Even as most sources of credit have dried up over the past few months, one has been going strong: the asset-based lending market. In fact, total committed credit lines among asset-based lenders increased 5.6 percent in the first quarter of 2008, reports the Commercial Finance Association (CFA), a New York-based trade group. And this is after a jump of 4.4 percent in the final quarter of 2007. In all, the industry is nearing $500 billion in total loans outstanding.

As its name suggests, asset-based financing refers to loans made against the assets a company uses to operate its business. The assets generally include inventory, capital equipment, and/or real estate.

One driver behind the growth in asset-based loans is, not surprisingly, the tightening lending policies at many banks. “The cash flow [lending] business has tightened, and businesses that need financing have to go somewhere,” says Andrej Suskavcevic, chief executive officer with the CFA.

Moreover, many cash flow lenders are moving away from the excessively low interest rates and skimpy covenants of the past few years, says Gregg Wise, senior managing director with GMAC Commercial Finance's structured finance division. This makes asset-based lending relatively more competitive.

At the same time, a growing number of hedge funds and private equity players are offering asset-based loans, says Suskavcevic. In some cases, an asset-based loan is part of a larger deal. For example, a manufacturer may obtain a cash flow line of credit, along with an asset-backed loan, to support its launch of a new product line.

From the lender's point of view, asset-based financing can be considered less risky than a loan based just on a company's expected cash flows, as the assets offer the lender protection. Even if the company's performance drops drastically, the assets should retain their value. “We look at the balance sheet and income statement, but they don't weigh as heavily on the credit decision,” says Robert Martucci, senior vice president with Rosenthal Business Credit, New York. “This is because we look at the performance of the asset.”

As a result, asset-based loans usually lack the financial covenants that accompany most cash flow loans, Wise notes. For instance, many loans that are tied to a company's cash flow stipulate a maximum debt-to-EBITDA ratio the company can carry. This typically wouldn't be found on an asset-based loan.

This is not to say that asset-based lenders simply open up their checkbooks. They first need to verify the value of the assets backing the loan. So, before lending against machinery, the lender may have an independent appraisal firm value the equipment. If the loan is against inventory, the lender typically will require weekly or monthly reports on inventory levels.

While each loan is individually negotiated, most follow some general guidelines. Many lenders will advance up to the lesser of about 60 percent of the cost of inventory or 80 percent of its liquidation value, Wise notes. Loans for fixed assets, such as machinery and equipment, generally top off at about 80 percent of liquidation value, while loans against real estate tend to run between 50 percent and 70 percent of the appraised value.

For companies that already are highly leveraged, asset-based loans tend to be less expensive than cash flow loans, although the difference isn't as dramatic as it was a year or so ago, Wise notes. For example, 12 months ago, it wasn't unusual to find asset-based loans at 150 basis points over LIBOR. Today, these loans are more likely to be priced at LIBOR plus 225 to 300 basis points, he says.

Along with the interest rate comes a closing fee, which usually increases as the loan gets more complicated or requires syndication, Wise says. Borrowers also may pay a fee for any unused line of credit, as well as fees for periodic appraisals.

Companies generating strong cash flows often are able to get better rates when borrowing from their banks, Martucci notes. Even these firms may find, however, that the typically less stringent covenants of asset-based loans still tip the balance in their favor, he adds.

Although asset-based loans exist across most industries, they're more common, not surprisingly, in capital-intensive sectors, such as manufacturing, transportation, textiles, and distribution. Several years ago, asset-based loans also began appearing among service companies, which would pledge intangible assets, such as patents or trademarks. Today, these loans make up a small portion of the overall asset-based lending market; Martucci estimates that they account for less than 10 percent of his firm's asset-based loan portfolio.

As almost all areas of the commercial financing markets shift, asset-based lending continues to move into the mainstream. “It's a viable financing option,” says Suskavcevic.