Why lenders still love retail, bankruptcies and all

Asset-based loans are a safe and popular form of financing for lenders. But for distressed retailers it can be a “trap.”
Yujin Kim/Retail Dive

This story is part of Retail Dive’s “Money in Retail” series, which looks at how finance and financial firms influence retail operations.

In 2019, Barneys New York faced a familiar set of problems for department stores. It had been hit by price wars, e-commerce penetration, declining customer traffic and sales, and increasing rents. Many of its stores were unprofitable, and others were falling short of projections.

By June, revenue was down $34 million year over year, the retailer’s restructuring officer said later in court papers. In response to the sales skid, the lenders behind Barneys’ asset-based credit facility reduced the amount the retailer could borrow by $5 million. The move was meant to protect the lenders from losses. It also suddenly downsized Barneys’ operating funds.

A snowballing financial crisis followed that affected its stores, with crimped liquidity hurting Barneys’ ability to allocate merchandise. Products piled up in unprofitable stores while profitable ones couldn’t meet demand. As bills came due, Barneys also had fewer funds to pay off its vendors, who began slowing shipments and tightening credit. Things only got worse from there: bankruptcy, store liquidations, and ultimately a sale of the cherished retail brand to licensing conglomerate Authentic Brands Group.

As with scores of other retailers, Barney’s asset-based facility was a crucial form of financing. While executives tried to right the ship, the loan kept the company afloat. Until it didn’t.

For retailers, asset-based loans (ABLs in industry parlance) provide a flexible and often crucial form of financing. For banks and other lenders, they are a nearly risk-free investment vehicle — though some lenders are taking on more risk as competition in the space reaches a fever pitch.

Some observers say retailers in deep distress can face a perverse set of incentives from the ABL, which typically is tied to the value of inventory for retail companies. And while the loans may be the only lifeline for those trying to turn the business around, they can also encourage a retailer to continue racking up debt while their business collapses around them — a problem that can bleed out to suppliers.

In the worst cases, as retail analyst Philip Emma said, ABLs can provide retailers “the rope to hang themselves on.”

From loan of last resort to mainstream

Once seen as a loan of last resort, lenders and retailers alike have gotten comfortable with the ABL over the past two decades.

In an often painfully cyclical industry, ABLs can smooth out cash flows over the year and provide working capital. Because ABLs are secured and based on asset valuation, banks typically set far fewer restrictions on them, making them more flexible than other loan types.

In retail, borrowing levels are based largely on the estimated liquidation value of a retailer’s inventory. That’s how banks protect their loans: They don’t lend above the estimated liquidation value of a retailer’s total inventory. Those estimates have gotten precise over the years. Moreover, liquidating a retailer’s inventory is often more straightforward and predictable than the assets in other industries, which has helped make retailers the leading consumers of ABLs.

The financing can fund distressed retailers trying to pull off a turnaround. It can also fund startup retail and e-commerce companies, providing them with capital at a time of high growth and heavy cash use. ABLs can be used for daily operations like payroll and buying inventory. They can be used for capital investments like store refurbishments. Private equity firms have also made prolific use of the ABL, including to fund leveraged buyouts and to pay themselves dividends out of the retailers they own.

When retailers go bankrupt, asset-based loans are typically what fund their operations in bankruptcy, whether the company plans to reorganize, sell itself or wind down. In the court process, the loans take the form of debtor-in-possession (DIP) financing, often from a retailer’s existing ABL lenders, in what’s called a roll up. Even when a bankruptcy spins out of control, DIP lenders almost always recoup their loans.

Ryan Mulcunry, managing director with B. Riley Financial’s Great American Group, said that most of the retailers his firm appraises never go into liquidation. They are “pretty healthy retailers that are using one of their largest assets, which is their inventory, to make strategic changes in their business model or really just to buy inventory for a highly seasonal business,” he said. “There’s lots of reasons why ABLs exist, and most of them are not because of distress. But the banks obviously want to make sure that if it all fell apart, that they can get out.”

Appraisal and liquidation go hand in hand. And liquidators typically double as appraisers, because they can get the best read on the likely value of that inventory. “All of our values are approved by our liquidation group,” Mulcunry said. That experience gives them insight into how going-out-of-business sales might play out, even down to how certain products and categories might sell in specific geographies.

‘Lending is as aggressive as I’ve ever seen it’

In 2018, U.S. lenders had nearly half a trillion dollars in ABL commitments, with transactions expected to grow up to 7% in 2019, according to a June report from the ABL industry’s main trade group, the Secured Finance Network.

One of the attributes of this industry is that it’s kind of counter-cyclical, because we provide working capital to businesses.

Retail as an industry leads the way, representing nearly 24% of the total syndicated ABL facility commitments between 2015 and 2018.

The rash of bankruptcies, store closures and distress in several retail sectors have not scared off those lenders. Even in tough times, the loans have proven safe.

“One of the attributes of this industry is that it’s kind of counter-cyclical, because we provide working capital to businesses,” said Richard Gumbrecht, CEO of Secured Finance Network. Companies use ABLs to finance growth in good times, and in bad times use them as working capital comes under pressure.

