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We've noted the strong and steady increase in the use of asset-based lending over the last few years, as well as an increase in deal sizes. What are some of the drivers behind these trends?

Hayes: There has been a renewed interest in ABL from some of the larger banking institutions that had previously devoted fewer resources to this type of lending.

Ettershank: Certainly, more invoice financiers are looking to provide ABL solutions. Market knowledge and understanding has broadened among customers, prospects and introducers.

Brewer: ABL has become a fully integrated and accepted capital markets product. It is no longer only the province of last resort lending. It is also not confined to small- and mid-market deals. We see it far more in larger transactions and in circumstances where historically it may be have been avoided because ABL was considered a product for companies that had some level of operational or financial difficulty.

Clark:We have certainly seen a definite rise in multiple tranche debt deals in which asset-based lending is a component of an overall credit facility that includes a revolving loan piece, a term A loan piece, and a term B loan piece. The asset-based lending component of that package is the revolver piece of these larger transactions. That has been driven by changes in the US economy from a manufacturing base to a service-oriented economy.

Lammas: ABL has been characterized by an appetite for increasingly large deals - $1bn deals have been closed in the US. Europe lags behind, but we anticipate £100m plus becoming increasingly commonplace as the syndication market establishes itself.

What began as a financing alternative for companies in trouble is more widely considered an acceptable tool for  healthy

companies looking to improve cash flow. What are some of the reasons for the change in attitude towards ABL?

Brewer: There is no longer a negative implication that if you borrow from ABL lenders you are unable to obtain financing from cash flow lenders. There is a recognition that ABL lenders are not just lenders of last resort, and that for lots of companies it makes more sense because there is more flexibility based on fewer financial covenants and more flexibility if there are performance issues in the future. For a company that needs to raise meaningful money and wants to avoid many financial covenants that could be tripped, one way is to put together a covenant-friendly deal with some sort of second lien high yield offering, together with an ABL senior loan product. This is popular alternative to what might have been done a few years ago.

Lammas: The right companies can raise more cash than from a traditional source by making the best use of giving away a full asset debenture. The facilities are very flexible - a mixture of revolving, evergreen facilities, and term debt, which is repaid through a more traditional capital and interest repayment profile.

Kahn: The great advantage is that companies that are growing can take the comfort that as their turnover grows their facilities will grow. That makes it easier for them to plan ahead and create a future model for what their financing needs will be. Another advantage is that the loans revolve and are of a facility nature as opposed to term loans. The company does not have to manage its business in the face of looming repayment requirements. The disadvantage is that if turnover decreases then the company may have reduced facilities as available security diminishes.

Clark: The shift to cash flow deals has resulted from the lending structure, which involves the asset-based lender combining with an investment

fund to provide financing not only against the hard assets of the borrower but also against the enterprise value of the borrower. In this structure, the investment fund steps in and lends money against intangible assets such as intellectual property, goodwill and foreign assets of the borrower. Also, many of the asset-based lenders in the late 1990s began participating with their banking affiliates in providing large liquidity for LBOs and MBOs. Many of the asset-based lenders are owned by banks which provide a steady stream of product for asset-based lenders. In addition, much of the marketing efforts of ABLs are now directed towards the LBO funds and private equity firms. These factors allow asset-based lenders to participate in cash flow loans in addition to their traditional form of tangible asset-based financing.

Ettershank: As far as we are concerned, ABL has always been an acceptable tool for healthy companies, and those with foresight made use of it. For example, we have a client who has now been using our facilities for 15 consecutive years. Their success and that of similar businesses has given this form of finance real credibility and enabled us to highlight the benefits, such as flexibility, improved management of working capital and suitability for growing companies.

What factors have driven the surge in larger companies seeking credit from asset-based lenders?

Ettershank: Large companies now see ABL as a credible alternative form of finance, and a real alternative to securitization that is easier and cheaper to implement. Use of ABL has also been fuelled by the credit squeeze among fallen angels.

