Who is the SOFA King?
SOFAs originated in the non-bank ABL sector as a way for independent firms to differentiate themselves from bigger banks. But, as Charlie Perer writes, with more and more bank-ABLS embracing SOFAs, it is the large institutional lenders that have been crowned the SOFA kings
By Charlie Perer
The Secured Over Formula Advance (SOFA) has been back in vogue for quite some time as it is one of the true competitive differentiators that a mid-market bank or non-bank ABL firm can use to separate it from the competition. Or, rather, it was until other lenders started to follow the same path.
The SOFA product is exactly what it spells out to be: a non-formula over-advance in the form of a term or an interest-only loan that is secured but effectively non-collateralized as it is separate from the formulaic borrowing base. So why is it being used more aggressively now, especially by banks? The simple if counterintuitive answer is that banks can more easily make and justify a SOFA than non-bank ABLs, making bank-ABLs the top dogs in the modern SOFA market. Here is a little context as to the how and why.
The SOFA emanated several decades ago as a creative tool for ABLs to acquire clients by providing excess availability for new clients. By providing a SOFA, the ABL could acquire a client from a competitor and provide a clear availability differentiator. When the ABL moved borrowing base dollars to the SOFA, it would create availability, as the SOFA amount created dollar for dollar availability on the borrowing base. This ancillary product was also used to keep the best clients from leaving, because a secured but non-collateralized stretch piece made it difficult for competitors to refinance the incumbent and have sufficient or any opening availability without matching the SOFA.
From a market perspective, the bank-ABLs dominate this product more so than the non-bank ABLs as they are tightly managed by lender finance institutions such as Wells Fargo. Additionally, most smaller firms cannot afford to risk providing this product to smaller businesses that lack scale and liquidity. This is why the SOFA is most commonly used in ABL facilities starting at $15 million and up.
The best historical use for the SOFA would be to generate opening excess availability so loans outstanding were fully in margin with excess availability. Where today’s SOFA has evolved is that the ABL is really lending on the enterprise value of the business and utilizing a rapid amortization to get the ABL back in margin fairly quickly. Cash flow recaptures have now been added to longer-term SOFAs as a way to mitigate risk. Bank-ABLs have also had to become more sophisticated given increased competition from non-bank ABLs. So today’s SOFA certainly draws from history but is typically longer in term, based on some enterprise analysis and contains a cash flow recapture to effectively shorten the term.
The ABL is not really in position to provide more cushion if a deal goes sideways, and the SOFAs are getting more aggressive in dollars at risk, term length and overall risk. SOFAs used to consist of two-year terms, but many are starting to extend to three years, with several ABLs out in the market with five-year terms. Most of these situations are sponsor-backed, but if a deal goes badly, the marginal deal that got the SOFA is clearly where the biggest loss is going to occur. For that reason, this product has historically been used sparingly and only for a firm’s best clients given the non-formula risk and the inherent situational risk that lead to the need for a SOFA. Said differently, the ABL runs the risk that the SOFA is a bridge to nowhere rather than a problem-solver. It is also why non-bank ABLs with less capital cushion use this product more sparingly.
To be clear, when used properly, a SOFA is the perfect utility for an experienced ABL. It can win a client, keep a client or save a business. Not all businesses conform perfectly to an ABL structure, especially if you factor in businesses with seasonality, in-transit inventory or foreign receivables, among other things. The longstanding bank ABLs apparently are allotted a number of risk rating deals to provide a SOFA, and lender finance groups provide a small over-advance bucket for their non-bank ABL clients. The clear issue is that a utility product for ABLs is morphing into an everyday product. Champagne, after all, is nice during major holidays but not for lunch every day.
The key change in the SOFA use is obviously ABLs going from a limited-use product designed to acquire and keep only the best clients to a much more widely-used product with loosening credit standards. When SG Credit Partners started its cash flow lending group five years ago, our primary goal was to provide an offensive rather than defensive SOFA, given a core part of our business is bank-to-ABL financings. Our goal was to help ABLs acquire and retain new clients rather than compete with them, with the clear trade-off a lower rate from a bank-ABL compared to the SG Credit version of a SOFA, which is unregulated and has more flexibility than a bank. It was a great time to enter the market, but our firm clearly underestimated the competitive market forces and ability of banks to dominate this market.
The majority of deals lost have been to bank-ABLs providing SOFAs, which was counter to what we expected. From a non-bank lenders’ perspective, the client is paying LIBOR for true non-collateralized risk. The client is paying significantly less than what most non-banks pay for their capital.
This bank-ABL risk is pervasive throughout the country as the SOFA is now part of standard marketing collateral for many bank-ABLs. When SG Credit Partners started out as Super G Capital, our goal was to use our capital to finance the risk that ABLs should not or could not finance. What we quickly found was that many ABLs were already providing offensive SOFAs to acquire clients and were calling us to get out of SOFAs when clients underperformed or went sideways — still a great phone call, if contrary to how we thought the market would shake out. Fast forward to 2019, and today the market opportunity is a strong mix between offensive and defensive SOFAs which ebbs and flows based on the risk the bank-ABL industry wants to take. The uniqueness and benefit of a non-bank, unregulated firm is the ability to provide flexible structures and solve the majority of needs that ABLs can’t solve.
As to the question, who is the SOFA king? The bank-ABLs are king but are primed for a changing of the guard as we head into tighter credit markets. Stay tuned as the market starts to rationalize, and credit/risk departments begin to again value safety over growth.
For avoidance of doubt, all opinions and observations expressed by the author are his own. In addition, the author welcomes feedback from banks and ABLs around the country. •
Charlie Perer is co-founder and head of Originations at SG credit Partners (previously Super G Capital). He is responsible for originating and structuring transactions across all loan products and corporate development initiatives. He can be contacted at Charlie@sgcreditpartners.com or 310-562-2020