Asset Backed lending

Asset-Backed Lending

Background:

Asset-backed lending funds have enjoyed good returns in recent years, sparking the interest of investors and their advisors in the process. Over the five-year period from '96 to 2000, for example, when most stock indices exhibited bi-polar behavior with large gains being followed by sometimes larger falls, many asset-backed lending funds averaged over 12 percent annually, with few losing quarters and little market correlation. Not many investors are familiar with this part of the investment world primarily because it has long been the preserve of professional investors and large investment houses. This report introduces the subject and sets out to provide answers to the following questions:

1. What exactly is asset-backed lending?
2. What are the key risk factors and qualities required for investment success?
3. What investment performances can we anticipated

Asset-Backed Lending:

Where does a middle-sized business go when it urgently requires short-term liquidity? Not to a traditional lender such as a bank if it has already mortgaged its real estate and pledged its receivables (money owed by its customers). Traditional lenders typically prefer larger clients, while other asset classes generally mil below their radar. So the business approaches a recommended non-traditional lender who in turn will carry out the following tasks:

Major elements of the business will be analysed, its strengths and weaknesses determined and cash flow projections developed.
Each un-pledged asset class will be identified, reviewed and conservatively valued.
Where necessary, industry experts will be consulted to confirm key conclusions.

If such investigation unearths assets which can provide ample collateral, he lender will then prepare, negotiate and close a loan offer secured by the assets. Typically such loans are short- term by design - about twelve months - coming with relatively high interest rates and up front costs and little in the way of prepayment penalties.

In such a deal, both parties stand to benefit. The lender obtains a good annualised return- more than fully secured by conservatively valued assets. The business gets quick liquidity, the ability to capitalise on an opportunity or solve a problem and the flexibility to refinance with a traditional lender or restructure. Clearly such deals do not make the front pages but they go on all the time. For example, a software development company was losing money, needed liquidity and had a valuable if unconventional asset in the form of a customer list that included many fortune 500 firms.

The customer list presented value to its competitors should they acquire the company. Using the customer list as collateral for a loan, the company had time to approach competitors and finally negotiate to be acquired.

Risk Factors:

These can fall into three categories:

Mild: In good economic times it is not unusual for an asset-backed lender to find it harder to place loans. While not exactly a risk, funds are not fully deployed

Short-term: During times of financial crisis there is typically a capital flight to quality, such as occurred in 1998 after the Russian financial crisis. Here, interest rate spreads between 'safe' treasury securities and 'less safe' bonds widen. This causes a drop, albeit temporary, in the market value of asset-backed loans.

Severe: Here, companies become distressed and pledged assets are sold to repay associated loans. Should this occur during recessionary times and asset values drop significantly, losses can be incurred.

Success Factors:

Successful asset-backed lending requires a strong set of skills and assets which include:

1. A good brand name or reputation (most businesses seek out the lender).
2. Good industry experience and analytical skills.
3. Strong negotiating skills (the costs of such loans to business are high, but typically so are the benefits).
4. Strong risk-management techniques which include:
• diversification of investments by company, industry and region;
• modest use of leverage;
• focus on short-term loans;
• strong collateralisation of loans where pledged assets substantially exceed the amount of the loan.

In summary, non-traditional lenders go where banks fear to tread. Those with superior reputations, skills, speeds of response and risk management controls fare the best.

Future Returns:

Asset-backed lending is classified as an "event-driven" investment strategy, as returns in this arena are driven more by the volume of loans, their pricing and the quality of their collateral than by the movement of equity prices. Market correlation is very low, although economic crises do cause a degree of temporary volatility. In recent years, banks and traditional lenders have moved away from this more complex sector. This suggests that the future could look even better than a very respectable past, where asset-backed funds achieved equity-like
annual returns with minimal volatility or market correlation.