An asset based loan (“ABL”) is often the financing of choice for retail borrowers – and for good reason. In its simplest form, an ABL is a credit facility, usually in the form of a revolving line of credit, the availability of which is based exclusively on the value of a company’s “eligible” assets. In the retail context such eligible assets are, for the most part, the company’s accounts receivable and inventory. There are numerous advantages of an ABL over a traditional loan: an ABL is typically easier to obtain since it is based on a company’s assets and not cash flow; an ABL provides ready cash to support liquidity needs; an ABL often includes flexible borrowing and repayment terms and less restrictive financial covenants; and, particularly beneficial to retailers, an ABL commonly accounts for seasonality and allows more borrowing during periods of slower sales. The borrower in the ABL is required to submit a “borrowing base certificate” on a monthly or even weekly basis, which details the current inventory levels (and accounts receivable), deducts certain amounts such as letters of credit, applies the applicable borrowing percentage (usually a percentage of the net orderly liquidation value (“NOLV”) of their inventory), and the result is the amount of cash available. In addition to borrowing base certificates, the company is also subject to field examinations and inventory appraisals conducted at least once a year, if not more often, which determine the percentage applied to their borrowing base calculation.
When retail sales are booming, the company and the ABL seemingly work like a well-oiled machine: inventory is rapidly converted to cash, which is then used to pay the loan and fund purchases of new inventory, which, in turn, increases the amount the company can borrow at any time, commonly known as the “borrowing base”. A difficulty arises, however, when one of these necessary steps is obstructed – which is exacerbated in the bankruptcy context. There seems to be an inherent conflict between the fluid nature of retail inventory flow and the fixed nature of a borrowing base. It would certainly be maddening if American Express restricted my credit limit on a weekly or daily basis depending upon what was, or was not in my closet at any given time.
When the amount you can borrow depends upon your inventory levels, the retail company is incentivized to keep inventory levels high through new inventory purchases, which, in turn, often requires drawing cash from the credit facility. This vicious circle illustrates what is colloquially referred to as the “ABL Trap”. Even when it may be in the company’s best interest to reduce or hold off on inventory purchases, the selling of inventory without replenishment will lower its borrowing base and increase the risk of an overadvance – that is, when the amount borrowed exceeds the calculated availability.