Today, ABL lending to retailers is a booming business. “It has got increasingly more competitive and in favor of the borrowers,” Bill Kearney, senior managing director with Encina Business Credit, said. “Six, seven, eight years into the [U.S. economic] expansion, things started getting aggressive. And they have just continued to the point I would say, today, lending is as aggressive as I’ve ever seen it in 30 some years in the industry.”

Money looking for a place to go — and a safe one at that — has created new players. In its report, the Secured Finance Network noted that large banks dominate the ABL market, but lending from smaller banks and non-banks “continues to proliferate.” Non-banks accounted for some $30 billion of the total loan commitments out there.

We’ve seen competitors do what we won’t. ... The amount of yield we see — when something feels like it’s too much risk, it probably is.

“There’s new entrants,” Kearney said. “There were new competitors in the market last year, there’s going to be new competitors in the market this year. There’s no increase in the amount of loans. So, you have static demand. But you have a big increase in supply. As a result, pricing and structure goes down.”

As lenders scramble to issue ABLs, the super-safe loans could become less safe. “Excessive competition” among lenders could weaken documentation, underwriting standards and quality of borrowers, according to Secured Finance Network, which listed the possibility among the industry risks in the coming years.

“We’ve seen competitors do what we won’t,” said Lynn Whitmore, managing director with Wells Fargo’s retail finance unit. She pointed to loan structures that are “impossible to manage because it’s too much risk” or “bait-and-switch” tactics that give lenders levers to pull, like large reserve requirements, if a borrower’s performance declines. “The amount of yield we see — when something feels like it’s too much risk, it probably is.”

“You’ve only got so many things you can compete on,” Gumbrecht said. “Price is one of them, terms are others. A certain lender may say, ‘You know what? I’m willing to waive that covenant, or I’m willing to give you a higher advance against these assets or these things that the other guy said are ineligible. It’s a slippery slope, because the more you do those kinds of things, you’ve got to be super-responsive to anything that happens in the environment that could cause your borrower to default.”

“But that is happening,” he added. “As more money chases a finite amount of deals — that’s the nature of competition. Every now and then the less sophisticated lenders ... get burned.”

His organization also points to “ABL light” lending, which incorporates aspects of the ABL but without all of the standard elements and controls. In fact, some don’t have built-in mechanisms that allow lenders to liquidate the loan if a company takes a turn for the worse, one of the hallmark features of the ABL. That nebulous class of loans, which is more common among smaller banks and non-banks, “will not be able to withstand credit strains” the way ABLs can, according to the Secured Finance Network.

It’s not hard to see how those conditions could make for a nasty surprise for lenders down the road. You have a loan type that is historically a low-risk financing vehicle. Money piles in. Underwriting and borrowing standards go south. And suddenly a safe investment for lenders is no longer so secure.

“I hate to make the comparison, but it compares to the 2005-2006 timeframe before the last downturn,” Kearney said. “Lending, like the economy, goes in cycles. And that’s just where we are in the cycle.”

But by recent figures, ABLs still look pretty safe. The percent of ABLs that were charged off (i.e., declared uncollectible) for every year between 2015 and 2017 was essentially zero, according to Secured Finance Network data.

The ABL ‘trap’

ABLs provide a ready and relatively easy form of capital to retailers, even those struggling with cash flow issues, says Emma, who was an analyst with Debtwire at the time he spoke to Retail Dive.

The downside, he noted, is that “they can keep borrowing against the value of that inventory until it reaches a point where the lenders say, ‘Okay, now you don’t really have a lot more left to borrow against.’”

“Inventory is an asset, but you don’t keep it very long. ... If you’re good, you turn it four or five times a year, six times, whatever it is,” Paula Rosenblum, co-founder and managing partner at RSR Research, said. “The object of the game with an ABL is to keep your inventory high enough so that you have buying power.”

“Basically, your borrowing power is tied to your inventory,” she added.

That can create tension for retailers, who may need to clear inventory as part of a turnaround, or just as part of running a healthy retail business. “It almost creates, sometimes, an incentive for management teams to be over-inventoried,” Emma said.

In order to borrow, you have to have inventory to borrow against. You see this time after time, they just keep buying inventory even though it’s absolutely against their interest.

As Bradford Sandler, a partner with Pachulski Stang Ziehl & Jones, explains, ABLs are typically a good product for all involved, and when ABLs are working as they’re supposed to — a retailer uses it to buy inventory, they sell the inventory, and use the proceeds to pay down the loan and new purchases — everybody is happy. “But if their sales are slow, and they’re not converting that inventory into cash, they can’t repay the loan,” he said of retailers. “So it becomes a real problem.”

Keith Patrick Banner, a bankruptcy attorney with Greenberg Glusker, says in the worst scenarios, retailers he works with can end up in bankruptcy or a loan workout, in which the parties renegotiate the terms or restructure the debt. “The ABL trap kind of leads them to that point, unfortunately, because they keep buying inventory, because they have to — it’s just a matter of necessity,” he said. “In order to borrow, you have to have inventory to borrow against. You see this time after time, they just keep buying inventory even though it’s absolutely against their interest.”

