ABL-Induced Distress: When Minor Headwinds Turn Into Serious Issues

Welcome to the 146th Pari Passu newsletter.

Most newsletters take time off at the end of August when deal activity slows down. We take time to cover a technical topic!

Businesses are almost always seeking new capital, and every lender is seeking to protect their returns. However, it is often the case that these two desires do not align, and lenders either won’t lend or won’t offer attractive terms to businesses without strong cash flows to support debt payments. This is where asset-based lending presents itself as an attractive form of debt financing for businesses in margin-volatile, asset-heavy industries that need a flexible source of capital. 

However, ABL is not without its negatives, and in the case of Party City, it drastically accelerated the company’s shutdown. In today’s write-up, we’ll learn how ABL works, what businesses benefit from it, how it can perpetuate distress, and what recently happened to Party City.  Let’s get into it.

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ABL Introduction

Asset-based lending (ABL) is a form of secured financing where credit is provided based on the value of a company's assets. Traditionally, lenders analyze a company’s cash flows and ability to pay interest and principal when determining credit terms. On the other hand, ABL primarily relies on the value of assets. Most often, ABL loans are secured on liquid assets such as inventory or accounts receivable, and the company’s cash flows are a secondary consideration [1].

ABL can originally be traced back to the 1980s, when lenders sought to minimize risk amidst economic uncertainty. Over the past few decades, ABL has grown in popularity as an alternative to traditional cash-flow-based lending for companies with a strong asset base and/or fluctuations in cash flows. ABL has also become especially popular for small to medium-sized businesses that may lack the credit ratings to otherwise secure attractive financing. 

Definitions

Before diving in, let’s look at some important definitions:

ABL Collateral: The assets pledged by the borrower, most often current, liquid assets.

Advance Rate: The percentage of the appraised collateral asset value that the lender is willing to extend as a loan or line of credit.

Borrowing Base: The Total amount available to the borrower under the ABL credit agreement, determined by multiplying the advance rate by asset value.

Borrowing Base Reserve: A reduction to the borrowing base imposed by the lender. 

Types of ABL Collateral

There is no hard and fast rule for determining what qualifies as ABL collateral. However, lenders will usually look for the two criteria: liquidity and the ability to value the asset accurately. Let’s look at two common types of ABL borrowers, retailers and manufacturers, and analyze what assets would likely be pledged as collateral. 

A retailer’s balance sheet typically consists of accounts receivable (from sales made on credit) and inventory (merchandise to sell). Both of these serve as great ABL assets due to their tangible nature and ease of appraisal. Generally, a retailer’s ABL credit facility would be secured on inventory and receivables [2]. Another common asset for retailers is brand intellectual property, representing the brand name the retailer has built that drives consumers into stores. Unlike inventory or accounts receivable, IP is much more challenging to appraise for a specific value. Additionally, it is difficult for a buyer to integrate and capture value from brand IP. Because of this, it is rare to see something like brand IP pledged as ABL collateral. 

While a manufacturer also has inventory and receivable balances, other collateral considerations exist. First, manufacturers report three different types of inventory: raw materials, work-in-progress (WIP), and finished goods. Depending on the type of manufacturer, certain inventory stages may not be eligible collateral or may receive a poor advance rate. The other significant consideration is equipment. Manufacturers in a relatively simple industry with standard equipment, such as a furniture maker, will have an easier time pledging it as collateral due to its clear resale value. On the other hand, highly specialized manufacturers like aerospace or semiconductor producers may not be able to pledge collateral [2]. 

The Underwriting Process:

The first step in underwriting an ABL credit facility is determining the value of the collateral. This can be divided into appraisal and risk adjustments. Firstly, to determine the value of an asset, lenders will typically use both market comparisons and cash-flow valuation. For something like equipment, which doesn’t directly generate cash flows, lenders will look at the recent sale or leasing prices of similar equipment to determine value. On the other hand, receivables generate cash flow in time and may be valued at their present value, less uncollectables. Second, lenders will also look at external conditions when determining value. For example, technology may become obsolete as innovation continues, causing a deterioration in value. 

