Distressed Debt Legal Insights: An Overview of FILO Loans

Welcome back to Distressed Debt Legal Insights, Ropes & Gray’s periodic source of timely insights for professionals navigating the complex world of liability management and special situations finance. This issue provides a brief overview of FILO loans: what they are and why they are useful.

Elements of FILO Loans

A FILO (first-in, last-out) loan, with increasing utilization as of late in the special situations arena, is commonly structured as an asset-based term loan that sits alongside an ABL facility. Like the ABL, it is sized based on a borrowing base typically consisting of eligible accounts receivable and inventory. The term loan is funded on the closing date, hence the nomenclature “first in” compared to the ABL, which is revolving in nature (even if drawn—or funded—on the closing date). The term loan is junior to the ABL in lien priority and/or payment priority, making it “last out” because FILO lenders recover last.

The FILO may also take a first lien on certain unencumbered or non-traditional ABL assets to supplement its collateral base. This can result in the FILO and ABL having a split-lien relationship akin to that of a typical term loan and ABL if the ABL decides to take a second-lien on the FILO additional collateral. For example, the FILO may have first priority on fixed assets (such as equity and intellectual property), with the ABL having first priority on working capital assets and second priority on fixed assets. In larger facilities, you may also see all three types of facility in the same credit: a term loan, ABL and FILO.

A FILO loan can be documented through a separate credit agreement to the ABL or under the same credit agreement as a separate tranche. The lender providing the FILO may prefer the former for voting purposes. A borrower and the ABL lenders, however, may prefer the latter for administrative ease, costs and voting control. The form of the FILO will likely be determined by the party with the strongest negotiating position. In addition, FILO loans often are accompanied by heavily negotiated intercreditor or other agreements among lenders, often with further tranches within the FILO loan itself.

How FILOs Work

Both ABL and FILO facilities are administered through a borrowing base, and the borrowing bases of the two facilities work in tandem. If a FILO loan is over-advanced (i.e., exceeds its borrowing base availability), rather than requiring a paydown, the typical mechanism is to create what is called a “pushdown reserve” in the ABL facility that blocks ABL availability by an amount equivalent to the FILO over-advance in order to provide a reserve for the FILO loan.

Among other intercreditor issues, for FILO lenders to remain protected, it is important that FILO loans include a cap on the amount of the ABL facility, and limit the ABL’s ability to change its borrowing base definitions or advance rates. Intercreditor agreements also will include highly negotiated provisions relating to each lender’s rights to provide debtor-in-possession financing and other chapter 11 matters.

As the junior loan, FILOs typically have standstill periods following an event of default, but these are often shorter than typical first lien/second lien standstills. For certain specified events of default – namely payment and insolvency events of default – the standstill period is typically 30-60 days. For other events of default, it is often 90 days.

Why FILO Loans are Useful

In a typical ABL, borrowings are capped at a percentage of the borrowing base collateral, often approximately 85-95% of the value of all eligible accounts receivable and 65-75% of the value of all eligible inventory. FILO lenders are typically willing to take on additional risk; the FILO loan effectively can bring the advance rate up to as much as 100%, providing the borrower with additional liquidity using the same borrowing base assets. The FILO loan utilizes the spread between the ABL and the FILO loan as its collateral coverage.

Although FILO interest rates are higher than ABL rates, FILO loans generally have a lower cost of capital compared to cash flow loans due to the ongoing appraisals and focus on the value of the collateral. Another benefit is that many FILO loans do not require amortization.

Why This Matters

FILO loans are a valuable and increasingly utilized liquidity tool, especially for retail companies with large pools of working capital that continue to face challenges from supply chain volatility, higher interest rates, tighter credit markets, and weakening consumer demand. Although a FILO loan can provide financing to a healthy company, it is often utilized by (di)stressed companies as a viable tool. FILO lenders consider these deal dynamics and the possibility of a chapter 11 filing when structuring FILO loans.