As lenders developed Asset-Based Lending models in the early 1990s, it quickly became apparent that retailers and consumer products companies were prime candidates for this type of financing. These companies typically had meaningful investments in working capital assets—inventory and accounts receivable. The development of professional asset-disposition platforms provided asset based lenders a clear line of sight to an exit in the event of a default through the liquidation of these assets.
Throughout the 1990s and into the next decade, asset-based lending structures inexorably replaced the traditional cash flow lending structure through which retailers and consumer products companies had traditionally been financed. While the commercial finance model was developing, significant changes were occurring in the way that consumer products were delivered and sold. Spurred on by technology and the proliferation of fast, free internet access, investments in working capital assets began to decline while investments in intangible assets increased. Ever creative and nimble, the commercial finance industry began to adapt to these changes. One solution to address the gap caused by reduced working capital levels came from lenders willing to provide additional liquidity by adding intellectual property (IP) and, in particular, brand assets to the borrowing base.
Early Models for IP Lending
Commercial finance companies were at the forefront of extending the ABL model to include intellectual property assets. Early participants in this type of lending were Paradox Capital and UCC Capital. In their model, intellectual property assets were used to increase the formulaic borrowing limits attributable to the working capital assets through loan structures that securitized all of the borrower’s intangible assets. The model worked especially well for borrowers whose intellectual property assets could be licensed, creating a royalty cash flow stream.
A key challenge for these lenders was finding credible valuation partners to support their underwriting. Traditional IP appraisal models took an investment-banking and accounting approach to valuation characterized by a top down analysis to determine fair market value with somewhat arbitrary discounts applied to generate distressed recovery values. A bottom’s up approach was required in order to provide an accurate opinion of liquidation values in a compelled sale. To address this need specialized IP valuation and disposition firms including Streambank LLC and CONSOR developed appraisal products that provided an understanding of IP liquidation dynamics and the market for distressed IP assets.
As the frothiness of the capital markets increased, additional lenders began to look at intellectual property assets to provide more than merely “boot” collateral. These included senior secured lenders such as GECC and Foothill, whichwere willing to “stretch” the ABL borrowing base into the IP but limited to a small percentage of Net Forced Liquidation Value. These innovations in IP lending came to a grinding halt by the end of 2008 as the lending environment adjusted to the new realities of the Great Recession.
IP Lending Takes Off
As the economy slowly but surely regained its footing, consumer product and retail companies continued to evolve making larger investments in intangible assets such as ecommerce websites, Customer Relationship Management systems, and social media marketing, while shrinking their investment in working capital with smaller retail footprints, and just in time inventory replenishment systems. New participants in the consumer products marketplace were created whose consumer interface was almost completely digital–so-called “digital natives.”
In order to provide efficient financing structures to these companies, Asset-Based Lenders once again provided structures that stretched past the tangible and working capital assets and into the intellectual property. The ABLs began to partner with private investment funds that were willing to make more aggressive advances against intangible assets in the form of second lien term loans, and First-In-Last=Out (FILO) participations directly into the senior lender’s collateral governed by an Inter-creditor Agreement that provided the FILO lender a first lien on the IP assets of the borrower and a second lien on the working capital assets.
These developments in IP lending were supported by market forces that made consumer brand assets a more dependable form of collateral. These market forces included the development of Pure Play Licensing companies. These were companies that existed for the sole purpose of developing portfolios of brand assets that were then licensed to retailers, wholesalers, manufacturers, and media companies creating a dependable stream of royalty income. Many of these Pure Play Licensing companies tapped the public equities markets for liquidity including Iconix , Sequential Brands Group,Cherokee , and Xcel Brands Group. Both the publicly owned and privately held licensing platforms became customers for brands in transition creating liquidity for consumer brands as an asset class.
The liquidation community responded with increasingly sophisticated appraisal models that relied on market based analysis in addition to formulaic analysis to determine liquidation values. The definitions of what constitute an orderly versus a forced liquidation evolved as well building on lessons learned as more consumer and retail brands found their way into the distressed market.These liquidations created an increasing set of datapoints against which initial underwriting assumptions could be measured and the lessons learned applied to improve the predictive utility of the IP liquidation appraisal model.
The Broader Capital Markets Embrace IP Lending
As IP lending became more prevalent in the commercial finance market, Consumer and Retail IP became more acceptable collateral to the broader capital markets as well. The large public licensing companies such as Iconix were able to create securitizations built around the royalty income streams thrown off from brands licensed to mass merchants such as Target and Walmart which generate tens of millions in royalties each year. In some cases, the cash flows associated with the licensing companies’ brand portfolios supported large senior secured credit facilities syndicated to a variety of participating lenders. In today’s capital markets, there are few if any lenders to consumer products and retail companies that do not at least purport to have IP lending solutions in their toolbox.
Today’s IP lending market is principally driven by senior lenders working in conjunction with private investment funds. In cases where meaningful licensing revenues are being generated across a broad portfolio of brands, senior lenders are able to provide a one stop shop solution with an ever-increasing number of willing participants and club members. Stretch ABL, FILO and bi-furcated Term Loan B structures continue to encompass the majority of middle market deals where brand assets provide meaningful collateral value.
Increasingly, the trend is for more aggressive advances against intellectual property assets as term and FILO lenders are willing to use Net Orderly Liquidation Value as the underwriting standard versus Net Forced Liquidation Value. Intellectual property values have been enhanced by recent changes to the federal tax code which have lowered the tax burden attributable to corporate income from approximately 40 percent to 25 percent.
Ample liquidity exists in the secondary market for consumer brands driven by licensing companies and strategics looking to expand into new channels of distribution, and to leverage existing manufacturing capacity across multiple tiers of quality and price. Asset disposition firms such as Hilco Streambank have created more sophisticated market driven appraisal models that provide greater certainty in their projection of likely intellectual property liquidation outcomes. These models are supported by a wealth of data relating to actual IP recoveries in distressed sales.
Consumer product and retail brands were once consigned to the category of “boot” collateral. In today’s capital markets, they provide a meaningful bridge to enhanced borrower liquidity. As technology and changes in consumer behavior continue to re-define balance sheets, one should expect that the importance of intellectual property assets to the formation of these companies’ capital stack will continue to grow.