Advantages of Lines of Credit

Lines of Credit

ABL is a specialized loan product that provides fully collateralized cred it facilities to borrowers that may have high leverage, erratic earnings, or marginal cash flows. These loans are based on the assets pledged as collateral and are structured to provide a flexible source of working capital by monetizing assets on the balance sheet. While troubled companies often rely on ABL to provide turnaround, recapitalization, and debtor-in-possession (DIP) financing, ABL is also used by healthy companies seeking greater flexibility in executing operating plans without tripping restrictive financial covenants.

The primary source of repayment for revolving ABL facilities is the conversion of the collateral to cash over the company's business cycle. Loan advances are limited to a percentage of eligible collateral (the "borrowing base"). Strong controls and close monitoring are essential features of ABL. ABL lenders may also provide term financing for borrowers requiring longer-term capital or funding needs.

National banks may engage in ABL with no aggregate limitations, provided the volume and nature of the lending do not pose unwarranted risk to the bank's financial condition. Certain limitations apply to FSAs as set forth in 12 USC 1464(c)(2) and 12 CFR 160.30. ABL loans typically would be classified as commercial loans, which cannot exceed 20 percent of total assets provided the amounts in excess of 10 percent of total assets are used only for small business loans as defined in 12 CFR 160.3, "Lending and Investment - Definitions."1 An FSA, however, might engage in ABL under other authority, depending on the circumstances.2 For example, to the extent an ABL loan is secured by nonresidential real property, an FSA may make the loan under its nonresidential real property loan authority.3

Advantages

ABL's popularity among borrowers is attributable to the following characteristics:

  1. ABL provides ready cash to support liquidity needs, eliminating the need to wait for the collection of receivables.
  2. ABL provides important funding for companies in cyclical or seasonal industries by providing liquidity during slow sales periods and periods of inventory buildup.
  3. ABL provides rapidly growing companies the cash to fund growth or replenish internal capital used to fund growth by financing increases in receivables and inventory.
  4. ABL facilities are typically underwritten with a limited number of financial covenants; the additional risk this poses to the bank is mitigated by conservative advance rates against liquid collateral, strong collateral controls, and frequent monitoring.
  5. Borrowing terms and repayment schedules generally provide more flexibility and can be customized to fit the individual business requirements or business cycle.
  6. ABL borrowers in many cases can monitor availability on a daily basis.

For lenders, ABL can be a profitable, well-secured, and low-risk line of business if strong controls are established.

Disadvantages

ABL can present disadvantages for the borrower and the lender. For the borrower, an ABL facility is often more expensive than other types of commercial lending. Interest rates and loan fees are generally higher and the costs associated with frequent reporting requirements greater (despite this, ABL may be the most economical type of financing available to the borrower). Another potential disadvantage to the borrower is that loan agreements typically allow the lender to take control of the borrower's cash or more readily seize collateral if the borrowing base declines to a level that does not support the loan.

For the lender, the administration and monitoring of ABL is time and cost-intensive and particularly susceptible to borrower fraud, especially when a business experiences unpredictable cash flow or financial troubles.

Revolving Lines of Credit

A revolving line of credit (revolver) is the most common type of ABL. The facility allows the borrower to draw funds, repay draws, and redraw funds over the life of the loan. A revolver is commonly used to finance short-term working assets, most notably inventory and accounts receivable. Cash from the sale of the inventory and collection of receivables (conversion of working assets) is the typical source of repayment for a revolver.

A borrower that has substantial working capital needs, such as a wholesaler, distributor, or retailer, frequently uses revolving credit. A service company may also rely on a revolver to fund accounts receivable. A revolver is generally secured by working capital assets, such as accounts receivable and inventory. The value of the underlying assets determines the loan amount and the availability of funds. In some cases, a minimum amount of availability, often referred to as a "hard block ," must be available at all times. Typically, a borrower can draw against the revolver as many times and as often as needed up to the lesser of the available borrowing base or the revolver commitment amount. The outstanding balance of the loan should fluctuate with the cash needs of the borrower subject to the availability constraints of the borrowing base. Credit availability is restored when principal is repaid from the conversion of assets to cash and collateral is restored to the borrowing base.

The borrower must comply with the terms and conditions stipulated in the loan agreement, including lender controls and the treatment of cash proceeds, for credit to remain available. In general, cash conversion proceeds are applied to the outstanding balance of the revolver when received. This is commonly achieved through a lockbox arrangement, whereby the lender controls the borrower's cash receipts. The terms of a revolving credit facility can vary considerably. The maturity is typically short term, which allows the bank to reevaluate the risks and adjust the loan term s (commitment amount, advance rate, interest rate, monitoring requirements, etc.) as necessary to reflect the risks. In a growing number of cases, tenors have been extended to as long as five years, which introduces a greater degree of risk if not properly controlled .

