specific to that company and doesn’t have value to others (it can’t be sold to a competitor or customer). Typically, however, finished goods and some portion of raw material inventory would be marketable and against those components, a lender would typically advance 40-60%.
- Equipment is the second easiest asset class to lend on. Typically, the buyer will stipulate that the equipment be appraised and the ABL will offer to lend 65-85% against either the “forced” liquidation (auction) value or the “orderly” liquidation value. Which value standard gets used for the ABL’s underwriting often is determined by the cash flows of the target company; the more distressed or troubled the cash flows, the more likely the lender will require that a force or auction value be used.
- Real estate is less commonly borrowed against in distressed acquisition financing, but it can be used. (Most ABLs prefer not to lend on real estate but SPECTRUM will – see below). Because of the relative illiquidity of real estate, advance rates are lower, typically 50-60% of appraised fair market value.
Adding together the amount of borrowing capacity that the individual asset classes support (75-85% of AR; 40-60% of Inventory, 65-85% of M&E, and 50-60% of RE) provides the combined amount of borrowing capacity available. Not all of that can be applied to the purchase price, however. Because the acquired company isn’t profitable the ABL will require that there is a certain amount of undrawn borrowing capacity kept in reserve to fund losses expected over the coming weeks or months until the buyer’s turnaround plan takes hold. This reserve varies by situation, but 5-15% of the gross borrowing capacity of the credit facility is common, leaving 85-95% of the borrowing capacity to be applied towards the purchase price.
The sale of good assets or companies and putting them in the hands of new operators that may bring fresh ideas, execution, and capital to them can be a very good thing. Failing or troubled enterprises can be saved, including the many jobs involved. As the economy goes through difficult times the number of distressed companies will increase and provide opportunities for this type of corporate renewal. Asset-based lenders broadly, and SPECTRUM, specifically, are eager to help with these types of situations.
John L. Klehm, SVP
SPECTRUM Commercial Services
SPECTRUM provides asset based and accounts receivable financing by leveraging “the full spectrum” of assets; AR, Inventory, Equipment and Real Estate. SPECTRUM’s success is based on our philosophy of honesty and integrity in approach, competitive rates, creative financing solutions and excellence in customer service.