Strategic Considerations in Asset-Backed Lending

As a year like no other in the past century, 2020 bears the hallmark of an inflection point in which pre-pandemic trends have been accentuated and accelerated, with emergency action plans dusted off, to counter the turbulence of doing business in a world of outsized uncertainty. Balance sheet liquidity is one bellwether of business survival, and companies across the globe have drawn down on debt facilities, and issued equity to shore up their balance sheets to cushion against risks, known and unknown, and help navigate the journey ahead. Asset-backed finance is now, more than ever, a critical component of the company’s capital structure and gives impetus to review the strategic significance of this form of funding.

First, a brief reflection on the advantages of debt over equity in the capital structure, as well as the contextual setting of senior debt relative to asset-backed lending. Generally, equity tends to cost more than debt, because shareholders (unlike lenders of debt) bear the residual risk of conducting business enterprise and require higher returns to compensate for the uncertain promise of equity upside. In contrast, the cost of debt (i.e. interest) is lower because it is tax-deductible and reflects the certainty of returns (i.e. interest and principal repayments) promised to lenders in line with the company’s credit worthiness. In a COVID-19 world, the buttress of central bank support across capital markets has translated into an ultra-low interest rate environment, further widening the gap between the cost of equity and debt, at least for investment grade credit as well as high yield credit backed by durable business models and cash flows into the future.  

Senior debt represents the bedrock of debt financing, and its presence in the capital structure comprises a negotiated package of finance that, once molded to the long-term needs of the business and attenuated by a framework of covenants, is relatively static. Senior debt is primarily viewed as secured first by the firm’s operational cash flows with residual security thereafter in a general asset pool not secured in favour of asset financiers.

Asset finance, by contrast, is neatly suited to asset-rich balance sheets and operates far more flexibly and responsively, when the firm’s need arises. This form of financing is quicker and more efficient to implement, with the advantage of being dynamic in supporting the growth needs of the firm. A key feature is enhanced balance sheet liquidity, whether through financing new assets and optimizing cash flow over time or leveraging existing assets to free up capital to be deployed to more productive use.

In addition, as a financing solution tied to specific assets, cash flow can be improved by designing and matching the tenor and repayment profile to the expected behaviour of the assets over time, thus achieving more bespoke outcomes for the firm. In this form of finance, the security collateral generally comprises the specific assets being leveraged, which heightens the importance to both lender and borrower of loan to value metrics on inception and over time. This, in turn, necessitates a deeper understanding of the asset’s performance in situ and its recoverability, whether by use or market sale.

Another feature of asset finance is the flexibility to integrate this kind of facility into the functional operation of other debt in the capital structure and enhance the credit that underpins the asset-backed lending, where appropriate. This may be achieved, for example, by cross collateralization and cross-default arrangements, and while less frequent, the firm (lessee) and lender (lessor), may negotiate to afford asset finance facilities the benefit of financial covenants that trigger the same notifications as arise under senior debt arrangements. Also, asset-backed facilities separate to other debt enables the firm to diversify its sources of debt capital and reduce reliance risk.  

The matrix of product structures within the ambit of asset-backed finance is diverse and depending on the needs of the firm, may be implemented by way of a finance lease, hire purchase, secured loan or rental finance (i.e. operating lease). Rental finance stands apart in its procurement role for the firm, in that it distinctly serves as an opex solution in commercial terms, and is ideally suited to assets where the firm prefers to avoid asset risk that may be inherent in, for example, technological obsolescence over time. In addition, investment in the residual risk permits the lender to solve for a preferred cash flow outcome for the renter, with additional flexibility for the renter at end of the contract tenor to decide whether to continue to renting the assets, buy the assets or merely return them.

If you are questioning the current practices within your organisation, please feel free to contact one of our team for a review and some suggestions of what could be available for your benefit.