Once assets have been valued, the second step is determining an appropriate advance rate. Remember that the advance rate is the percentage of the borrowing base that the lender is willing to lend against. This rate is mainly dependent on the risk profile of the asset. For example, because the collection of receivables is relatively predictable, they may be advanced at 85-90% of their value. On the other hand, inventories may be as low as 50-75% because of their susceptibility to market fluctuations and changing consumer demand [2].

Next, the lender and borrower must agree on terms for monitoring asset value and financial, affirmative, and negative covenants. Typically, borrowers must regularly report the condition of collateral assets, inventory levels, ageing of pledged receivables, etc. This helps lenders safeguard returns by getting ahead of asset deterioration. If asset value dips below the covenant thresholds, lenders may impose measures such as borrowing base reserves (which we’ll cover momentarily). Additionally, ABL lenders may require the borrower to maintain specific liquidity ratios along with maintaining insurance on collateral and not taking on new debt without the lender’s consent [3]. 

Lastly, the ABL credit facility must be structured to meet the borrower's needs. The debt may be structured as a revolving credit facility (RCF) or an asset-based term loan (ABTL). An RCF provides flexibility, allowing the borrower to draw down funds when needed, repay them, and draw again, up to the defined borrowing base. This structure is excellent for businesses with varying working capital needs, such as retailers. For example, retailers experiencing holiday seasonality may not have funds to stock up on inventory ahead of the holiday season, so they draw down their RCF to fund inventory purchases and use the holiday proceeds to repay it. On the other hand, ABTLs work like regular term loans, providing a lump sum initial payment and a structured repayment schedule. 

ABL Use Case

After reviewing the ABL underwriting process, we can determine clear archetypes of businesses that would benefit from ABL instead of cash-flow-based lending:

1. Working-capital-intensive, margin-volatile businesses: While cash flow lenders look for financial metrics like EBITDA and the associated leverage and coverage ratios, ABL lenders would be more concerned with these businesses' working capital borrowing base. Retailers and distributors, for example, may be subject to fluctuations in demand and costs, influencing margins. However, these businesses can borrow against their strong balance of inventory and receivables to fund operations and expansion. 

2. Young, fast-growing companies: Growing businesses in a traditional asset-heavy space often have significant capital expenditures and may not yet be cash flow positive enough to secure attractive financing. However, if the company has built a strong balance of receivables, inventory, equipment, etc., it may be able to secure financing, such as an ABTL, to fund continued capex. 

3. Turnaround/restructuring events: Additionally, it is not uncommon to see ABL financing as new money in an in-court or out-of-court restructuring. Inherently, distressed businesses don’t provide significant positive cash flows. ABL financing gives access to liquidity while mitigating risk for lenders in a distressed situation. 

Hypothetical ABL Example

Let’s combine what we’ve covered so far into a simple example:

Summer Apparel Co., a hypothetical company, is a small/medium-sized business that sells spring/summer clothing through 20 brick-and-mortar stores and is developing an e-commerce channel. The company is investing heavily in marketing to grow its e-commerce platform and the opening of new stores, which is resulting in near-term negative EBITDA and cash flow. Here are some mock financials for Summer Apparel Co.:

Since the company has experienced volatile margins due to seasonality and expansion efforts, it has struggled to secure additional growth financing at attractive terms. Summer Apparel Co. instead opts to secure ABL financing backed by its strong balance of inventory and receivables. A $7.2mm borrowing base is calculated as follows:

• A/R balance (4,000) x 80% advance rate = 3,200

• Inventory balance (8,000) x 50% advance rate = 4,000

Remember that different assets usually receive different advance rates. In this case, assume the company is fairly efficient when collecting receivables, reducing the ABL lenders’ risk. The company advances A/R at 80% because of this. On the other hand, being a seasonal retailer, there is an inherent risk that inventory might not sell during the season. In response, the lenders only advanced at 50% of the inventory value. 