An over-advance may be a part of a revolving ABL facility. An over-advance is a loan advance that increases the loan balance beyond the amount supported by the borrowing base. The primary source of repayment for over-advances is typically the company's operating cash flow.

ABL facilities may include a preapproved seasonal over-advance for a brief period during the normal operating cycle when seasonal inventory buildup exceeds sales. In this situation, the bank increases the availability under the borrowing base for a defined period before the peak selling period. For example, a lawn and garden equipment manufacturer may require additional credit availability during the winter months, when sales are slow and inventory is accumulated for spring shipments. Over-advances are also extended for other purposes, such as to take advantage of trade discounts or to finance other assets.

Revolving ABL facilities are sometimes structured with two tranches that each share a senior lien on the collateral but have different repayment priorities. In this structure, the senior tranche is often referred to as the first-out tranche while the junior tranche may be known as the last-out tranche. As the name implies, the first-out tranche is senior to the last-out tranche with respect to repayment and receives all principal payment s until the first-out balance is fully repaid, after which principal is applied to the last-out balance. Although the structure may vary, the last-out tranche is typically disbursed all at once with n o repayment required until the loan matures or the collateral is liquidated. The last-out tranche provides additional financing to the borrower by allowing a higher overall advance rate while the lender benefits by receiving a higher rate of interest on that tranche.

A revolving ABL facility may also be structured using a second-lien loan to provide additional leverage. A second-lien loan is similiar to a last-out tranche in that it is subordinate with respect to repayment, but does not share a senior lien. A second-lien lender's interest is typically governed by an inter-creditor agreement that gives the first-lien lender greater control with respect to the collateral.

Term Loan

Banks frequently make term loans to ABL borrowers. Term loans commonly finance capital expenditures with the financed assets securing the loans. In ABL financing, however, term loans may be part of a large, structured financial transaction that combines ABL with other secured or unsecured debt.

Risks Associated with ABL

From a supervisory perspective, risk is the potential that events, expected or unexpected, will have an adverse effect on a bank's earnings, capital, or franchise or enterprise value. The OCC has defined eight categories of risk for bank supervision purposes: credit, interest rate, liquidity, price, operational, compliance, strategic, and reputation. These categories are not mutually exclusive. Any product or service may expose a bank to multiple risks. Risks also may be interdependent and may be positively or negatively correlated. Examiners should be aware of this interdependence and assess the effect in a consistent and inclusive manner. Refer to the "Bank Supervision Process" booklet of the Comptroller's Handbook for an expanded discussion of banking risks and their definitions.

The primary risks associated with ABL are credit, operational, compliance, strategic, and reputation. Price and liquidity risks may also be applicable to the extent the bank syndicates or sells ABL loan s. Refer to the "Loan Portfolio Management" booklet of the Comptroller's Handbook for detailed discussions regarding the role of price and liquidity risk in commercial lending.

Credit Risk

Credit risk is the most significant risk associated with ABL. An ABL borrower may not be as strong financially as other commercial borrowers, may operate in a highly volatile or seasonal industry, or may be experiencing rapid growth. Characteristics of higher default risk, such as high leverage, erratic cash flows, limited working capital, and constantly changing collateral pools, are common with ABL borrowers.

If properly controlled, ABL can result in lower losses in event of default when compared to other types of lending. ABL's reliance on controls and monitoring, however, can pose higher risk when the facility is not properly underwritten, structured, and administered. Credit risk can be posed by a borrower's inadequate accounting and inventory control systems or poor credit and collection practices, fraud, the failure of a major customer, inaccurate collateral valuation or lack of marketability, prior liens, and other factors described in this booklet.

1See 12 USC 1464(c)(2)(A) and 12 CFR 160.30. Small business loans include any loan to a small business (defined in 13 CFR 121) and any loan that does not exceed $2 million and is for commercial, corporate, business, or agricultural purposes. See the definitions of "small business loans and loans to small businesses" and "small business" in 12 CFR 160.3.

212 CFR 160.3l(a) provides that if a loan is authorized under more than one section of the Home Owners' Loan Act, an FSA may designate under which section the loan has been made. Such a loan may be apportioned among appropriate categories.

312 USC 1464(c)(2)(B). This statute generally limits nonresidential real property loans to 400 percent of the FSA 's capital.