Kahn: Ultimately it is down to a combination of better understanding of what asset-based lenders can offer and the fact that comprehensive asset based lenders are financing more than just the receivables. Also, quite a lot of the leverage buyouts of five years ago are looking for fresh finance.

Brewer: In an ABL structured deal, credit is available regardless of economic cycles. There are also far fewer financial covenants - sometimes no covenants - giving borrowers much more flexibility as long as the collateral coverage is sufficient. In addition, there is a willingness to lend not only against the historic province of asset based loans - current assets, namely accounts receivables and inventory - but also to lend against fixed assets like property, plant and equipment. The growth in appraisals from third parties has substantially aided those values. Borrowers also have the ability to work with lenders that remain committed and a lot more flexible, even if the borrower goes through a down-cycle, as long as the company has sufficient assets to support an ABL structure. Lenders that have offered loan transactions in a cash flow structure have not been as patient with borrowers as asset-based lenders, especially given financial difficulties that have occurred in the last few years. The marketplace is now aware of that, and larger companies are turning to ABL.

Hayes: We have seen a number of transactions in which larger companies have formed joint ventures with other companies, with each contributing assets into the joint venture. The participants typically do not want to use their own credit, either in the form of direct borrowings or guaranties. As a consequence, the joint venture - which typically has a lower credit rating than its owners - seeks an ABL. Also, from time to time, larger companies desire to segregate certain assets into leveraged non recourse subsidiaries, which then are funded via ABLs.

Clark: There is also a macroeconomic shift going on. The traditional mid-market category of finance has grown over the past few years to include larger companies. The mid- market is the traditional market for ABL, but over the last five years the mid-market has grown along with the US economy to include larger deals which are not being financed by traditional bank debt.

Demand for the ABL structure has created a competitive lending market. Surely that must benefit borrowers, when it comes to negotiating fees, pricing and covenants? 

Hayes: Fees, pricing and covenants on the transactions that I have seen have improved somewhat for borrowers over the past few years. Certainly, covenants are more carefully tailored to the specific borrower rather than being standard boilerplate. Overall, increased competitiveness has benefited borrowers. However, it is important to note that the terms of asset-based loans vary considerably, both from industry to industry and among companies in the same industry. As a consequence, the additional competitiveness and liquidity in the market today will not benefit all borrowers equally. 

Clark: The terms of ABL loans are tied to the terms that are provided to borrowers by the term B loan lenders which are part of the overall credit facility that I described earlier. The fees, pricing, and covenants of these deals are found in the pricing gap between low cost bank debt financing and higher cost mezzanine debt financing. Asset-based lenders fit nicely within these two levels of return in the credit market. Over the last five years there has been intense competition within that space as numerous new players, such as investment funds, arrive. It is these funds and their institutional investors that comprise approximately 70 percent of capital in the loan market today. This is a big advantage for borrowers because the number of investment funds looking for transactions combined with asset-based lenders looking for transactions means the pricing for mid-market debt financing remains very competitive and beneficial to borrowers.

Lammas: To an extent I would agree that borrowers benefit from competition, however in some instances the competition leads to deals with weak structuring - not by us I hasten to add. We stick to our principles when doing these transactions. But for new 

market entrants, competing in a factoring and asset-based lending market of 70+ players, who are seeking to build market share, there is a temptation to compete aggressively on price, risk and structure. This level of competition can be destabilizing and lead to bad debts. It will be the consistent performers in the industry who will ultimately prevail. 

During due diligence, analyzing the management team of the borrowing company has increased in importance. Why? 

Oldham: Management due diligence has always been important. But as asset-based lenders have evolved into cash flow lenders, at least in part, it is particularly relevant today. Ultimately, it is management that repays the loan, because it is management that sees to the execution of the business plan, creating sales, turning inventory into accounts receivable and accounts receivable into cash and cash into more inventory and loan repayment. This process includes everything from sales and marketing to finance and accounting. Management's history and track record at the subject company and predecessor entities can be of either great value or concern, depending on the results of research performed. 

Has the process of assessing management itself changed? 

