Private Equity

In these difficult economic times, companies seeking additional liquidity may turn to alternative sources of financing.  Companies with assets that can be monetized (e.g., accounts receivable, intellectual property, real estate, equipment, etc.) may discover a number of options available to them.  In particular, accounts receivable financing may be an attractive way for certain companies to obtain working capital relatively quickly.  For companies with existing covenant-lite credit facilities, this may be instrumental to avoiding revolver usage above the trigger threshold for the springing financial covenant.

Receivables financing arrangements may be structured in a variety of ways, including:

• Factoring: a third party purchaser buys accounts receivable from the company at a discount, shifting collection and customer default risk from the company to the third party purchaser and providing the company with working capital.
• Securitization: the company transfers accounts receivable to a special purpose entity that then issues new debt securities.
• Asset-based lending: a lender provides the company with a revolving line of credit where availability is based on an advance rate on the value of certain accounts receivable and secured by a pledge.  The company retains ownership of the receivables and the risk of customer default.
• Reverse factoring (supply chain financing): perhaps more akin to “payables” financing than receivables financing, a third party commits to pay the company’s invoices to its suppliers, usually within a shorter time period than the company would otherwise pay, in exchange for a discount from the supplier.

Each structure has its advantages and disadvantages, but many companies may find receivables factoring to present the most flexible and potentially cost-effective solution.  The ultimate structure and feasibility of a factoring arrangement for any company often will be determined by the nature of its business and its existing credit documentation.

Factoring arrangements may be tailored to a company’s needs and financial situation.  For example, the third party purchaser may provide a committed (or uncommitted) line, subject to a cap; a parent company may be required to provide a performance guaranty; the arrangement may consist of a one-time or continuous transfer of receivables; and the arrangement may be non-recourse or recourse (or limited recourse) to the company.  Among other advantages, a non-recourse factoring arrangement usually is not treated as debt on the balance sheet. 

True Sale Considerations.

To ensure the off-balance sheet treatment, parties to a factoring arrangement focus on ensuring that the transfer of receivables constitutes a “true sale”.  Generally, the transfer should be structured such that (a) the purchased receivables will be out of the reach of the bankruptcy trustee in a bankruptcy proceeding with respect to the company or its consolidated affiliates, (b) the third party purchaser has the right to freely assign the purchased receivables and (c) the company does not retain effective control with respect to the purchased receivables.  In many cases, the originator company transfers receivables to a bankruptcy-remote special purpose entity, which ultimately sells the receivables to the third party purchaser.

Eligibility Criteria.

Parties to a factoring arrangement also negotiate eligibility criteria that determine which receivables qualify for purchase.  These criteria may include legal enforceability (including governing law and jurisdiction of the account debtor), timing for payment, whether a receivable is subject to dispute or dilution, minimum credit ratings and other economic factors.

Credit Facilities Analysis.

For companies with existing credit facilities, it is important to confirm that the existing credit documentation provides sufficient flexibility for a factoring arrangement, without the need to obtain the consent of the existing lenders or other relevant creditors.  Careful review of the company’s existing credit agreements is required, including in respect of the negative covenants relating to asset sales (and any related mandatory prepayment provisions), liens, investments within and outside the restricted group, debt and transactions with affiliates.  Certain credit agreements contain a “permitted receivables financing” concept, which permits the borrower to structure a factoring transaction in the restricted group.

Unrestricted Subsidiary Financing.

In the absence of this concept, and assuming sufficient capacity under its existing credit documentation, the borrower may choose to enter into the factoring transaction through an unrestricted subsidiary.  In addition to implicating other negative covenants, the transfer of receivables from the restricted group to an unrestricted subsidiary will typically constitute a transaction with an affiliate, within the scope of the affiliate transactions negative covenant.  Unless it constitutes a specifically enumerated exception, such a transaction usually must be on arm’s-length terms and the borrower may be required to obtain a fairness or favorability opinion in respect thereof.

Tax and Operational Considerations.

In addition to the implications under their existing credit facilities, companies should consider the tax, commercial and operational impact that a factoring arrangement may have.  From an operational standpoint, the company (or special purpose entity) may be required to provide the third party purchaser with cash dominion and may be required to notify its account debtors of the factoring arrangement and/or redirect receivables payments as well.

Conclusion.

When exploring liquidity options during these tumultuous economic times, companies should remember to consider all financing options at their disposal.  For companies with accounts receivable, factoring arrangements and other receivables financing structures may provide a much-needed source of liquidity.