Attack on the 7-foot-tall Woman

Auditors hired to investigate corporate borrowers' working-capital assets pledged against their credit lines say they've been busier than last year.

Besides wrangling with their lenders to keep fees and interest rates down and ensure their credit lines will be renewed, corporate borrowers making use of asset-based lending have had a new nuisance to deal with in recent months: bankers seem to be upping their due diligence by making more onsite inspections of their borrowers’ collateral.

Under ABL agreements, lenders reserve the right to regularly check whether the collateral posted against their secured loans — typically working-capital assets — is all there. And that right entails the ability to make sure what borrowers claim in their weekly or monthly updates is accurate. In good economic times, however, lenders haven’t always been consistent about how often they send in their examiners.

During the current downturn, as regulators push banks to maintain their capital ratios and as companies’ inventories have ballooned in size, lenders are boosting their scrutiny of borrowers and the claims they make about their assets. “Lenders are focusing on their credit underwriting, knowing their borrower, and making sure that the collateral they say is there, is there,” says Paul Mattson, who conducts these examinations and has seen an uptick in requests for his services in recent months.

Although the increase in the number of collateral audits hasn’t been significant, questioning by examiners has grown more intense, say some who work in the industry. “Besides being a bit disruptive — some auditors will ask management a lot of questions and they take up space — it’s one more distraction for business,” says Robert Zadek, a member of the American Bar Association and an attorney at Buchalter Nemer who represents lenders. “But it’s a necessary distraction. You can’t tell the bank, ‘Don’t audit me.’ “

As a result, some companies must deal with more frequent audits of their collateral and the unexpected costs that go along with those audits. The inspections typically last between three and five days, costing $125 per hour. In total, they can each cost between $3,000 and as much as $27,000 for midmarket companies, which are those mostly likely to seek ABL financing.

First Capital, a financial services company specializing in ABL, conducts about 1,200 of these examinations every year, as much as three to four times in the case of some borrowers. Those exams are designed to verify that receivables are indeed collectable and that a borrower doesn’t have shelves stocked with, for example, unsellable T-shirts for 7-foot-tall women, says Mark Sunshine, president and chief operating officer of First Capital, noting that his firm has always conducted such examinations. The inspections are designed to verify that borrowers have the “right mix” of inventory, he adds.

But during the good times, some lenders may not have been regularly conducting the audits. Instead, observers say, they were more likely to waive the right to win over a potential borrower.

Bob Schleizer, managing director at Kinetic Advisors, which counsels distressed mid-market companies, says this shift began late last year, as sales across industries fell, inventory turnover slowed, and commodity prices declined. By that point, companies were sitting on products that they had overpaid for when, earlier in the year, the price of copper, oil, and aluminum had been much higher.

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