Oldham: The old fashioned 'shoe leather approach' of directly checking out owners and managers via audits and interviews is still prevalent and prudent. But performing additional outside background investigations is a routine part of the due diligence performed today. This is a big difference compared to the methods used just 10 years ago, when such background investigations were performed on a deal-specific basis at best. 

An important part of asset-based lending is tracking company performance and working with the borrower going forward. What are the advantages

of this hands-on, close-monitoring approach to lending?

Ettershank: Asset-based lenders understand their clients' businesses because they see their trading performance daily. It is therefore possible to track trading patterns and the current or future cash flow impact. We are not waiting two or three months for the next trading review or financial report to inform us of changes in performance; we will already have anticipated the impact, discussed it with our client and started dealing with the emerging issues. 

Hayes: There is an obvious advantage to the lender in that it will be aware of potential problems earlier rather than later. But maybe more importantly, there is also a benefit to the borrower of having another experienced person (that is, the ABL lender) looking at the borrower and its plans. It is human nature for the management of a company to have a strong belief in their company, and occasionally that strong belief can blind management to potential difficulties. Obviously, no borrower likes to be told that there may be problems on the horizon, but many times an independent view can save the borrower from losses associated with potentially flawed analysis. Furthermore, close monitoring by the lender puts it in a position to react quickly when a borrower needs additional credit to take advantage of an opportunity. An additional advantage is that asset-based lending can provide efficient cash management services to smaller companies that may not have adequate staff to handle cash management internally.

Brewer: If there is careful and consistent monitoring by a company's asset-based bank group, adjustment to the borrowing base and availability will be gradual and measured. It is the best way to avoid surprises to the borrower. At its very core, ABL is about careful collateral monitoring. If asset-based lenders can understand the collateral and its value, it will enable them to take an inordinately flexible approach to the borrower's operating requirements and its business.

Successful collateral monitoring  has a wonderful benefit to the borrower. It provides certainty about how much financing will be available, compared to financial covenants where companies can work hard to control their performance but may fall subject to market shifts and trends that adversely affect their financing. If collateral is carefully monitored, a lender can afford to proceed with very few financial covenants. Also, if it is the first time a particular company has done an ABL transaction, it may lead to them doing a better job of managing their own receivables and inventory, which is an added benefit. 

Clark: In the traditional sense, the close-monitoring approach of the asset-based lenders allows borrowers in financial distress to receive financing against the liquidation value of their collateral. In other words, the company balance sheet may be in bad shape with excess debt and losses, however, the asset-based lenders can lend against the hard asset collateral (namely, receivables, inventory and equipment) provided asset-based lenders can obtain first priority lien against such assets. The close monitoring approach of these assets allows asset-based lenders to lend to companies which otherwise would not obtain traditional bank financing.

One of the interesting asset groups being considered by asset-based lenders is intellectual property. What difficulties are involved in accurately evaluating the market value of intangible assets? 

Kahn: Since each brand name is different, these can be difficult to benchmark. If you take inventory or plants and machinery, you know the price at which it will sell because valuers with experience selling particular pieces of inventory tell you so. That doesn't mean that an intellectual brand cannot be lent against, it just needs more cash flow generation techniques to value it, and is therefore a more sophisticated valuation. While plant, machinery and inventory valuation is typically done by valuers, brand value is more likely to be done by accounting firms. 

Brewer: Simply put, if you lend against intellectual property it can have less value in the future. So what do you do? Well, there are third party experts now who are willing to provide an appraisal on the value of well-known trademarks. There are definitely transactions being done with a component of the borrowing base allocated to IP, particularly trademarks. The issue is this: if you close the deal and the company does not perform well, unlike collateral which tends to keep a fairly constant value or if it drops can be monitored closely, monitoring a deterioration of a trademark based on a company that has not performed well is something people need to be thoughtful about. Some asset based lenders have addressed that dynamic by amortizing the portion of the borrowing base attributable to the intangible asset. With the passage of time, the portion of the borrowing base that is based on an intangible asset reduces, so if the companies performance deteriorates, you put less value on the trademark at that time and protect against further deterioration. There is also more careful and thorough valuation of patent technology and the ability to license it. If you have the right expert, you can be successful lending against that as well. 

