• Asset-based lending (ABL) is a form of corporate lending that leverages collateral and may allow borrowers to maintain optimal capital structures and sufficient liquidity.
   
• For investors, ABL may present a differentiated source of returns within the private credit world, one with the opportunity for potentially higher yields and appealing downside mitigation accompanied by strong structural protections and explicit collateral backing. 
   
• As underwriters of ABL facilities, Napier Park seeks to maximize borrowers’ access to capital while minimizing our—and our investors’—risk of loss. Conservative valuation of loan collateral is a key element of our risk-management process.
   
• ABL is a relatively niche sector within private credit compared to the cash-flow loan market. We believe the time-tested perspectives, strategies and relationships developed by Larry Klaff and Lisa Galeota through their 60-plus years of combined experience with ABL distinguish our expertise as lenders in this asset class.

With a cloudy macroeconomic trajectory and persistently above-target inflation further exacerbated by tariffs, investors have shown increased interest in this subset of the private credit market as a potential diversifying complement to other public and private credit exposures. For borrowers anticipating potential disruptions in credit availability, ABL offers the opportunity to unlock additional liquidity by leveraging unencumbered assets on their balance sheet, including inventory, accounts receivable, real estate, machinery and equipment, and intellectual property.

Leveraging over 60 years of combined industry experience and nearly 20 years working together, Larry Klaff, head of asset-based lending, and Lisa Galeota, head of asset-based lending portfolio management and underwriting, below discuss asset-based lending and how nonbank lenders may generate attractive long-term risk–adjusted returns for investors through this differentiated asset class.  

Q: What is asset-based lending?

Larry: Asset-based lending facilities are a form of corporate borrowing secured by specific assets of the borrower, such as inventory, accounts receivable, real estate, machinery and equipment, and intellectual property. Properly structured ABL facilities have priority recourse to the inventory or other assets securing the loan.

ABL facilities are another tool for companies seeking to optimize their capital structures. To provide these facilities, nonbank lenders like Napier Park may partner with borrowers—as well as with their bankers and private equity sponsors, as appropriate—to tailor bespoke, flexible lending structures that meet their liquidity needs.

For investors, ABL may present a differentiated source of returns within the private credit world, one with the opportunity for potentially higher yields and appealing downside mitigation accompanied by strong structural provisions and explicit collateral backing.

Lisa: Before going into more specifics about ABL, it may be helpful to quickly clarify what ABL is not. Though the similarity of their names can sometimes cause confusion among investors, asset-based lending facilities are not the same as asset-backed securities—a subset of securitized credit—which are typically collateralized by the cash flows produced by large pools of debt instruments such as mortgages and student loans amalgamated from multiple borrowers. ABL also differs from “factoring” in which a company sells its accounts receivable to a financial entity at a discount to realize immediate cash flows rather than wait for these invoices to be paid. While accounts receivable can be used as collateral for an ABL facility, the borrower retains ownership of any assets pledged as collateral unless remedial action becomes necessary.

Perhaps as important is to differentiate between ABL and more traditional middle-market loan structures, including both broadly syndicated loans (aka leveraged loans) and direct lending. These loans typically are underwritten based on the borrower’s current and/or expected cash flows and governed by a range of maintenance covenants tied to those cash flows, as reflected by credit statistics like maximum leverage ratio and minimal interest coverage ratio.

In contrast, ABL facilities are generally focused on the collateral available to secure the loan; appraising the value of the pledged collateral is thus a key component of the ABL diligence process. Loans generally are limited to a set percentage (the “advance rate”) of the value of the borrower’s collateral assets (the “borrowing base”).

In efforts to mitigate risk, we appraise the collateral in the context of a downside scenario as opposed to a sale in a more normalized market environment. Advance rates against collateral vary by asset class and the lending institution’s comfort level and familiarity with that asset class. As an example, an ABL lender may be willing to lend 100% of the value of a borrower’s inventory but may go only to 70% of the value of machinery and equipment. Both the advance rate and the structure of the ABL facility depend on a range of factors that influence the quality and resilience of the collateral assets.

Q: How does exposure to asset-based lending fit in an investor’s portfolio?