Summer Apparel Co.’s new ABL facility consists of a $2mm ABTL to fund its footprint and e-commerce expansion and a $5.2 mm RCF to provide seasonal flexibility. The terms of the debt include monthly receivables aging and inventory reports so lenders can keep tabs on collateral. As receivables and inventory age, it is typically less likely that they are converted into cash, so lenders require consistent updates to accurately reflect the risk of those assets. The terms also include an on-site audit every quarter. Additionally, the company must maintain a minimum cash balance of $500,000. If collateral values decline or the company breaches covenants, the ABL lenders reserve the right to impose a borrowing base reserve. We’ll dive into this deeper later, but simply put, a borrowing base reserve is a reduction to the available funds under an ABL facility put in place to protect lender returns. If a reserve were put in place, the company would have less borrowing ability under its RCF facility. 

Following the issuance, the company successfully grew its customer base by expanding both online and in-store platforms and using the RCF to fund additional inventory purchases, paying it down with proceeds from a strong summer season. Despite temporarily being cash flow negative, the ABL facility provided critical liquidity for operations and expansion. While a simple example, this case showcases ABL's usefulness as an alternative to cash flow-based lending.

When ABL Lenders Perpetuate Distress

While ABL facilities can provide a needed lifeline to specific businesses, under certain circumstances, ABL lenders can exacerbate distress and drive companies into bankruptcy. This usually comes as a cascading effect, when companies begin to experience mild distress and ABL lenders, looking to protect returns, implement measures that strain liquidity. 

In two recent Chapter 11s, Joann and Express, lenders imposed a borrowing base reserve, which ended up accelerating the filing. A borrowing base reserve is a reduction to the available borrowing base by the ABL lender. A reserve may be implemented for different reasons, with the most common being the perceived deterioration of the borrowing base’s liquidation value [4]. Since reserves limit borrowing ability under an ABL facility, they have the ability to severely strain liquidity, especially for businesses that rely on ABL to fund working capital needs.  

Let’s apply this example to Summer Apparel Co. Assume a year goes by, and the company uses the $2mm ABTL to build out and market an e-commerce platform ahead of this year's summer season. Additionally, in February, the company drew down another $3.7 mm to help fund summer merchandise purchases. For simplicity’s sake, let’s assume A/R and inventory are the same as last year. This left Summer Apparel Co. with $1.5mm of availability under the RCF, combined with cash of $500,000 for total liquidity of $2mm. 

Contrary to expectations, the company experienced lower-than-expected e-commerce traffic and declining same-store sales during the peak April-June season due to a competitive e-commerce landscape and increased competition from online fast-fashion retailers. Assume this left the company with a breakeven TTM EBITDA of $0 and a couple of big problems. The first problem was the inability to pay the portion of the RCF that it had drawn down to purchase the inventory. The second problem came once the peak season was over. Once July rolled around, the company attempted to sell merchandise at a discount to generate much-needed cash. These events did not go unnoticed by creditors. Following multiple monthly reports, field audits, and the peak season ending, the ABL lenders became skeptical of the true worth of the company’s borrowing base.

In response, the ABL lenders imposed a $1mm borrowing base reserve. With $1.5mm of undrawn funds, this reserve would cut RCF availability to $500,000, a third of its current capacity. Available liquidity was reduced to $1mm ($500,000 of RCF + $500,000 in cash). Once the peak season had passed, the company would have a tough time generating sales to become cash flow positive. Additionally, it’d now be footing a monthly interest expense of roughly $40,000 (S + 400 x $5.7mm). With a cash burn of over $100,000 per month, the ABL lenders would declare a default, as the company broke its minimum liquidity covenant. Summer Apparel Co. filed for Chapter 11 bankruptcy by the end of the year. 

Let’s assume that during bankruptcy, Summer Apparel Co. underwent a fire sale and, as lenders predicted, the liquidation value of the borrowing base seriously declined. With the reserve in place, the company drew the remaining $500,000 before running out of cash, and now had an outstanding balance of $6.2mm. Let’s also assume that the total proceeds from the liquidation totalled $4mm. In this case, the ABL lenders, which sit at the top of the capital structure, would recover ~$65% of their claim ($4mm proceeds / $6.2mm outstanding). If there were any unsecured claims, they’d receive nothing.

