How Investors Can Increase Their Return on Equity

by Charles V. Lemmon

A. The Premise:

An asset-based financing structure can increase an investor’s return on equity.The primary advantages to a buyer of utilizing an Asset Based approach to finance an acquisition over one of the more “conventional” approaches, such as borrowing under existing bank lines and/or using long term third party funding include:

  1. Higher leverage is permitted.
  2. A lower cash investment is required.
  3. The operating company maintains its flexibility with cash.
The reason for these advantages is perhaps best explained by considering the conceptual distinction, from the point of view of the lender, between an Asset Based Approach to lending and a “Conventional” (also known as “Cash Flow”) Approach. This distinction is represented in the chart below. Conventional Approach vs. Asset-Based Approach. This distinction is represented in the chart below.

Conventional Approach vs. Asset-Based Approach

Type of Loan Lender’s Primary Protection Resulting Characteristics
Conventional (or “Cash Flow”) Cash Flow of Borrower Viability Loan Amount is tied to a multiple of expected Cash Flow Viability Low Leverage Amortization Schedule
Asset-Based Assets of Borrower Viability Loan Amount tied to Liquid Value of Borrower’s Assets Viability Lender takes a Security Interest in Assets in a Borrowing Base Low Leverage requirement and Amortization Schedule Waived

In the Conventional or Cash Flow Approach to lending, the lender’s protection is primarily in the cash flow of the entity being financed. The lender therefore ties his loan to the expected cash flow of the borrowing entity or of the entity guaranteeing the loan. This means that the lender will require a history of stable cash flow and will lend an amount representing a conservative multiple of that proven cash flow. A rough rule of thumb, for instance, is a multiple of 2 to 3.5 times the proven cash flow. As an added measure of precaution, the lender in a conventional lending package will require an amortization schedule (usually tied to the cash flow, of 3 to 5 years, sometimes longer) and a low leverage ratio (the rule of thumb generally being under a 2 to 1 ratio of total liabilities to equity).In the Asset Based Approach to lending, on the other hand, the lender assumes a different orientation. The lender bases its protection on the assets rather than the cash flow of the borrowing entity. Therefore, rather than tying the amount of his loan to the cash flow or to the leverage or to the amortization capability of the borrower, the Asset Based lender ties his loan to the liquid value of the assets (forming the “Borrowing Base”) of the borrowing entity. Furthermore, the lender maximizes that liquid value by taking three steps: 1) the lender takes a security interest in the assets of the borrowing entity; 2) the lender establishes a lending formula on the basis of the liquid value of those assets, for instance 80% of accounts receivable and 50% of inventory; and 3) the lender obtains information on a daily and/or weekly basis as to the level and nature of those assets and the entity’s borrowing needs. Under this system, because the loan is protected by the assets of the company, the lender need not restrict his loan to a conservative multiple of cash flow, there is no need to require an amortization schedule or seasonal clean up, and there is no need to require low leverage.In selecting between an asset based package and a conventional approach to finance an acquisition (either through borrowing under an existing line or through a long term, third party loan), the buyer must carefully consider the fundamental trade offs, which are summarized in the following two sub sections.

B. Borrower’s Benefits in an Asset Based Approach:

There are numerous benefits that can be realized by using an Asset Based loan to completely or partially finance a merger or acquisition/divestiture. Six of the most obvious benefits are:

