Amid Retail Bankruptcy Wave, Why Do Lenders Still Favor Them?

In 2019, Barneys New York faced a series of common challenges in the department store industry: price wars, e-commerce penetration, declining foot traffic and sales, and rising rents. Many of its stores were losing money, and others were not performing as expected.

According to the retailer's restructuring officer later revealed in court documents, by June of that year, its revenue had declined by $34 million year-over-year. Facing the sales slump, the lenders of Barneys' asset-based credit facility (ABL) reduced the borrowing availability by $5 million. This move was intended to protect the lenders from losses, but it also abruptly squeezed Barneys' working capital.

The ensuing financial crisis affected store operations: limited liquidity weakened Barneys' ability to allocate merchandise, causing slow-moving products to pile up in unprofitable stores while profitable stores couldn't meet demand. When bills came due, Barneys had less money to pay suppliers, who began to slow shipments and tighten credit. The situation then deteriorated rapidly: bankruptcy, store liquidations, and ultimately, the beloved retail brand was sold to licensing group Authentic Brands Group.

Like many other retailers, Barneys' ABL was its key form of financing. As executives tried to turn things around, the loan kept the company running—until it didn't.

For retailers, ABL (known in the industry as ABL) provides a flexible and crucial form of financing. For banks and other lenders, it's an almost risk-free investment vehicle—although as competition in the field heats up, some lenders are taking on more risk.

Observers note that deeply distressed retailers may face distorted incentives from ABL—which is typically tied to the value of a retailer's inventory. While the loan may be a lifeline for those trying to turn the business around, it can also encourage retailers to keep piling on debt as the business collapses—a problem that can spill over to suppliers.

In the worst case, as retail analyst Philip Emma put it, ABL can provide retailers with a "rope to hang themselves."

From last resort to mainstream choice

ABL was once seen as a loan of last resort, but over the past two decades, both lenders and retailers have become accustomed to it.

In the cyclical retail industry, ABL can smooth cash flow throughout the year and provide working capital. Because ABL is secured and based on asset valuations, banks typically impose far fewer restrictions on it than other types of loans, making it more flexible.

In the retail sector, borrowing capacity is primarily based on the estimated liquidation value of a retailer's inventory. This is how banks protect their loans: they won't lend more than the estimated liquidation value of the inventory. These valuations have become quite precise over the years. Additionally, liquidating a retailer's inventory is often more straightforward and predictable than assets in other industries, which makes retailers major users of ABL.

This type of financing can provide capital for distressed retailers trying to turn around, as well as for startup retail and e-commerce companies during high-growth, high-cash-burn periods. ABL can be used for daily operations like payroll and purchasing inventory, or for capital investments like store renovations. Private equity firms also use ABL extensively, including financing leveraged buyouts and paying dividends from their retail portfolio companies.

When a retailer goes bankrupt, ABL typically funds its operations during bankruptcy—whether the company plans to reorganize, sell itself, or liquidate. In court proceedings, these loans appear as debtor-in-possession (DIP) financing, often coming from the retailer's existing ABL lenders, known as a "rollover." Even if the bankruptcy spirals out of control, DIP lenders almost always recover their loans.

Ryan Mulcunry, managing director at Great American Group, part of B. Riley Financial, said most retailers his company evaluates never enter liquidation. He said, "They're fairly healthy retailers using one of their largest assets—inventory—to make strategic adjustments to their business model, or simply to purchase inventory for a highly seasonal business. There are many reasons ABL exists, and most are not distress-related. But banks certainly want to ensure that if everything collapses, they can walk away cleanly."

Appraisal and liquidation go hand in hand. Liquidators often double as appraisers because they can most accurately judge the potential value of inventory. Mulcunry said, "All our valuations are approved by the liquidation division." This experience gives them insight into how going-out-of-business sales will go, down to how specific categories perform in specific regions.

"Lending aggressiveness is unprecedented"

According to a June 2019 report from the Secured Finance Network, the ABL industry's main trade organization, U.S. lenders' ABL commitments in 2018 approached $500 billion, with 2019 deal volume expected to grow by up to 7%.

"One of the characteristics of this industry is its counter-cyclicality, because we provide working capital to businesses."

Retail led the way, accounting for nearly 24% of total syndicated ABL commitments between 2015 and 2018.

The wave of bankruptcies, store closures, and distress across multiple retail sectors hasn't scared off these lenders. Even in tough times, the loans have proven safe.