How can lenders avoid exposing themselves to overvaluing a brand name or a particular patent, for example? 

Kahn: One critical issue is to look at the ownership of the brand, because there is a lot of sub-branding and licensing done. You have to see whether you have propriety rights over the brand, and what may happen in an insolvency event. For example, you may have the license to sell Ralph Lauren towels, but that license may terminate on insolvency. When you actually own the brand, you can get much more value from it. Lenders need to carefully ascertain what the title of the brand is and what happens under certain circumstances. 

Hayes: This is certainly a difficult issue, because of the potential for quick obsolescence of intellectual property. Two points I would make: first, having a large and varied number of patents or brand names

is helpful so that the risk is spread over a variety of intangible assets. Second, a careful analysis of any outstanding legal challenges to material intellectual property is important. 

Clark: Intellectual property has become a critical component to the new structure of lending that has emerged in the past few years. The term B loan lender is the lender within the lending group which makes the judgment as to the value of intellectual property as part of the overall enterprise value of the borrower. With this new structure, the exit strategy for the lender group has become a sale of the company (since part of the collateral for the lending group's security package will be a pledge of stock of the borrower to the lenders). As such, these loans become almost like a venture capital or equity style of investment where intellectual property becomes a key component of overall value. Assessment of value with respect to brand name and patents will be made by third party valuators much like any venture capitalist would assess such an asset. 

So what does the future hold for lending against intangible assets? 

Lammas: We have provided loan facilities based on brand value, but you need expert advice prior to making such a decision. Rather than looking at it simply as an ABL against the brand value we look at it more analytically as an area of cash flow lending, in which we are making a judgment about a company's overall business value. In these cases it's about how asset based lenders can adopt the best practice of cash flow lending techniques and utilize them in a broad, sophisticated package. 

Ettershank: It is critical that the lender understands what he is valuing, in terms of its potential liquidated value. We are secured lenders - we lend against assets with a defined measurable value - so we need to look cautiously at intellectual property and its transferability and robustness before agreeing to place real value against it. 

Kahn: Currently, a lot of asset-based lenders will take brands as side collateral and comfort. But as 

the market becomes more sophisticated and competitive, the time will come when asset-based lenders will regularly lend against brands, once they see that they can get value from them.

Let's turn our attention to the geographic spread of the ABL market. Obviously, this form of financing has had a massive impact in the US. But what factors are holding back companies in Europe from jumping on board? Or is it just a matter of time before they do?

Lammas: ABL in the US was driven by VC Sponsors at a time when traditional providers pulled up the drawbridge as a result of over stretched lending, lending too cheaply and with too much leverage against EBITDA. In Europe so far it has been more difficult to match that growth, as the industry is still in its infancy, there are few true ABL players and bank debt provision has so far been successfully provided by a very small number of dominant banks keen to maintain market share.  The ready availability of traditional bank debt from regular high street retail banks in the UK is cheap and can also be highly leveraged - they know the product, have access to market and can make up their margins through cross selling channels. It will be interesting to see if this traditional, aggressive approach from the banks will run out of steam at some point in the future, if their returns are poor compared to the bad debts they will take. If it doesn't, traditional bank debt will remain competitive owing to its captive markets, and it will take longer for ABL to establish itself to the level achieved in the US. 

What about the European legal framework as it relates to rights over collateral in the event of insolvency? How does it compare to the favorable creditor laws in North America?

