The Challenges to and Strategies of Recalibration of the Asset Footprint Across International Platforms
Date September 2019
Originally published in The Secured Lender
With the increasing globalization of markets and operations, the location and ownership of assets - inventory, brands, and other assets - has become an integral component of supply chain management. Calibrating the international asset footprint for a company or its secured lender allows for the maximization of asset values and the identification of areas of risk, but it comes with significant challenges.
Even a casual glance at the front page of most major financial publications spells the apparent doom of open markets and the inevitability of an impending global recession. Economic expansions do not last forever, of course, and what goes up must come down. We do not presume to know when, or how severe, the next downturn will be, but conventional wisdom suggests that it will eventually be upon us again. In fact, fears of an imminent recession were palpable at the time this piece was being finalized.
To paraphrase Mark Twain, though, reports of the demise of global trade have been greatly exaggerated. The value of global merchandise trade and trade in commercial services in 2018 grew by 55% since the depths of the global economic crisis in 2008. In fact, global trade has grown 333-fold since the World Trade Organization started gathering data in 1948 through 2018. This, despite the dawn of the nuclear age, global recessions, conflicts and wars, the rise of worldwide terrorism, and multiple challenges to open markets during this 70-year time period.
Moreover, in today’s age, the ubiquitous presence of the internet and relatively easy access to information for an increasingly broad swath of the world’s population has had a profound and perhaps irreversible impact on the expansion of international trade, even in the face of growing protectionism and political trade barriers. As Børge Brende, President of the World Economic Forum, aptly stated in his opening remarks at the Annual Meeting of the Global Future Councils in Dubai last year: “Globalization’s future is no longer about physical trade. It is about knowledge, information and technology. Digital trade already accounts for 12% of international trade, and data flows are predicted to increase another fivefold by 2022. The result will inevitably be not less globalization but more, different, globalization.” In the age of information, global trade may slow down or change, but it cannot be stopped.
Against this backdrop, many global businesses will continue to adapt and grow to meet the ebb and flow of global demand, while others, unable to manage the complexity of spread-out cross-border operations during uncertain times, will undoubtedly fail. The ones standing tall at the other end of next downturn will probably be those companies that have mastered the art of skillfully managing their balance sheet and supply chain across disparate jurisdictions and cultures.
The challenge for secured lenders, and a differentiating factor to borrowers in today’s harshly competitive asset-based lending environment, will be the capacity to provide increasing liquidity to growing or large-scale global operations in the face of economic uncertainty, differing legal enforcement environments, and most of all, widespread collateral locations. While some lenders’ existing international operations will naturally afford them a measure of competitive advantage under these circumstances, no lenders, even multinational ones, are immune to the perils of multi-jurisdictional ABL underwriting.
So, what is a lender to do if one its borrowers identifies a highly profitable opportunity to sell its goods or wears in far-flung locations from its main market, but lacks the capital to finance the production cycle from raw material to finished product delivered to its final destination? When it comes to pledging movable assets, inventory in particular, many developed and developing countries do not provide capital providers with the customary and time-tested predictability of, for example, the Uniform Commercial Code and Bankruptcy Code in the United States, the Insolvency Act in the United Kingdom, or the Personal Property Securities Act in Australia. While obtaining a local credit facility in some locations may be possible, there are virtually entire regions (e.g.: Latin America, Southern Europe), where lenders will provide little or no availability against inventory and most intangibles. This is largely due to the complications, and in some cases the sheer impossibility, of enforcing a security interest in those types of assets without actual possession at all times, which generally defeats the purpose of a working capital loan.
On the flipside, a borrower may need to forego a potentially advantageous opportunity to expand its business outside of its and its lender’s main jurisdiction due to the detrimental effect it would suffer in its core territory if it redeploys resources to a location where it will not be capable of obtaining the financing to conduct business. Without the necessary working capital financing, most companies would need to access the capital markets and confront the unsavory prospect of diluting equity ownership, or, find a local partner that can provide the necessary local funding and infrastructure. The latter, while advantageous, is easier to conceptualize in theory than to implement in practice, and it depends on the context. For example, a company that sells consumer products under a recognized brand may benefit by contracting with a licensing partner with existing local operations and the ability to place finished products in the appropriate sales channels. On the other hand, manufacturing or technology companies may view they lack direct control of their operations as an insurmountable barrier to entry. And even those companies who can find local partners or are willing to take the plunge will need to navigate the unique tax and dividend-repatriation peculiarities of each country, and how they dovetail with their own tax strategies.
When confronted with these circumstances, lenders have few choices. In certain narrow circumstances, some governments have agencies which promote the export of goods of services of local companies by providing guarantees to local lenders that are generally considered as safe as AAA-rated government bonds (e.g.: EXIM Bank in the United States or EDC in Canada). The availability of these guarantees, however, is generally very limited and specific. There are often limitations based on the borrower’s size (EXIM Bank’s stated goal is to promote small and mid-size businesses). Furthermore, the application process can be very lengthy and approval uncertain, as EXIM Bank requires similar collateral enforcement assurances as any other secured lender would expect. Finally, these options often depend on political sentiment tides and are not permanent – EXIM Bank’s charter, for example, has been left to expire by Congress several times, which resulted in lengthy periods during which it was not operational, and is currently set to expire again on September 30, 2019.