Now, let’s look at recoveries without a borrowing base reserve in place. If the company were to draw the full remainder of its RCF, the total balance outstanding would be $7.2mm. For simplicity's sake, let’s assume the company still ended up filing and liquidating with proceeds of $4mm. In this case, ABL lenders would recover ~56% ($4mm proceeds / $7.2mm outstanding). While a real-world case would likely involve many more moving parts, these differing recoveries highlight the fundamental purpose of a borrowing base reserve. 

This hypothetical example highlights the chain reaction that can occur when an ABL borrower becomes distressed. An unexpected decrease in demand tightens liquidity while signaling deterioration of the borrowing base. In response, ABL lenders can impose a reserve, restricting liquidity even further. Without access to borrowing capacity under an ABL facility, a distressed company is forced to burn already scarce cash, which can result in the breach of even more liquidity/cash-related covenants. This liquidity spiral is a harsh reality for today’s businesses and highlights a potential drawback of ABL. 

The decision for ABL creditors to enforce terms is never an obvious one. While in this example, it did improve returns, it also accelerated the borrower’s Chapter 11 filing. The accelerated filing and subsequent sale eliminated the possibility of any operational turnaround. In this hypothetical case, a turnaround was pretty unlikely, but real-world ABL creditors must carefully weigh their options before making decisions that seriously limit a borrower's runway. 

Party City: A Real-World Example

On December 21, 2024, Party City Holdco Inc. filed for Chapter 11 bankruptcy in the Southern District of Texas – its second Chapter 11 and third restructuring since the pandemic. We’ve covered Party City’s history of distress extensively in our past write-up, but to quickly summarize, the company was a first-of-its-kind party goods and costume retailer. With the first store being opened in 1986, the company quickly grew as a chain of retailers and went public in 1996 before being delisted shortly later. In 2005, Party City was bought by a private equity firm, and ownership changed hands multiple times over the next decade before once again going public in 2015. The company continued to grow, with revenue peaking at $2.43bn in 2018 [5]. 

In 2019, sales began to decline while increased distribution costs shrank margins. In 2020, the COVID-19 pandemic resulted in store closures and a massive hit to demand from a lack of in-person events, leaving the company with -$123mm of EBITDA. The company was also saddled with roughly $1.5bn of long-term debt at the time from previous private equity ownership. In response to its declining liquidity and debt burden, the company entered an out-of-court exchange, detailed in our previous write-up, that reduced the overall debt load by $558mm and provided $90mm of new money to the company [5]. 

A year later, it seemed like Party City had recovered and completed a successful turnaround. Unfortunately, after very poor Halloween 2022 sales, the company was once again looking to modify its capital structure. This time, it was in the form of a prepackaged bankruptcy that aimed to delever its capital structure by equitizing a substantial portion of outstanding debt. The company filed in January 2023, and creditors approved a POR that equitized the company's 1L notes, provided $150mm of DIP financing, and reduced debt by over $1bn. Importantly, it allowed DIP lenders to be repaid with second-lien debt instead of cash and also included the reinstatement of Party City’s ABL facility in the amount of $250mm plus a $17.1mm FILO facility[5]. The ABL facility was senior secured on all eligible “prepetition ABL priority collateral,” which included trade receivables, credit card receivables, inventory, and in-transit inventory. All collateral was advanced at a rate of 90% [11].

