More suppliers are stepping forward to finance companies that buy their goods. These arrangements can create the impression of interests conveniently snapping into alignment, with a key vendor betting on the go-forward prospects of a struggling partner.
They can also introduce risks that were never accounted for in the original loan agreement.
Vendors to the ‘rescue’
In a typical distressed deal, the financing picture involves a senior secured revolving line of credit and perhaps a subordinated debt layer or stretch loan. If the stars align, a new investor might put equity into the business. But in at least four recent deals observed by Tiger Finance, a new party has entered the picture: a supplier providing its distressed customer with extended, interest-free payment terms, effectively stepping in as an unsecured working-capital lender.
In one of these cases, a manufacturer extended $125 million in interest-free inventory financing to a consumer products brand, which in return committed to place at least $100 million in annual purchase orders with the manufacturer. The borrower eventually defaulted on this quid-pro-quo requirement, and the vendor took ownership of the company, transitioning from trade creditor to controlling shareholder.
Why vendors are becoming lenders
Imagine a supplier whose customers include a retailer with 400 U.S. stores. If those locations go dark, the supplier loses 400 sales outlets for its goods. By shipping inventory on zero-interest, extended terms and keeping the retailer afloat, the supplier continues to generate margin on each unit shipped, even if the retailer itself is operating at a loss.
The financing arrangement might bridge the company to calmer waters, which would be all to the good. But if the company falters, the supplier can either double down on its strategy or simply take post-default ownership of its customer.
Hidden risks
In a well-run lending facility, regular borrowing base reporting, periodic field exams and covenant monitoring surface credit problems early. When vendor support is doing heavy lifting in the capital structure, that early-warning system is compromised. Vendors are non-traditional lenders operating outside of established frameworks. Their financings are often disclosed to lenders only in summary form, if at all, and default triggers, minimum purchase requirements, change-of-control clauses and the vendor’s right to accelerate repayment can be buried in separate vendor credit agreements that senior lenders never see until issues arise.
Vendor support is unpredictable and can evaporate quickly. Suppliers make decisions based on their own profit pressures, supply-chain priorities and relationships with company management. If a situation changes or a dispute with management arises, they could turn their back on the company.
At that point, the lender might face a battle over who has priority on the collateral, or find itself stuck in the middle of an ownership fight between equity and the vendor, or end up dealing with a new controlling party that has no track record of running the business, not to mention different priorities when it comes to repaying debt.
For the senior ABL lender, this is a risky combination of opacity and unpredictability.
How lenders should respond
The answer is not to walk away from all deals that involve vendor financing. In today’s environment, these arrangements are sometimes the only thing keeping a borrower liquid enough to service its senior debt. What lenders can do is make sure from the start that the structure and documentation take vendor risk into account.
Any vendor support that is central to the deal should be treated as a core structural element. Lenders should require full disclosure of vendor financing terms as a condition of loan approval, and keep that disclosure current throughout the life of the credit facility. It also makes sense to stress-test the borrowing base against a scenario in which vendor support disappears.
As an example, if vendor support drops below agreed minimums, this should trigger protective measures such as a reduction in the borrowing base, a cash sweep or a mandatory paydown. Change-of-control provisions should be written to cover vendor-driven ownership transfers.
In one recent transaction, Tiger Finance structured the facility so that the vendor’s formal assertion of its ownership claim automatically triggered a mandatory payoff of Tiger’s position as senior lender. The vendor was not blocked from taking over the company. In effect, the vendor’s own contract remedies served as the lender’s exit trigger. This approach can be applied to any deal in which vendor financing is carrying real structural weight.
Opportunity for better outcomes in distressed situations
Given today’s economic pressures, suppliers are being more intentional about using the balance sheet as a strategic tool. The vendor-as-lender trend will continue for the foreseeable future, leading to more deals that do not fit neatly into either a conventional secured lending framework or a standard trade payables arrangement.
In the absence of control, the risks are significant, which is why rapidly liquidating the chain is a common response to a sudden contraction of vendor support. But with a proactive, well-planned structure in place, vendor financing situations can translate into more orderly winddowns that better align the interests of creditors.
The key is to treat vendor financing exposure with the same rigor you would apply to any other subordinated or contingent claim in the deal. Require full disclosure, stress-test the borrowing base, build the covenants, and protect your position regardless of what the vendor ultimately decides to do.
Handled properly, this approach stands to improve liquidity management, reduce material risk (such as skyrocketing bankruptcy costs), and bolster the overall outcome. You have essentially turned an unpredictable vendor into an advantage in monetizing your loan.
Editor's Note: This article was originally published on ABL Advisor, a sister publication of Equipment Finance Advisor.