Loans that save troubled companies - asset-based financing

Nation's Business, August, 1984 by Robert I. Goldman

WHEN A COMPANY runs into trouble, banks and suppliers come clamoring for their money. In the past, such a crisis usually meant selling off valuable assets to satisfy debts or filing for protection under Chapter 11 of the federal bankruptcy code. Today, however, a growing number of companies are electing to use asset-based financing.

The ability to stay in business through alternative financing can sometimes produce extraordinary results. Although Ideal Toy possessed the marketing rights to Rubik's Cube, the company was on the verge of bankruptcy. If it had not been able to borrow against its accounts receivable and its inventory to get working capital, the company would not have been around to enjoy the soaring sales and profits that this product generated. Ideal was subsequently sold to CBS for a very handsome sum.

In asset-based financing, loans are made on a secured basis against the company's tangible assets, such as accounts receivable, inventory, plant and equipment. Lower interest rates and availability of larger loans are among the principal reasons for the emergence of this financing mechanism. Asset-based lenders include commercial finance companies and the secured lending departments of banks, which in recent years have significantly expanded their activities.

Unsecured credit would be preferable, of course. But troubled companies having difficulty meeting traditional bank loans usually need additional money to get back on their feet. To obtain the money, they must often restructure their debt and offer a substantial amount of unencumbered assets as loan collateral. They must also win the cooperation of existing lenders and perhaps major suppliers.

The bank, meanwhile, is obligated by government regulations to establish reserves against a potential loss on unsecured loans. To get out of the loan, or at least reduce its size, the bank usually encourages borrowers to sell off assets and apply the proceeds to the loan. If this is not feasible, it generally seeks to collateralize the unsecured loan under a new agreement with covenants that may establish net worth and working capital minimums, plus restrictions on capital expenditures, salaries and payment of dividends. BOTH THOSE approaches, designed with only the bank in mind, will probably leave the company worse off than before. But suppose a new lender steps in with fresh funds, secured by the same type of collateral the bank wants to use to satisfy its present loan?

This asset-based financing has saved many companies that otherwise would have been forced out of business, because it can often generate enough funds for both traditional loan payments and added working capital. Most creditors will listen to any new financing plan that enhances their chances for repayment and spares them liquidations, which generally involve large write-offs. And if the company's problems are eventually resolved, their cooperative attitude could help them regain a valued customer. The troubled company therefore has a certain degree of bargaining power.

When a lighting fixtures manufacturer began losing money and its loan became classified, the bank shifted the account to its own secured-lending department. Despite new management and a realistic restructuring plan, the company did not have enough collateral to support the bank loans and also provide essential working capital. Owners of the company came up with personal funds, primarily obtained through second mortgages on their homes, to support a higher level of credit. The bank matched these funds, and the added working capital bought time for a turnaround. IT IS NOT UNUSUAL for one asset-based lender to step in where another wants out. Often, independent commercial finance companies, whose stock-in-trade is trouble, are more venturesome and flexible than the secure-lending arm of a bank. Generally, a company that looks around should be able to find a replacement for a reluctant lender.

Even when the financial problem is relatively mild, the bank may want to get out of its loan because is has lost faith in the company's performance. Another lender can then step in to replace the bank, dollar for dollar, if there is sufficient collateral. If additional funds are needed, the new lender can devise a broader or more creative package of assets to provide adequate cash flow.

Selling the company may be inevitable, however. A new lender could speed the process by financing a leveraged buyout, in which the buyer finances the purchase largely by borrowing against the acquired company's assets.

A dramatic example of a leveraged buyout that turned into a turnaround is the Whitin Roberts Company of Charlotte, one of the country's oldest manufacturers of textile machinery.

When a downturn hit the textile industry in 1981, Whitin Roberts suffered significant losses for two successive years. An investor who owned a small textile machinery plant in New Hampshire offered to buy the operation from the parent company, White Consolidated Industries. The purchase price was met by arranging a $4 million loan on the accounts receivable, inventory and equipment of Whitin Roberts, plus loans against its real estate.