The alternative for secured lenders is to look at each country where the pledged assets are or would be located, and, engage in a case-by-case underwriting process for each of those jurisdictions. This requires a deep understanding of what is and is not possible under local commercial law and practice with respect to each individual asset class. The straightforward procedure in the United States of simply having to search one registry in the jurisdiction in which the borrower is organized for the existence of prior liens, and if the results are clear, then filing one ordinary all-asset UCC-1 financing statement to properly perfect its security interest, is a rare exception rather than the norm in most countries. The procedures and laws governing security interests are as diverse as there are countries, and the nuances relating to enforcement rights are equally germane to each separate jurisdiction (and some time they differ even within a country). Some countries, for instance, have very clear laws when it comes to taking a security interest in accounts receivable, while an enforceable consensual lien in inventory in that same country, even though embedded in its commercial laws, is practically useless from a secured lender’s typical ABL underwriting criteria. The situation is sometimes the exact opposite in other countries, and somewhere in between in most other places. As a matter of fact, ABL underwriting is not unlike real estate: location, location, location …
In many places where typical lending is not possible, a liquidity provider must implement alternative structures that resemble asset-based lending by providing enhanced protection under local laws which would not be available if the infusion of funds was structured as a loan (such as, for example, inventory consignments with cash dominion or sale and leasebacks). Even so, the lender still needs to be fully aware of any restrictions relating to payments to a foreign lender, or that affect the transfer of the proceeds of sale of collateral post-enforcement outside of the jurisdiction. Often, there are registration steps that must be taken on the front end, and even when capital flows to offshore entities is permissible, it is not uncommon to encounter tax withholding requirements. All of this doesn’t come without cost – in our experience, the price tag of many of these alternative structures is often prohibitive.
An additional but essential element of underwriting risk for a secured loan is, of course, a reliable valuation of the pledged collateral. At first glance, secured lenders may find comfort in the fact that typical ABL valuation metrics such as NOLV (Net Orderly Liquidation Value) or FLV (Forced Liquidation Value) have, on the whole, identical definitions around the world. This, however, can be misleading without a further examination of what the practical meaning of an “orderly” or “forced” liquidation truly means in the relevant country. In some jurisdictions, an “orderly” liquidation in a court-supervised insolvency process may take two or more years in the ordinary course of that country’s judicial process. This is often the case in many jurisdictions, where a speedy auction is simply not feasible under the prescribed rules that govern sales of collateral by lenders. The rule of thumb, therefore, is for the underwriter to fully appreciate the underlying premise of the valuation in the context of local practice.
For example, in many civil law jurisdictions (mostly, but not solely, countries which operate under civil law systems), a lender cannot take the collateral in satisfaction of the debt without running an auction, and many jurisdictions have limitations on a secured lender’s credit bid rights. Other countries essentially curtail any options to enforce rights against non-possessory collateral, such as retail inventory, or in the proceeds of sale of inventory which are not controlled by the lender. Furthermore, the party selected to undertake the valuation must have practical experience with disposition of the relevant assets in that specific jurisdiction, rather than a mere theoretical understanding of comparable sales and discount rates.
The final factors that complete the underwriting equation, once the legal and value considerations have been solved, are pricing and the advance rate. These are intertwined terms (particularly in countries with liquidity shortages and high prevailing interest rates) and contingent on specific country risks and expected volatility, as one size does not fit all jurisdictions. The risk factors to be considered include political turmoil or violence, transfers, expropriation, inflation and currency exchange risks. Some of these factors can be mitigated through hedging and others with insurance, but all such strategies involve significant additional costs on top of high risk-adjusted pricing. These could ultimately make the loan unattractive to the borrower because of the combination of low advance rate and very high costs.
A point worth emphasizing is the importance of understanding the art of the possible in a multi-jurisdictional workout in distress or bankruptcy. This adds further layers of complexity to the structuring of cross-border secured loans. The implementation of more uniform protocols which address cross-border cooperation and conflicts of laws issues such as Chapter 15 of the Bankruptcy Code in the United States, EU Insolvency Regulation, or UNCITRAL’s Legislative Guide on Insolvency Law have provided helpful guidance for lenders as they embark in cross-border lending. However, insolvency regimes are very dissimilar and many countries have not adopted laws that are in harmony with cross-border cooperation, especially when it comes to disposal of pledged collateral. The often-used strategy to restructure obligations through the sale of assets and business units is frequently hindered in cross-border workouts by the multiplicity of applicable laws (in many cases, not just commercial laws, but also labor, environmental, etc.). This topic warrants a separate follow-up piece, which the authors will address in an upcoming edition of TSL.
To sum up, global expansion is a key growth factor for many companies, particularly those whose home market share has peaked. Oftentimes, the biggest impediment for companies to pursue new markets is lack of adequate working capital, as many asset- based lenders are not comfortable or capable to lend against assets located in countries in which they do not have operations, even for longstanding clients. While the prospect of providing liquidity in non-core jurisdictions may seem daunting after reading this article, the authors can attest from direct personal experience in over a dozen “non-traditional ABL” jurisdictions that it is feasible for certain assets classes in specific countries, with the appropriate local expert legal and tax advice, a trustworthy valuation, the right structure (including the exit strategy), properly risk-adjusted pricing, and a meticulously-modelled advance rate. Fundamentally, it is a tailor-made process which requires a deep practical understanding of how to operate in each relevant jurisdiction within the established risk underwriting precepts of asset-based lending, sprinkled with some creative structuring dust.