Rosenblum said she has worked for a retailer where a consultant was brought in to revamp the stores, who cancelled the company’s purchase orders as part of his efforts. “So the inventory went down to almost nothing, which destroyed the [borrowing base], and the company became insolvent.”

Steven Agran, a managing director with Carl Marks, said in an interview that struggling retailers can also get in trouble if fearful suppliers stop shipping to them, thus reducing their total inventory and, with it, their borrowing base.

Funding ‘deterioration’?

ABLs, with their flexibility and availability, can be a key form of financing to fund a turnaround. But that, too, can have a downside.

“It allows a troubled retailer to continue to operate, maybe even past the point where there’s a reality for them to continue to operate in,” Emma said. As an example he points to Bon-Ton, the discount department store that liquidated in 2018 after years of declining sales.

“As long as they were in compliance with their loans, the banks kept funding them,” he said. “So you can see with Bon-Ton, as their business deteriorated, their revolver balance kept rising and rising and rising. And the banks still had collateral value.”

“It allowed Bon-Ton to fund significant deterioration in their operation,” Emma added, while also noting that ABLs can buy retailers time to pull off successful turnarounds.

“Our product will give you what it gives you. It’s fairly simple from a mathematical perspective, and it’s based on that third-party valuation [of collateral],” Wells Fargo’s Whitmore said. “There’s really no early trigger that an ABL lender has, or I would argue should have, other than the value of that collateral.”

That is part of an ABL’s essence: Its security, based on assets, allows it few covenants. That is what makes it flexible for retailers. They can often spend as they see fit. But it also means there are fewer brakes that banks can push to keep a borrower from running off the rails.

Supposing ABLs can allow a retailer to keep going past the point of reason, where’s the harm? If lenders get their money back, and retailers get more chances to roll the dice, who’s hurt if the loans stretch a retailer’s operations beyond their natural lifetime?

“From a supplier’s perspective, the more [retailers] are funding their business with the value of their inventory, that translates to there’s more debt, which means there’s more calls on the value of that inventory,” Emma said. “And that limits the remainder for everyone else,” he added, pointing to bankruptcy liquidations, where secured lenders are first to be paid back with the proceeds.

‘Suppliers are at risk’

When Forever 21 filed for bankruptcy last fall, initially with plans to reorganize as an independent company, it had an agreement with J.P. Morgan to provide the fashion retailer a $275 million asset-based DIP facility to finance it through Chapter 11. With around $40 million in rent coming due, and goods that needed to be purchased for the holiday season, Forever 21 attorneys said the financing was “absolutely critical.”

That’s what ABLs are for: working capital to fund a business. When a retailer is in bankruptcy, a DIP — which often takes the form of an ABL — gives suppliers confidence to extend trade credit to retailers.

But things can go awry. In December, Forever 21’s DIP lenders took all its cash to pay the loan balance down to zero, leaving the retailer without money as bills piled up, according to Forever 21’s unsecured creditors.

Finding itself without a path to reorganization, Forever 21 pivoted, opting to sell itself. Suppliers objected by the dozens to the retailer’s $81 million sale to landlords and Authentic Brands Group. One group of overseas suppliers said vendors “have suffered literally hundreds of millions of dollars of unpaid claims,” while the bid for the retailer only set aside $53 million for vendors.

When Toys R Us liquidated in bankruptcy, suppliers were similarly burned. The toy giant, like Forever 21, had initially looked to reorganize when it entered bankruptcy with a huge debt load and declining sales. But after its holiday numbers fell short of targets laid out in its DIP loan terms, Toys R Us defaulted.

By the spring, Toys R Us was out of money and lenders were unwilling to put up any more. The company’s inventory was liquidated, its stores closed, and the brand’s valuable intellectual property assets went to lenders. Lenders were protected by the security they had on the inventory. Suppliers, meanwhile, were paid nickels on the dollar in a settlement.

If the music stops and there’s not enough money to pay all the administrative claims, at the end of the day, the suppliers are left holding the bag.

“Suppliers are at risk because once they supply goods, the goods are usually subject to the lenders’ lien,” Sandler said. That lien gives lenders priority in bankruptcy, while suppliers rely on administrative claims to get repaid in a court process.

“If the music stops and there’s not enough money to pay all the administrative claims, at the end of the day, the suppliers are left holding the bag,” Sandler added.

Put simply, ABLs can be fuel for a turnaround, or a dumpster fire. In most cases, ABLs are a useful and elegant instrument for both retailers and lenders. But retail leaders can be a confident, optimistic lot — just ask the restructuring professionals that go in to help when things go wrong.

Retail execs might see a future, even when the world is closing in. And a retailer’s ABL lenders are primarily incentivized to keep tabs on their collateral — i.e., a borrower’s inventory — rather than the health of the business.

Lenders, and it’s fair to say most executives, are typically going to come out whole even in a worst-case scenario. That leaves employees, suppliers and others to absorb the damage when a retailer — rather than winding down gracefully and deliberately — runs smack into the wall of its loan.