Larry: ABL exposure has broad appeal to a wide variety of investors searching for a differentiated source of return. We believe the combination of consistent, obtainable return targets—a coupon typically above the Secured Overnight Financing Rate (SOFR) plus closing and other ancillary fees generated during the course of the loan—and low ABL may offer investors a differentiated source of returns, with potentially higher yields and downside mitigation. Asset-Based Lending: Collateralizing Corporate Assets page 3 First Eagle Investments principal loss can provide investors with low-variance risk. Investors interested in ABL typically already have an allocation to other alternatives, and any allocation to an ABL strategy likely would go into that bucket of their portfolio. Further, they understand and are comfortable with the illiquidity and opacity that comes along with privately negotiated loans.

Lisa: Though we view ABL as a strategic portfolio exposure, the features of these loans have caught the eye of investors in an environment marked by high inflation, a shaky economy and diminishing liquidity. Asset-based loans historically have diversified some portfolios while providing something of a “valuation floor” implied by carefully vetted and monitored collateral. Our experience has been that asset-based loans, thoughtfully structured and amply collateralized, can experience low loss-given-default rates.

The current attention is not surprising, as the ABL industry historically has been countercyclical. Although there appears to always be a need for ABL facilities, they likely will have a smaller audience among borrowers and investors alike when Wall Street is flush and capital is readily available. Once liquidity is constrained, however, borrowers may find an ABL facility to be one of the more economical funding options, while investors recognize the attractive blend of risk and reward that may be provided through a portfolio of rigorously underwritten asset-based loans.

Larry: The highly structured nature of ABL is a bit of a double-edged sword. While disciplined underwriting, proper controls and diligent monitoring may help mitigate the potential loss on these loans, the complexity of these tasks can expose inexperienced lenders to considerable risk.

ABL deals are based on what may appear to be fairly simple formulas, but that’s not to say they are easy to execute or source. A large part of it is access—to the deals, to the right appraisers, to institutional knowledge like understanding intercreditor relationships—that can only be developed after years in this business. I think this is why many large institutions that maintain their own investment operations for certain asset classes choose to outsource private credit and ABL to dedicated managers. They understand that you just can’t insert yourself into this world and expect to be consistently successful.

For our part, we remain focused on the resources we believe differentiate us as experienced lenders and help us put our investors’ money to work in attractive lending opportunities.

Q: How are ABL facilities typically structured?

Larry: ABL facilities can be structured as term loans or revolving lines of credit. As underwriters, we seek to maximize the borrower’s access to capital while minimizing our risk of loss. Relative to cash-flow loans, ABL facilities tend to include fewer financial covenants; in many cases, the covenants that do exist are focused on maintaining collateral coverage and the loan-to-value ratio. Additionally, it is common for ABL facilities to include negative covenants that specify actions the borrower is prohibited from undertaking without lender approval, such as voluntary prepayment of junior debt and release of collateral. “Cash dominion”—through which a lender has control of a borrower’s cash receipts—is another risk-mitigation tool. Depending on the loan, all or some of these provisions may apply on a “springing” basis, going into effect only if certain liquidity thresholds are triggered.

Not surprisingly, asset-based lenders direct their most intense focus on the value of the borrower’s collateral. Term sheets outline frequent and detailed monitoring requirements for collateral, along with a variety of triggers intended to mitigate downside impact by keeping the borrowing base on formula while also providing fee-generating opportunities for the lender.

Lisa: ABL facilities pay a floating interest rate based on a spread to SOFR and in many instances we include a SOFR floor. They typically have a term of five years or less, though I’d estimate our deals last an average of 12 to 24 months; at the end of the day, it is usually in the borrower’s economic interest to retire these typically higher interest loans as soon as feasible.

While an ABL facility through alternative lenders such as Napier Park provides borrowers with flexible access to needed capital, it often comes at a higher cost than traditional loans; companies often are able to obtain cheaper financing once their near-term balance sheet and/or liquidity concerns have stabilized. For us, a condensed loan life can have a notable positive impact on the internal rate of return we seek to generate for our investors and allows us to recirculate that capital sooner to source new deals.