Richard Gumbrecht, CEO of the Secured Finance Network, said, "One of the characteristics of this industry is its counter-cyclicality, because we provide working capital to businesses." Companies use ABL to finance growth in good times and as a buffer when working capital is under pressure in bad times.

Today, ABL lending to retailers is a thriving business. "Competition is increasingly fierce and increasingly borrower-friendly," said Bill Kearney, senior managing director at Encina Business Credit. "When the (U.S. economic) expansion enters its sixth, seventh, eighth year, things start to get aggressive. And it's continued, and today I'd say lending aggressiveness is unprecedented in my 30-plus years in the industry."

Money seeking investment—and safe places to put it—has spawned new players. The Secured Finance Network report notes that large banks dominate the ABL market, but smaller banks and non-bank lenders are "continuously expanding." Non-bank institutions account for about $30 billion of total loan commitments.

"There are new entrants," Kearney said. "There were new competitors in the market last year, and there will be this year. Total loan volume hasn't increased. So demand is static, but supply has surged. As a result, pricing and structure are moving down."

As lenders scramble to issue ABL, these ultra-safe loans could become less safe. The Secured Finance Network lists "excessive competition" as one of the industry's risks in the coming years, suggesting it could weaken documentation standards, underwriting standards, and borrower quality.

Lynn Whitmore, managing director in Wells Fargo's retail finance division, said, "We see competitors doing things we wouldn't do." She noted that some loan structures are "too risky to manage" or use "bait-and-switch" tactics, providing lenders with leverage like large reserve requirements that they can invoke when a borrower's performance declines. "The yields we see—when something feels too risky, it probably is."

Gumbrecht said, "There are limited points of competition. Price is one, terms are others. A lender might say, 'You know what? I'm willing to waive that covenant, or I'm willing to advance more against these assets, or accept assets others consider unacceptable.' It's a slippery slope, because the more you do these things, the more you need to stay highly vigilant about anything in the environment that could cause a borrower to default."

"But it's happening," he added. "As more money chases limited deals—that's the nature of competition. Every now and then, less sophisticated lenders... will get burned."

His organization also points to "ABL-lite" lending, which includes some aspects of ABL but lacks standard features and controls. In fact, some have no built-in mechanisms allowing lenders to call the loan when the company deteriorates—a hallmark feature of ABL. This ambiguous loan category is more common among smaller banks and non-bank lenders, which, according to the Secured Finance Network, "cannot withstand credit stress like ABL can."

It's not hard to see how these conditions could plant seeds of future trouble for lenders. A historically low-risk financing tool, with money flooding in and underwriting and borrowing standards slipping, suddenly becomes a less safe investment for lenders.

"I don't want to compare, but it's similar to 2005-2006 before the last recession," Kearney said. "Lending is like the economy; it's cyclical. We're at this point in the cycle."

But recent data shows ABL remains fairly safe. According to Secured Finance Network data, between 2015 and 2017, ABL charge-off rates (declared uncollectible) were essentially zero each year.

The "trap" of ABL

ABL provides retailers with ready and relatively easy capital, even those with tight cash flow, Emma said. He was a Debtwire analyst at the time, speaking to Retail Dive.

The downside, he noted, is that "they can keep borrowing against inventory value until the lender says, 'Okay, you've got nothing left to borrow.'"

"Inventory is an asset, but it doesn't hold forever... If managed well, it turns four, five, six times a year, depending on the situation," said Paula Rosenblum, co-founder and managing partner at RSR Research. "The game of ABL is to keep inventory high enough to maintain purchasing power."

"Basically, your borrowing capacity is tied to inventory," she added.

This can create tension for retailers, who may need to clear inventory as part of a turnaround or simply for healthy operations. "It almost creates an incentive for management teams to over-inventory at times," Emma said.

"To borrow, you have to have inventory as collateral. You see it time and again, they keep buying inventory even when they know it's absolutely against their interests."

As Bradford Sandler, partner at Pachulski Stang Ziehl & Jones, explained, ABL is usually a good product for all participants when it works properly—retailers use it to buy inventory, sell it, and use the proceeds to repay the loan and fund new purchases—everyone benefits. "But if sales are slow and you can't convert inventory to cash, you can't repay the loan," he said of retailers. "So it becomes a real problem."

Keith Patrick Banner, a bankruptcy attorney at Greenberg Glusker, said in the worst cases, retailers he works with may end up in bankruptcy or loan restructuring, where parties renegotiate terms or restructure debt. "The ABL trap unfortunately leads them to that point, because they keep buying inventory because they have to—it's a survival need," he said. "To borrow, you have to have inventory as collateral. You see it time and again, they keep buying inventory even when they know it's absolutely against their interests."

