What is a concentration limit in a borrowing base?

Why lenders cap a single customer

An asset-based lender is diversified across a borrower's customers. If one of fifty customers fails to pay, the collateral loses a fiftieth of its value and the lender's cushion absorbs it. If one customer makes up half the receivables, a single bankruptcy, dispute or change of supplier would cut the collateral in half overnight. The advance rate, typically 80% to 90% of eligible receivables, cannot absorb that.

The concentration limit keeps the collateral diversified by rule. Borrowing bases commonly cap any single customer at 20% to 25% of eligible receivables. Receivables from that customer up to the cap count normally; anything above it is excluded from the borrowing base as concentration excess. The invoices remain collateral, and the customer may well pay every one of them. The lender simply will not lend against more than the cap.

Concentration excess is ineligible because of who owes it, not because anything is wrong with it.

How the cap is calculated

The limit is applied after the other ineligibles. The lender first removes aged invoices, cross-aged customers, contras, affiliates and other exclusions, then tests each remaining customer's eligible balance against the cap. Agreements differ on the base the cap is measured against, usually total eligible receivables, and that definition is worth reading closely, because it changes the answer for a business with a very large customer.

An example. A manufacturer has eligible receivables of 2,000 before the concentration test. Its largest customer accounts for 800 of that. The cap is 25% of eligible receivables. The line advances 85%.

Every invoice to that customer may be current and undisputed. The business still borrows 255 less than it would if the same receivables were spread across more customers.

What happens as a big customer grows

The limit bites harder the faster the largest customer grows relative to the rest of the book. Hold everything else at 1,200 of receivables and let the largest customer's balance rise, with a 25% cap measured on total eligible receivables:

Going from the first row to the last, receivables grow by 900, all from the largest customer. Eligible receivables grow by 300. Two-thirds of the growth is unfinanced. This is the pattern that catches growing suppliers to big customers: sales rise, working capital needs rise with them, and the line does not keep up. It is why sizing a working capital line needs a forecast by customer, not just a forecast of total sales.

Negotiating a higher cap

Concentration limits are one of the most negotiable parts of a borrowing base, because the lender's concern is the customer's credit, and some customers are very good credits. Common exceptions:

• Customers with strong credit. Lenders often agree to a higher cap for a named customer that is investment-grade rated or otherwise financially strong, sometimes set customer by customer.
• Government receivables. Federal, state and local agencies rarely fail to pay, though they can be slow and assignment rules apply. Lenders may allow higher concentration where the receivables are properly assigned. See lines of credit for government contractors.
• Credit-insured receivables. If the concentrated account is covered by trade credit insurance with the lender as loss payee, the lender may count more of it.
• A long, clean payment history. Years of on-time payment by the customer, documented in the aging history, supports a request even where the customer is not rated.

What a lender will agree to depends on the customer, the lender's own policy and the rest of the borrower's credit. Bank and non-bank asset-based lenders often take different views of the same customer; see bank vs non-bank ABL. The time to ask is before the term sheet is signed, with the customer's credit and payment history in hand, not after the first field exam.

When one customer dominates the business

The concentration limit is the borrowing base's version of a broader concern. A business that depends on one customer for a large share of its revenue carries that risk in its earnings as well as its collateral, and lenders underwrite both. For how that affects the size and terms of a loan as a whole, see customer concentration and debt, and for buyers, how concentration affects financing an acquisition.

For a business whose largest customer sits well above any cap a lender is likely to accept, the options are usually some combination of these:

• A customer-specific higher cap, negotiated on the customer's credit, with the rest of the borrowing base at normal terms.
• Credit insurance on the concentrated account, which can make more of it eligible.
• A cash-flow line or term loan alongside or instead of the asset-based line, sized on earnings rather than collateral. See asset-based vs cash-flow lines.
• Factoring the concentrated account, since many factors underwrite the customer's credit rather than the borrower's and may be more comfortable with a strong, large customer. Transparent's book holds 116 lenders that write factoring; see factoring vs asset-based lending. Any split of receivables between a factor and a lender needs both to agree.
• The customer's own supplier finance program, where one exists, which again requires the lender's consent because it sells receivables the lender may hold a lien on.

The documents that let a lender assess concentration up front are an AR aging by customer with days outstanding, a customer list with the balance owed by each, and for a key customer, the contract or purchase orders and its payment history. Showing the concentration, and the customer's credit, at the start usually leads to a better answer than letting the lender discover it in the aging.