Our deal with The Jessica Simpson Collection is a good example of how quickly a business circumstances can change. In 2020, Jessica and her business partner/mother Tina Simpson sought to repurchase the nearly two-thirds ownership of the licensing business they had sold in 2015 to Sequential Brands Group, which was preparing its portfolio of brands for bankruptcy auction. We arranged a term loan with another lender to help finance the deal on behalf of Jessica and Tina, and in November agreed to provide a term loan secured by an advance against the brand’s value, with the brand value assessed in a downside/quick-sale scenario. About six months later, the acquisition complete, our investment was fully repaid by another lender pleased to provide financing to the now wholly owned company without having to deal with the noise that can surround merger and acquisition (M&A) activity. A make-whole provision in the deal ensured that we were paid a year’s worth of interest despite the loan being taken out after six months, which was an important yield enhancement for our investors.

Q: How do you seek to mitigate loan losses?

Lisa: Risk management is embedded throughout our process. As we like to say, it’s always raining outside our office windows.

While liquidation is a rare outcome of the ABL facilities we arrange, we underwrite and structure our loans as if the borrower is going to go out of business and its collateral assets will need to be sold in short order for us to be repaid. And we value that collateral at a price that reflects a challenging liquidation, not its current fair-market value. While this may sound pessimistic, our conservative approach allows us to confidently extend credit to companies that traditional lenders may be reluctant to engage with, such as those going through a transition due to either growth or stabilization.

Larry: Properly structured ABL agreements feature a range of provisions intended to protect the lender’s interests, which historically has helped support low loss-given-default rates. The value of collateral (the borrowing base) is constantly in flux and we, as lenders, need to confirm that it retains sufficient value to recoup our loan principal—while considering higher priority debt, if any—should liquidation be required.

The management of asset-based loans typically is extremely hands-on. Not only are borrowers obligated to frequently report on the value of their pledged collateral and factors that may impact its quality, lenders typically also perform periodic field audits to obtain third-party reviews of this collateral. Considerations include salable condition of the inventory/collateral, whether relationships with key customers and vendors have been retained, and timely collection of accounts receivable.

In downside scenarios, cash flow-based lenders may want to adjust the terms of a loan to provide borrowers sufficient time to get back on track, but such measures are unlikely to improve outcomes for an ABL facility; collateral is not like fine wine—impairments in value are unlikely to improve with age. And since asset-based lenders are so close to the collateral assets, we are able to act quickly when stress occurs.

Q: Why would a borrower choose asset-based lending over other forms of financing?

Larry: Borrowers in the ABL space often are companies that have high working-capital needs and substantial assets but sometimes inconsistent cash flows, such as retailers that maintain large inventories or industrials renting significant capex equipment. In many cases, these are middle-market companies with more limited access to the established cash flow capital-market channels, there are a variety of situations in which an ABL facility makes sense for them.

An ABL facility can expand a company’s senior debt capacity and may help lower its weighted average cost of capital when compared to other sources of financing. It allows healthy companies to quickly monetize their assets without giving up control of them, which can fund expansion for a growing business or smooth out liquidity for businesses in seasonal or cyclical industries. It helps troubled companies continue to operate through structural transitions or balance-sheet recapitalizations. ABL also serves as a way for a private equity sponsor to tap into the capital needed to cost-effectively finance an acquisition or leveraged buyout.

Lisa: ABL facilities also serve as a flexible financing solution during periods of market volatility and macroeconomic uncertainty. Today, middle-market companies face numerous challenges to their margins, including supply-chain disruptions, recession fears and soaring prices for input materials, wages and transport. Meanwhile, the cost of capital remains high, and large money-center banks continue to be selective about the companies and industries they want to do business with. Historically, times like these have created opportunities for nonbank lenders like Napier Park to work in conjunction with large banks to provide financing that makes sense for the borrower’s capital structure.

Q: How would you characterize the current demand environment for ABL?

Lisa: As a countercyclical asset class, demand for ABL is currently strong. Persistently higher rates combined with overall economic uncertainty—sticky inflation and a teetering jobs market, exacerbated by roiling tariffs—have weighed on mergers and acquisition activity and the demand for traditional cash flow loans that often accompanies them.

We currently see ABL demand triggers from two directions: companies proactively seeking more liquidity, and lenders demanding greater liquidity from borrowers to comfortably maintain covenants within outstanding loans. In either case, nonbank lenders may provide this liquidity—often to levels beyond the comfort of traditional providers—by accepting assets as collateral that many banks won’t lend against during periods of economic uncertainty. Seasonality also plays a role in demand for ABL; consumer-focused companies, for example, seek liquidity to fund manufacturing and ensure timely availability of merchandise for back to school and/or Christmas.

