Excess availability is an absolutely critical aspect of asset-based lending.

Unlike leveraged lending where covenants and structures are tied to historical accounting measurements from the borrower’s financial statements, asset-based lending through the tool of excess availability attempts to more closely track the real time liquidity of a company. Although the basic formula for calculating excess availability is almost always the same, there are variations in elements that can be added or subtracted.

One variation involves deducting from the basic formula past due payables or checks or other forms of payment that have been issued but not sent to the payees, or both, since the existence of either of them can distort the real liquidity of the borrower. This level of precision tends to appear in smaller transactions where the amounts of excess availability maintained by a company are smaller and so can be affected by delays in accounting for payments to suppliers.

Another variation is the addition of qualified cash to the calculation of excess availability. This is defined as unrestricted cash or cash equivalents of a borrower that may be added to the borrowing base subject to certain conditions. More sophisticated asset-based lenders recognize that to the extent the cash represents the payment of receivables that are still included in the borrowing base (because of the delays in receiving a monthly borrowing base certificate), adding the cash to excess availability may distort the presentation of the liquidity position of the company. Accordingly, in an effort to mitigate this risk, the lender at least wants the qualified cash that is added to the calculation of the borrowing base to be excess cash that is held by the borrower above the amount of its short term liquidity needs and therefore is set aside in a separate bank or investment account, rather than being cash that is moving through the ordinary course collection and disbursement process. In addition, the asset-based lender attempts to address this issue by putting a cap on the amount of qualified cash that may be included in the calculation of excess availability, typically structured as a hard dollar cap. The issue of qualified cash only arises in larger, higher quality credits that are generating significant cash and expect limited borrowings under the asset-based facility. Otherwise adding qualified cash to the borrowing base is unnecessary since the best use of any excess funds for a company generally is to pay down the asset-based revolving facility and reduce its interest expense, which then of course creates excess availability.

A third and relatively recent trend in the calculation of excess availability, but only for extremely creditworthy borrowers, is to add suppressed availability to excess availability up to a small percentage of the borrowing base and subject to other certain limitations. Suppressed availability means the amount of the borrowing base that is in excess of the line, and as with qualified cash, this concept only arises in larger, higher quality credits. Most of the time, the amount of the line will be materially in excess of the anticipated borrowing base of a company so that this will not be an issue. However, a company with a strong cash flow position that does not project the need for a large line may wish to reduce the costs of upfront fees by sizing a facility somewhat smaller than the anticipated amount of the borrowing base. This gives rise to suppressed availability. The concept of using suppressed availability for purposes of the calculation of excess availability is not consistent with the purpose of testing excess availability since the company could not in fact borrow based on this portion of its borrowing base. Nonetheless, for a small amount and subject to other limitations and a high quality credit, the asset-based lender may be willing to include it.

While the tests incorporated into the definition of the term payment conditions have been around for some time, the development of a single defined term for use in negotiations and throughout the credit agreement has become a helpful convention for simplifying the discussions and documentation.

There are several areas of negotiation around the components of the definition. The first is the amount of excess availability that will be required to satisfy the conditions, whether as a percentage of the loan cap (often with a fixed dollar floor), a percentage of the line, a percentage of the borrowing base, or a fixed dollar amount.

In the negotiation of the excess availability thresholds, in response to a request from a prospective borrower to lower them, a lender may be willing to consider the use of different thresholds for acquisitions and investments than for restricted payments. For example, if the borrower would be required to have excess availability of 17.5% of the loan cap generally, the lender might be willing to lower this to 15% of the loan cap for investments but keep it at 17.5% for restricted payments. The lender may be willing to make this distinction on the basis that with an acquisition or investment the borrower receives some value in the form of offsetting assets in exchange for the use of its funds, which represents some benefit for the borrower (assuming it is a successful acquisition or investment). However, for a restricted payment, the only beneficiary is the equity owner that receives the dividend or distribution.

Another potential area of negotiation is whether the borrower must provide projections of excess availability for some period of time after the applicable transaction or payment. Any time a company uses its funds for an acquisition, investment, optional prepayment of debt, dividend, or other restricted payment, the company should consider the impact on its liquidity of such use of its funds relative to its cash needs in the future. In theory, a company should not want to use its funds to pay a dividend only to find three, six, or even twelve months later that it is struggling to meet basic working capital needs, like payroll, rent, or raw material purchases. The lender has the same concerns. Consequently, it is not uncommon for the payment conditions to require the company to provide information about its projected excess availability for some period of time after the applicable transaction or payment. This is not a requirement that the company must have excess availability at the applicable levels in the future, but just that in its reasonable, good faith judgment it projects that it will. It is also not a requirement for the delivery of a typical set of projections for financial statements. It is simply for the basic components of excess availability. Notwithstanding the logic of including the delivery of such information as one of the payment conditions, borrowers may seek to eliminate it. In this case, as a compromise, the lender may be willing to shorten the time period for the projections of availability.