This brings us to 2024, in which Party City has faced challenges, including inflationary pressures, macroeconomic factors, and changing consumer preferences. The company was looking to secure additional financing to support operations. Rather than issue debt, Party City retained Hilco Valuation Services with hopes of receiving a higher inventory valuation, which would increase available ABL funds. To the company’s surprise, Hilco instead determined a “significant reduction” to the net orderly liquidation value of the inventory. In response, the ABL creditors implemented a discretionary $50mm borrowing base reserve [6]. Party City immediately began arguing for a revised appraisal, and Hilco ended up with a slightly higher value, but the discretionary reserve remained in place. Here’s what the Chief Restructuring Officer, Deborah Rieger-Paganis, had to say about the reserve in the first day declaration [8]: 

Assuming the reserve eliminated all borrowing capacity, we can work our way back to estimate Party City’s borrowing base at the time of filing. We know that the company had drawn roughly $162mm in total commitments under the ABL/FILO facilities. Since we know the $50mm reserve eliminated all borrowing capacity, we can infer the borrowing base at the time of filing to be roughly $212mm ($162mm drawn + $50mm reserve). This number, which is $38mm less than the original $250mm makes sense because we know the borrowing base is calculated as a percentage of collateral value. We also know Party City’s inventory value declined, which results in a smaller borrowing base. This $212mm number is important as it reflects the approximate liquidation value of Party City’s eligible collateral, which we’ll return to when calculating recoveries. 

Following the implementation of the reserve, Party City began delaying new inventory orders and rent payments to preserve cash [6]. However, given the mere $16.4mm of cash reported on the petition date and with no ABL facility to draw from, Party City would run out of cash quickly and be forced to file on December 21, 2024. 

In February, the company received a $20mm bid from New Amscan, an affiliate of Ad Populum, for its IP and wholesale assets. Additionally, the company’s store leases were auctioned off to other retailers nationwide, with Dollar Tree and Five Below being the biggest buyers [9]. Acquiring leases, formally known as assigning leases, provides a great opportunity for liquidating retailers to raise funds for the estate. Party City likely held many leases in desirable locations or at below-market rates and was able to pass them to a third party in exchange for a one-time fee. See our write-up on Section 365 for a great explanation of lease treatment in Chapter 11. 

Let’s use the information available to infer creditor recoveries. We estimated Party City’s borrowing base at roughly $212mm. We also know that it was advanced at a rate of 90%. This puts Party City’s eligible collateral (receivables and inventory) at roughly $235mm. We’ll also assume the borrowing base was comprised of 68% receivables and 32% inventory as it was in the 2023 bankruptcy [8]. This leads us to the recoveries outlined in the table below.

The ABL/FILO lenders will likely end up receiving a full recovery, while the Second Lien Notes, which held junior liens on ABL collateral, receive around 20%. 

Party City serves as a perfect example of an ABL-induced liquidity trap. The company experienced moderate headwinds, leading to a decline in the appraised valuation of its borrowing base. In response, ABL creditors effectively removed Party City’s ability to borrow under its revolving credit facility. Near-term liquidity was squeezed because the company relied heavily on the RCF to fund operations, resulting in limited runway, a swift Chapter 11 filing, and a poor recovery for second lien creditors. Additionally, equity holders, who primarily consisted of previous senior noteholders whose claims were equitized in the 2023 bankruptcy, received nothing. 

In Party City’s case, it's pretty clear that the reserve ultimately ended the company’s ability to operate as a going concern. If you’re pondering the legality of such a destructive action, you’re not alone. However, Party City’s ABL reserve, along with almost all others, is permissible under the credit docs as long as the decision is made under reasonable credit judgment. This is essentially an objective standard, meaning the borrower is not treated in bad faith or a manner inconsistent with industry norms. 

Key Takeaways

Asset-based lending is a great financing method for companies in margin-volatile, asset-heavy industries such as manufacturing, distribution, and retail. A strong amount of working capital provides a borrowing base to finance continued growth or operational needs. As we saw in the hypothetical example, ABL can be especially helpful for retailers seeking flexible financing. However, ABL is inherently formulaic, and unforeseen market conditions may affect multiple aspects of the ABL equation. Party City’s case highlights that lenders will almost always do what they can to protect returns. In an ABL structure, which involves detailed reporting along with the ability for lenders to implement measures such as borrowing base reserves, moderate headwinds can be compounded into serious liquidity issues.

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