Q: How does Napier Park find asset-based lending opportunities?

Larry: Though billions of dollars trade hands, ABL is a relatively small sector compared to the cash flow-loan market, and the relationships we developed over time have contributed greatly to deal flow. Lisa and I combined have more than 60 years of experience in the ABL space. We both joined First Eagle (which acquired Napier Park in 2022) in July 2020 after more than 14 years working together at Gordon Brothers Finance Company and a predecessor company. At Gordon Brothers, which was majority-owned by BlackRock at the time of our departure, we sourced, originated and structured ABL facilities valued at more than $1 billion across a wide variety of industries. Over our careers, we have participated in deals brought to us by private equity sponsors, investment and commercial banks, other credit funds, law firms and corporate advisors, and the borrowers themselves. We have participated in ABL facilities across the risk/return spectrum, from first-lien term loans and FILO (first in, last out) tranches to debtor-in-possession loans and exit financing.

I bring up our backgrounds not as a pat on the back but to highlight the importance of experience in asset-based lending—and experience working with different asset classes and underwriting across market cycles, in particular. Gordon Brothers is one of the largest asset-monetization firms in the world, if not the largest. I joined them in 1996 and spent the next quarter-decade observing how various assets are monetized worldwide, in both good times and bad. Lisa came a few years after I did. Understanding the collateral appraisals and how valuations ebb and flow over time directly informs our underwriting process, which we believe has the potential to minimize losses in a wide variety of worst-case scenarios.

Lisa: Understanding the nuances of collateral assets underpins our assessment of their potential net orderly liquidation value (NOLV). Equipment in a distribution center typically is easier to sell than hospital equipment, for example, while the value of a pump used in shale-oil extraction will likely be more sensitive to oil prices than a water truck with multiple uses beyond the oil patch. With confidence in our appraisal of a company’s collateral across its range of eligible assets, we often are able to underwrite larger loans than a more narrowly focused lender would, turning what may otherwise have been a $30 million facility into a $50 million one—a significant consideration for a middle-market business.

In our experience, being part of a larger platform—our alternative credit platform manages $42 billion in assets globally—really helps.¹ While it doesn’t necessarily make us better underwriters, scale of this magnitude may enable us to commit more capital and provide a broader array of financing alternatives to borrowers, unlocking access to a wide network of potential deals—and, by extension, presenting opportunities for enhanced portfolio diversification for our investors.

Larry and I are focused on ABL, but our colleagues in direct lending originate cash flow-based loans to lower middle-market companies. Private equity sponsors, in particular, may recognize the potential benefits of flexible, low-friction access to a variety of structures through a single lender as their portfolio companies’ circumstances evolve.

Q: In an increasingly competitive market, how does Napier Park differentiate its capabilities to garner share and generate returns for investors?

Larry: With 60-plus years of combined experience in the ABL space, we’ve incorporated what we consider time-tested strategies into structuring credit agreements to avoid potential pitfalls. Our success providing asset-based lending solutions is predicated on flexibility and strong relationships with borrowers, other lenders and advisors. A deep understanding of our borrowers’ assets and businesses—both as they react to particular market conditions and structurally evolve over time—enables us to provide adaptable solutions that address objectives on both sides of the table. Extending our thinking beyond the conventional credit box, we are able to creatively tailor ABL parameters and criteria, including eligibility of collateral, advance rates, borrowing base, covenants and reporting requirements.

We strive to be a good partner for borrowers, their private equity sponsors and/or other advisors, and our investors. Our transaction with West Marine—one of the largest, most recognized brands for boating and water-sports equipment in the US—is a good example of working collaboratively with a sponsor and lender to structure a facility that addressed the needs of each party. The sponsor had acquired West Marine as demand for leisure goods boomed during Covid, but sought additional liquidity as workers returned to the office and spent less time and money on recreation. New management was introduced to develop and implement sophisticated marketing strategies going forward, and we worked with the sponsor and largest lender to develop what seems to have been a win-win structure for their borrowing needs. In addition to limiting our exposure by conservatively assessing the borrowing base and advance rate on high-quality inventory, a last-in-first-out structure provided us with additional security on this short-term, high-coupon, fee-rich transaction.

In all events, we strive to balance the interests of borrowers and investors, focusing on intelligent structuring to mitigate losses and provide a differentiated source of attractive risk-adjusted long term returns to investors.