Brewer: Particularly with the new Article 9, the Uniform Commercial Code in the US is consistent in all 50 states. It works in a way that allows everyone to understand protection of their liens and gives them the ability to exercise rights or remedies against 

Clark: Europe is where the US was 10 years ago with respect to ABL; lenders are lending against the traditional ABL assets of receivables, inventory and equipment. ABL is a product that is legal intensive in the sense that the lender must be assured that it has a first priority lien over all of the assets forming the borrowing base for the loan. Lenders must also be assured that bankruptcy and insolvency laws are favorable to them so they can enforce security and collect sufficient proceeds from any realization of the borrower in order to get the loan repaid. In the US and Canada, these laws are well developed and familiar to lenders. The comfort level is very high for asset-based lenders when it comes to the legal environment associated with that type of financing. I do not have a lot of experience with European laws in this regard, however, I think that the same principles and comfort with lending laws need to be there in European jurisdictions to permit lenders to lend on a first priority lien basis and then enforce security if need be in a bankruptcy and insolvency situation. To the extent that such laws in Europe become more aligned with North America, I would expect that Europe would have more US lenders participating in credit facilities in Europe. 

Kahn: The different laws in Europe lead to a difficulty of priority for the lenders when a company gets into trouble. The ability to get clean legal title to the underlying asset is a key factor when assessing recoverability of the asset and hence the valuation. However, with local knowledge, you can normally find structures that work around it. There will be calls for uniformity of laws dealing with collateral and insolvency. But I think it will take a considerable number of years - over a decade - before anything will change. 

Brewer: There is a lot less history in bankruptcy and insolvency circumstances in Europe. The judges and the courts need to work to encourage asset-based lenders, for whom a major focus is the value of their collateral and the ability to preserve that value in bankruptcy and insolvency proceedings. That absence of a history is a bit of a problem in Europe. But once a history starts to develop, there will be more asset-based lending. That will be a gradual phase as Europe reaches a critical mass - then the floodgates will open. 

And where does Asia fit in?

Hayes: Continued interest by a wide variety of lending institutions will keep the market competitive, and many lenders will look for expansion and opportunities in Asia. Less developed countries that are seeking capital inflow will continue to develop certainty in their legal systems to encourage this type of lending. 

Brewer: In many of the developed countries in Asia there is a tremendous incentive to see the asset-based approach to lending. It makes good sense for economic growth, jobs and opportunities to implement policy objectives that make credit more available. But at present, the legal systems and frameworks in much of the Asian marketplace are not conducive to ABL. Still, as financial institutions continue to become more and more global, they are more intent on offering a common, beneficial product to their customers - regardless of jurisdiction. So although it might take a little longer, asset-based lending will come to Asia. 

So how do you see the ABL market taking shape in 2005 and beyond? 

Kahn: There will be a move to more comprehensive asset-based lending, with the inclusion of more assets to be financed. There will also be a move to larger deals and more cross border financings in the larger end of the market. Many of the main high street clearing banks will focus on the market and perhaps grow more competitive than they have

been in the past. So we expect the market to grow and to become more sophisticated. 

Clark: I see the market continuing to grow as more and more investment funds come into the market. What we have really seen in the past five years is that the debt finance market has reflected an overall change in the US economy from a manufacturing based economy to a service industries based economy, which has meant a shift from lending purely against hard assets to lending against hard assets combined with the distress enterprise value of the borrower. There is a lot of money in the marketplace chasing deals, so I would expect that growth in this area will continue in 2005 and beyond. 

Lammas: Overall we anticipate growth will accelerate, particularly with larger loans. Syndicates will increase as people become more comfortable with the credit processes of other lenders and legal documents become more boilerplate and less bespoke. When it comes to cross border syndicated lending, everyone is on a steep learning curve. The legal side can depend on the quality of personnel that each lender can muster, and their level of knowledge and expertise - which can be mixed.

Brewer: I expect the ABL market to continue to grow, and for that growth to be exponential. It is now a widely accepted form of financing as a capital markets product for all companies, including large companies. Because of the flexibility, particularly on the financial covenant side and other aspects, we are going to see more and more use of it in the US, and in Europe as well as in Asia. As people grow more comfortable about collateral valuation and the ability to protect their interest in that value in a bankruptcy and insolvency event, or another circumstance where they are exercising rights and remedies, we are going to see more growth. Some of that is affected by the fact that so many companies are multinational. If they have valuable assets, particularly with a predictable value, it is a magnificent form of financing.