How Operating Loans Work
9 November 2006Operating loans are designed to finance the working capital assets of a business. At rates from just below prime (for investment grade companies) to prime + 3% (typically cash flow breakeven companies), lenders effectively perform the role a supermarket within the financial services industry with this product (high volume, low margin business).
Lenders are able to charge such relatively low rates (relative of course to the various other sources of capital in the marketplace), for a number of reasons:
• They have a first charge over all of the company’s assets.
• They really only finance the cash flow cycles of the business (the time from the sale in invoiced, until the time it is collected). They do not take on any market risk, with only a minimal amount of execution risk (ie. the company has demonstrated over an extended period of time that others will buy and pay for their products and services).
• The assets that are financed in an operating loan are very liquid or very close to becoming cash so they should be able to repay any loans outstanding in short order in a wind-up scenario, thereby greatly reducing the risk usually associated with lending. Accounts receivable are closest to cash and get the highest margin amount (usually in the 75% range), with Work-In Process and Raw Materials might receive a margin availability in the 25%-50% range.
• Lenders finance only a percentage of the assets through their margin formula, ensuring that the business has equity (or other more patient capital) supporting the business as well (represented by the un-margined portion). Moreover, industry norms suggest that recovery rates in a receivership scenario are in the 66% range, ensuring a modest amount of the line advances are ever truly at financial risk (ignoring the opportunity cost of undertaking a recovery process).
• It might be best called “impatient capital” – interest is paid monthly, the loan must always be “in margin”, and the assets are liquid as mentioned above.
After completing their preliminary due diligence , the senior/operating lenders establish an absolute amount for the operating loan and the corresponding margin formula (approximate percentages listed above).
On a go-forward basis, the borrower submits a margin certificate (daily, weekly or monthly depending on the situation) which includes its current receivables, payables and Priorities (primarily funds owed to the government that have priority to all funds owed to creditors in a liquidation scenario) to establish the margin value of the loan (never greater that authorized amount of the loan itself). The Priorities are always subtracted from the assets after the margin is applied – another trick the lenders use to be conservative. Some lenders request this certificate monthly (Sched As and Sched Bs), some do it weekly (so called Asset Based Lenders – their deals are a bit riskier and therefore require more monitoring).
The most expensive operating lenders, who theoretically take the most risk are the so-called “factoring” firms. These firms might request daily margin reports from the borrower to even more tightly control the availability on the line. They will also use lock boxes (segregated accounts the borrower uses to make all of it’s bank deposits through that the “factorer” has access to) to control all of the cash of the borrower.
After the margin calculations are completed and the revised margin amount is established, the company must operate its business within that limit until the new margin is established for its subsequent period…and the process starts anew (the lender/borrower Circle of Life).
FMU
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