It is customary for the excess availability tests that are included in the payment conditions to include a look back concept. In other words, the lender does not want to just look at the excess availability at a single point in time, since there may be special or one time circumstances that have an impact on excess availability at that point in time. In order to get a more accurate picture of the company’s liquidity as measured by excess availability, the payment conditions will typically require that the excess availability have been above the agreed upon threshold for some period of time prior to the applicable transaction or payment. The period prior to the transaction or payment for measuring excess availability is often negotiated. It can be as long as 90 days or as short as ten days, although around 30 days is typical.

Some borrowers request that excess availability during this period be based on a daily average. This is less desirable from the lender’s perspective since an average can mask where the excess availability really is over time. For example, excess availability may be very high at the start of the period but then decline dramatically towards the end of the period. However, the lender retains some protection by the fact that the borrower is still required to have the agreed upon amount of excess availability immediately after giving effect to the transaction or payment.

Excess availability is commonly used in connection with pricing, the frequency of reporting of the borrowing base, the frequency of field examinations and appraisals, cash dominion, and financial covenant testing. It is also used as part of payment conditions in connection with baskets for negative covenants.

With respect to negative covenants, an asset-based facility will use excess availability as part of the conditions for permitted transactions under the credit agreement, rather than some form of leverage ratio, as is typical in a leveraged finance transaction. In general, the lender wants to know that after the company pays a dividend, or makes an investment or an optional prepayment of its debt, it will have a comfortable amount of funds available to it under the credit facility for its future working capital needs.

The levels of excess availability used can be quite challenging for the asset-based lender, particularly for a larger company with significant working capital needs. The amount of liquidity may not be perceived as being adequate for meeting even relatively short term obligations in these circumstances.

While excess availability may be useful criteria for understanding the impact on the liquidity of the company of making investments, paying dividends or other restricted payments, optional prepayments of debt, or any other cash outlays, it is not as useful in determining the conditions for the company to incur additional debt. When consenting in advance to the incurrence of new debt by a company, a lender is concerned about the ability of the company to service the new debt and more generally about the likelihood of a default under the new debt.

Having a significant amount of excess availability means that the company should have the liquidity to make the payments on the new debt at least for some period of time. However, the company’s capacity for additional debt ultimately depends on the total amount of debt as well as the ratio of debt to EBITDA, together with the amortization, interest, and fees of the new debt, and the debt’s maturity.

While amortization, interest, and fees go to the cash flow capacity of a company, maturity goes to both the cash flow capacity and the risk of default. When going into a new transaction, an asset-based lender generally will not want to have any material debt with a maturity that is inside its own maturity date (subject to exceptions in specific transactions where it can be addressed through reserves against the borrowing base). After the credit facility is in place, when permitting new debt under the terms of the credit agreement, the lender will similarly want to require that the maturity date for the new debt be after the maturity date of the asset-based facility by at least 90 days and often six months. Besides the maturity date, the likelihood of default under the new debt will also depend on the restrictiveness of the covenants and the nature of any financial covenants. None of this is addressed just by excess availability.

Particularly with the evolution of the Leveraged Lending Guidance, asset-based lenders are less likely to rely on excess availability alone. While the use of leverage ratios has been relatively limited in asset-based lending, asset-based lenders are increasingly conscious of limiting the overall leverage of a company, as well as the maturity of the new debt, the amortization of the new debt, and the restrictiveness of its terms.

In looking at the levels of excess availability for its different uses, asset-based lenders generally like to use a hierarchy of amounts which generally coincides with the most desirable approach from the borrower’s perspective.

The borrower will typically want the threshold for the testing of the financial covenant to be the lowest amount of excess availability relative to the other uses of excess availability. The next higher amount of excess availability would be used to trigger cash dominion, the next for more frequent field exams and appraisals, and finally, if the borrower falls below the highest amount of excess availability, triggering the delivery of a borrowing base certificate weekly rather than monthly.

This relationship between the excess availability thresholds is consistent with the lender’s position. As a company’s performance begins to deviate negatively from the original expectations, the lender wants more information to understand the situation, which it will obtain from the more frequent reporting of the borrowing base. Accordingly, the highest amount of excess availability must be maintained for the borrower to only have to report the borrowing base monthly. Similarly, if excess availability drops below a higher level, the lender will want the ability to conduct more frequent field exams and to obtain an updated appraisal to better understand its exposure relative to the value of the collateral that it is relying on. Sometimes the more frequent field exams and appraisals are set at a higher level than the requirement for the more frequent delivery of the borrowing base certificate; however the principle is the same. At the next level the lender wants to trigger cash dominion and thereafter the testing of the financial covenant.

Thus, the foundation of asset-based lending is rooted in reporting, field exams and appraisals, cash dominion, and the construct of the borrowing base, concepts which all are integrally connected to the use of excess availability.