The effect of COVID-19 on revolving lines of credit
May 7, 2020 | By Ed Gately, Managing Director
According to what we are seeing, the financial hardship resulting from the COVID-19 pandemic is driving some companies to convert their revolving credit facilities from secured cash flow-based to asset-based lines of credit. Asset-based credit facilities are applicable to businesses in retail, wholesale and general distribution, where high levels of inventory are more common.
The reasons for converting to asset-based credit facilities
We’re observing two reasons for this conversion:
- Fear of running afoul of covenants
When a company’s EBITDA (or (or earnings before interest, taxes, depreciation and amortization) drops below a certain level, it risks violating the terms of its cash flow-based revolving line of credit. We’re seeing companies take a proactive approach by converting to asset-based lending revolvers upfront, rather than waiting until they’re close to breaching their covenants.
- Need for liquidity
Asset-Based credit facilities typically provide access to greater liquidity because borrowing limits are based upon margined collateral rather than traditional financial metrics. They are also popular among companies experiencing high growth.
We believe there will be more conversions to asset-based facilities for some time—possibly over the next 12 to 18 months—until conditions normalize. Shelter-in-place orders have the potential to shape longer-term patterns, and even after those orders are lifted, we don’t think people will return so quickly to their old consumption habits in terms of what they buy, where they buy it, and how much they spend. Until businesses are able to fully rebound, we foresee more of them pursuing facility conversions.
Companies with asset-based revolvers are already drawing down on their credit facilities, borrowing to add cash to their balance sheets in order to make sure they have access to sufficient liquidity to weather this crisis.
The evolving terms of asset-based lending
Asset-based lending terms are evolving as a result of the physical and economic consequences of the pandemic, which are making it difficult to conduct inventory appraisals in order to assess the value of companies’ loan collateral.
After all, not only is it an unsafe environment for appraisers to physically perform assessments of inventory, but there’s also the question of timing: How do you appraise merchandise meant to be sold during a given season if it needs to be replaced with inventory for a subsequent season by the time you open for business?
Apparel is one example of merchandise affected by seasonality, though other types of merchandise, such as technology products and home appliances, are not exempt from seasonal and other considerations. Ultimately, the monetary assessment of inventory is based on the price at which the appraiser believes the retailer can liquidate the inventory.
What’s more, we are still at the early stages of this crisis, and we haven’t yet seen the full financial implications of this pandemic for most companies. Current levels of unemployment will affect consumer demand for some time, and, until the economy normalizes, liquidation values could be impacted.
There are three ways in which we see asset-based lending terms evolving:
- Lower appraisals
We expect monetary assessments of inventories—from consumer products to rental equipment—to decline across the board and reflect more conservative estimates.
- Higher loan pricing
Interest rates on asset-based lending have already risen by 75–100 basis points to reflect the current liquidity environment and increased credit risk.
- Cash provisions
Lenders are beginning to incorporate anti-cash-hoarding provisions into their asset-based lending agreements. These provisions are designed to preserve banks’ liquidity by ensuring that borrowers only draw funds for a need and deploy them accordingly.
In summary, the COVID-19 pandemic is triggering a conversion to asset-based credit facilities whose terms are evolving as a consequence of the economic environment. We can expect more to come.
Head of Asset-Based Finance
Mr. Gately specializes in formula-driven revolving lines of credit and term loans based on eligible assets including accounts receivable, inventory, equipment, and owner-occupied real estate.
- The COVID-19 crisis is triggering conversions to asset-based credit revolvers.
- Reasons include fear of covenant violation and need for liquidity.
- Asset-based lending terms are evolving toward lower appraisals, higher loan pricing and anti-cash-hoarding provisions.