Rosenblum said she worked with a retailer where the company hired consultants to restructure stores, and the consultants canceled the company's purchase orders as part of the effort. "So inventory dropped to nearly zero, destroying the borrowing base, and the company became insolvent."

Steven Agran, managing director at Carl Marks, said in an interview that distressed retailers can also get into trouble if suppliers stop shipping out of fear, thereby reducing total inventory and the borrowing base.

Financing "deterioration"?

With its flexibility and availability, ABL can be a key form of financing for turnarounds. But it has downsides.

"It allows a distressed retailer to keep operating, possibly even beyond what is realistically viable," Emma said. He cited Bon-Ton, the discount department store that liquidated in 2018 after years of sales declines.

"As long as they meet the loan terms, the bank keeps funding," he said. "So you look at Bon-Ton, as the business deteriorated, the revolving loan balance kept rising. The bank still had collateral value."

"It allowed Bon-Ton to fund a major deterioration of its operations," Emma added, while noting that ABL can also give retailers time to successfully turn around.

Wells Fargo's Whitmore said, "Our product gives you what it can give. It's simple from a mathematical standpoint, based on third-party (collateral) valuations. ABL lenders don't have real early triggers, and I don't think they should, except for collateral value."

This is part of the nature of ABL: the asset-based security means it has very few covenants. This makes it flexible for retailers, who can often decide their own spending. But it also means banks have fewer brakes to pull, unable to prevent borrowers from going off the rails.

Assuming ABL allows a retailer to keep operating beyond a reasonable period, what's the harm? If lenders get their money back, the retailer gets more chances to roll the dice, and the loan extends the retailer's operations beyond its natural life, who gets hurt?

"From a supplier's perspective, the more a retailer finances its business against inventory value, the more debt it means, and the more claims against that inventory value," Emma said. "This limits what's left for others," he added, pointing to secured lenders getting priority from proceeds in bankruptcy liquidations.

"Suppliers are at risk"

When Forever 21 filed for bankruptcy last fall, it initially planned to reorganize as an independent company, reaching a deal with JPMorgan for $275 million in asset-based DIP financing to help it through Chapter 11. With about $40 million in rent due and needing to buy merchandise for the holiday season, Forever 21's lawyers called the financing "absolutely critical."

This is exactly what ABL is for: providing working capital for the business. When a retailer goes bankrupt, DIP (often in the form of ABL) gives suppliers confidence to extend trade credit to the retailer.

But things can go wrong. In December 2019, Forever 21's DIP lenders took all its cash to bring the loan balance to zero, according to its unsecured creditors, leaving the retailer without funds as bills piled up.

After failing to reorganize, Forever 21 moved to sell itself. Dozens of suppliers opposed the retailer's $81 million sale to landlords and Authentic Brands Group. A group of overseas suppliers said suppliers "suffered hundreds of millions in unpaid claims," while the acquisition only set aside $53 million for suppliers.

When Toys R Us liquidated in bankruptcy, suppliers were similarly hurt. The toy giant, like Forever 21, initially entered bankruptcy hoping to reorganize, but was burdened with massive debt and declining sales. After holiday season performance missed targets set by DIP loan terms, Toys R Us defaulted.

By spring, Toys R Us ran out of money, and lenders were unwilling to put in more. The company's inventory was liquidated, stores closed, and the brand's valuable intellectual property assets went to lenders. Lenders were protected by the inventory collateral. Suppliers received only a few cents on the dollar in settlements.

"If the music stops and there isn't enough money to pay all administrative claims, ultimately suppliers will bear the loss."

"Suppliers are at risk because once they supply goods, the goods are typically subject to the lender's lien," Sandler said. That lien gives lenders priority in bankruptcy, while suppliers rely on administrative claims to get paid in court proceedings.

"If the music stops and there isn't enough money to pay all administrative claims, ultimately suppliers will bear the loss," Sandler added.

In short, ABL can be fuel for a turnaround, or a disaster. In most cases, ABL is a useful and sophisticated tool for both retailers and lenders. But retail leaders are often a confident, optimistic bunch—just ask the restructuring professionals who step in when things go wrong.

Retail executives may see a future even as the world closes in. And a retailer's ABL lender's primary incentive is to keep an eye on the collateral—the borrower's inventory—rather than the health of the business.

Lenders, and to be fair most executives, usually walk away clean even in the worst cases. This leaves employees, suppliers, and other parties to bear the losses when a retailer hits the loan wall—rather than winding down gracefully and deliberately.