  1. Lower Initial Investment: By utilizing an Asset Based Package, leveraged on the assets of the entity being acquired, a buyer can generally minimize the initial cash investment. The reason here is two-fold. First, the assets of the acquired entity frequently will provide a greater borrowing availability than will a conservative multiple of the acquired entity’s cash flow. The greater the borrowing availability, the less equity investment needed. Second, capitalization of the acquired entity will not be constrained by low leverage that is normally required in a conventional bank loan.
  2. Cheaper Than Equity: The higher leverage permitted under the Asset Based-Approach will normally provide a better return on the investor’s equity than would a conventional financing approach. For example, consider a company doing $25 million in sales, on assets of $10 million, and with internally-generated liabilities (e.g., trade debt and accruals) of $2.5 million. This leaves $7.5 million to be funded externally. Assume an EBIT (Earnings Before Interest and Taxes) of 10%. It is likely that a conventional lender will require a leverage factor (total liabilities to equity) of no greater than 1:1, but an Asset Based Package might readily permit a 3:1 leverage factor. You can see from the chart shown at the end of these benefits, how the Asset Based Approach provides the better return on equity, even if the stipulated interest cost were 2% higher (e.g. 10% vs. 8%).
  3. May Enable Higher Sales Generation: Furthermore, an Asset Based Approach would also be less expensive than a conventional approach, if the conventional approach could not comfortably provide for growing working capital needs. For instance, if a company’s growth in sales were in any way constrained by availability of working capital, to the extent an Asset Based Package could provide for the incremental working capital needs to field that growth, the Asset Based Approach would almost inevitably be the less expensive route even if it carried a higher interest cost. In the example below, a 2% higher interest cost on $5 million in borrowings would represent $100,000 of incremental interest cost per year. At a pre tax return on sales in the neighborhood of 10% the company need generate only $1,000,000 ($100,000 ÷ 10%) of incremental sales, or 4% higher sales volume ($1 million/$25 million) to pay for the higher interest cost. (Actually, the incremental sales required to cover the higher interest rate would be even less than 4%, as the marginal return on incremental sales is greater than the average return on sales.)
  4. Maintenance of Debt Capacity: To the degree that an Asset Based Package for an acquired entity requires a smaller initial investment and may eliminate the need for a parental guarantee of a loan that might otherwise be required, the financing of an acquisition can be completed without calling upon the debt capacity of the buyer.
  5. Future Operating Flexibility: In any acquisition situation there is a high degree of uncertainty. The buyer can never be sure as to whether the merger will result in a higher sales level due to the hoped for synergy of the new combination, or lower sales due to the change in ownership and adverse customer reaction. Consequently, it becomes essential that a maximum amount of borrowing flexibility be available to meet both the positive and negative contingencies. The Asset Based Finance Approach provides such flexibility through three characteristics. One, as mentioned above, it generally provides a greater borrowing availability than the conventional approach. Two, the borrowing availability is geared to the level of accounts receivable and inventory, so that the borrowing base generally rises and falls with the sales level. Hence, increased sales generally become self funding. And Three, the borrowing availability is “evergreen,” that is, unlike a term loan or conventional loan, there is no amortization or seasonal clean up requirement.
  6. Efficient Use of Cash: In the Asset-Based Approach to financing, the borrower is borrowing at any time only and exactly what he needs. This, in fact, can be established on a daily basis, as opposed to a conventional term loan where take-downs or pay downs are on a quarterly or monthly basis, frequently on a pre structured schedule. Hence, with an Asset Based Package, the borrower pays for only those funds he uses, on a day to day basis. Furthermore, there are no compensating balances required.
Balance Sheet
($Million)
Conventional Approach Asset-Based Approach
Total Assets $10.0 $10.0
Internal Liabilities 2.5 2.5
Bank Borrowings 2.5 5.0
Total Liabilities 5.0 7.5
Equity 5.0 2.5
Equity & Liabilities 10.0 10.0
Income Statement
($Thousand)
Sales 25,000 25,000
EBIT (@10%) 2,500 2,500
Interest on Borrowings @8% 200 @10% 500
Pre-Tax Profits 2,300 2,000
After-Tax Profits (@60%) 1,380 1,200
1,380/5,000= 1,200/2,500=
Return on Equity 28% 48%

C. Possible Concerns with an Asset-Based Approach:

Frequently, a potential Asset Based borrower may initially raise concerns that would dilute the advantages of an Asset-Based loan. Several of the most commonly raised issues and their explanations are as follows:

  1. Cost: The cost of borrowing under an Asset Based package generally runs 1% – 2% higher than under a conventional lending package. This 1% 2% reflects the higher cost associated with the lender’s need to monitor the asset values of the borrowing entity. However, despite the apparent higher cost of the Asset Based Approach, it will probably still be the least expensive means of financing the acquisition, as discussed under Benefits #2 and #3 above.
  2. Impact of Security Interest on Trade Creditors: In only a very few industries are trade creditors sensitive to security interests. Trade creditors are generally looking at their customers not on a liquidation basis; but instead, as a going concern. They are far more concerned, therefore, about the continuing viability of customers and their ability to pay on a timely basis. Suffice it to say that the buyer generally need not be concerned with the impact of liens on his assets as much as with the negative impact the acquisition may have on the viability of the acquired entity, and its ability to keep trade debt current by maintaining sufficient borrowing flexibility.
  3. More Frequent Information Required: Under the Asset Based Approach, a lender will reasonably request continuous updated information as to accounts receivable, inventory, and cash collections. Most corporate entities of any size generally not only have this information but also have it fully computerized. Consequently, a lender can normally “plug in” its computer system to that of the acquired entity’s, so that the borrowing entity can submit this information to the lender with little or no additional cost or time.

D. Asset-Based Lending Guidelines:

Not every acquisition situation lends itself to an Asset Based Financing Approach, for occasionally the nature or the size of the assets of the borrowing base do not provide sufficient liquid value upon which to structure an Asset Based package. The following provides a “rough rule of thumb” guideline as to when an Asset Based package generally can be supported. There are two standard criteria: demonstrated viability of the acquired entity and sufficient liquid value in the borrowing base.

1. Viability: Generally, a clear cut record of historical profitability or a demonstrated turnaround with positive cash flow (earnings plus depreciation) are sufficient for an initial indication of viability.

2. Liquid Value of Borrowing Base: There are two general issues regarding the borrowing base. These are qualitative and quantitative. Concerning the qualitative aspects, a lender is first interested in the nature of the accounts receivable, inasmuch as receivables generally carry the greatest liquid value. If the accounts receivable meet the following five qualitative criteria, they will generally provide a strong borrowing base.

a. Corporate Receivables: The receivables must be corporate rather than consumer receivables.
b. Sales on Normal Trade Terms: The borrower must be selling on “normal trade terms,” e.g., 30 or 60 day terms.
c. Diversified Customer Base: The customer base of the borrower must be somewhat diversified.
d. Domestic Receivables: The majority of the receivables must be from domestic corporations.
e. Unqualified Collectibility of Receivables: The terms upon which the borrower’s sales are made must be final. That is, they should not be subject to contracts, expressed warranties, consignment privileges, or dependent on the continuing existence of the borrower for their collectibility.

If the receivables meet these five qualitative criteria, they will probably provide a good borrowing base. The next issue then becomes one of quantitative coverage. There are three quantitative guidelines

1. Receivable Coverage: In general, half the total Asset-Based package must be covered by the liquid value of the accounts receivable borrowing base. For a rule of thumb, multiply 70% times the book value of accounts receivable to determine their liquid value. (There can be a number of exceptions to this rule, however.)

2. Other Coverage: There must be enough liquid value in the other assets to cover the rest of the borrowing needs.

3. Minimum Size: The smallest package a lender will generally consider in structuring an Asset-Based acquisition financing is $1 million. There is virtually no upward constraint.

If an entity to be acquired has an accounts receivable base that meets the above five qualitative criteria, and the proposed acquisition structure permits the above three quantitative criteria to be met, there is a high probability that a lender can structure an Asset-Based package to enable the buyer to purchase the acquired entity.

E. Conclusion

Many financial buyers are structuring their acquisitions today with financing assistance from asset-based lenders. In this way, smart investors are increasing their return on equity. C.V. Lemmon & Co. is skilled to evaluate, suggest, structure, negotiate, and complete both a comprehensive and customized Asset-Based financing package. Clients pay C.V. Lemmon & Co. for results.

Charles V. Lemmon is President of C.V. Lemmon & Co., Inc., a private M&A advisory firm in Dallas, Texas. Charles Lemmon can be contacted by telephone @ (214) 207-9694 or by e-mail at cvlemmon@cvlemmon.com.