Seeking financing? consider asset-based loans: two bankers explain why, when the economy is down, asset-based lending is up.

• Author: Kreft, Ira J.
• Position: Financing for Growth: Special Section

Many financial executives considering financing options in today's market are turning to asset-based loans, finding them to be versatile and cost-competitive debt instruments that provide increased flexibility over other alternatives. Yet, despite these clear advantages, some still view asset-based loans as "the last resort for commercial borrowers," or imagine them to be an expensive financing option that imposes an excessive reporting burden.

The reality is quite the contrary, as asset-based loans provide a borrower with enhanced operational flexibility through all business cycles and, with the ubiquity of computers, reporting has become efficient and non-burdensome. Since asset-based lenders have the benefit of liquid assets to provide protection, they place less reliance on the borrower's operating performance, a condition reflected by the relatively small number of covenant requirements attached to their loans.

By contrast, cash flow loans typically come with stringent -- sometimes highly restrictive -- financial covenants, such as a leverage ratio maximum, fixed charge coverage, interest coverage and minimum EBITDA (earnings before interest, taxes, depreciation and amortization). These requirements can put significant stress on a company's ability to operate freely, especially during an economic downturn.

Asset-based lenders are concerned with a company's asset coverage, liquidity and, to varying degrees, the borrower's ability to service its debt. The leverage ratio itself is not material.

Demand for asset-based loans rising

Many factors have spurred the recent appeal that is driving the demand for asset-based loan structures, but three stand out.

1. The widespread presence of aggressively structured cash flow loans completed in the late 1990's. During this period, when many companies were executing leveraged buyouts, acquisitions and rollups, banks were delivering highly leveraged cash flow loans, which were based on a multiple of the borrower's trailing earnings. The shortcoming of this lending strategy was that many of these loans depended on continued improvement in the cash flows of these companies, as well as a strong capital markets environment, to provide an exit for the borrowers and lenders. Neither of these conditions held true, with the result that many of these companies are now struggling to meet covenants or to fulfill maturing debt obligations.

2. The economic slowdown's effect since 2001 on companies of all types, but...