The ABCs of ABF: Part 2 – Basic Financing Structures

As investor interest in the asset-based finance (ABF) market has grown in recent years, investors increasingly access this market not only by acting as a source of private asset-backed lending to others, but also through their own ownership or management of these assets, whether acquired from originators (as discussed in Part 1 of this series) or originated through strategic partnerships. In Part 2 of our ABF series, we will discuss the basic asset-based debt financing structures that still form the core of financing, leveraging or exiting these assets.

Debt financing of the origination, acquisition or ownership of cash-generating assets allows investors to leverage capital efficiently, potentially enhancing returns while spreading risk. The core tenet of asset finance is that the assets and related contractual cash flows are segregated from operating risk and performance of the originating entity or the entity contributing assets to the facility. Debt is serviced by the cash flow generated by the assets, so lending is based on the credit risk of the underlying collateral pool and not the credit risk of the originator, contributor or any other entity. In each case, assets are ring-fenced in a bankruptcy-remote special purpose entity (SPE) and are not affected by the automatic stay in the event of a corporate bankruptcy of any other entity. On a basic level, financing facilities can generally be grouped into one of the following categories: term loans, revolving credit facilities and asset-backed securities. Funding under the former two may be provided by banks, financial institutions, investment funds or others. In the latter case, securities are issued through either private or public markets.

Term Loans

In a term loan transaction, a pool of assets is sold to an SPE that borrows a fixed amount of money from a lender or syndicate of lenders, which is repaid over a specified period with regular installments from the cash flow generated by the asset pool as the underlying assets amortize or pay off. This self-liquidating structure provides predictability in repayment schedules and interest costs.

Key features of term loans include:

• Fixed or Variable Interest Rates: Depending on the agreement, interest rates can be fixed for the loan’s duration or variable, based on benchmark rates plus a margin.
• Amortization: The loan is repaid in regular installments, which can be structured to match the cash flow from the pledged asset pool.
• Prepayment Penalties: Some term loans may include penalties for early repayment.

Traditionally, originators use term loan structures as an alternative to securitization for a fixed pool of assets. For asset purchasers, the term loan structure is most useful for financing a portfolio acquisition or a pool of seasoned loans moved from a revolving credit facility.

Revolving Credit Facilities

In a revolving credit facility, assets are sold to an SPE not in a single transaction but from time to time over the life of the facility as they are originated or acquired. The SPE enters into a revolving loan agreement with lenders that allows the SPE borrower to draw funds to make additional asset purchases. The assets acquired are pledged to the lenders as collateral for the loan. This provides a more flexible financing option than a term loan.

Key aspects include:

• Flexibility: Borrowers can draw and repay funds multiple times within the credit limit, providing liquidity for portfolio management.
• Interest Rates: Typically variable, based on benchmark rates plus a margin.
• Commitment Fees: Lenders may charge fees for the unused portion of the credit line.
• Borrowing Base: The amount that can be borrowed under a revolving credit facility will typically be the lesser of a dynamic borrowing base calculated by reference to the aggregate outstanding balance of assets owned by the borrower that meet specific eligibility criteria and a predetermined maximum facility amount.

This structure is particularly useful for managing cash flow and funding ongoing acquisitions through forward flow agreements. Traditionally, originators use revolving credit facilities to “warehouse” originated loans prior to securitizing or contributing the assets to a term loan SPE. Similarly, investors can use these facilities to fund ongoing acquisitions under forward flow agreements either on a long-term basis or prior to “taking out” these assets to a term loan or ABS issuance.

Asset-Backed Securities (ABS)

In an ABS issuance, an SPE will generally purchase a pool of assets and issue securities backed by such pool. As with a term loan, the collateral pool will generally self-liquidate over time (although in the case of short-term revolving assets such as credit card receivables, a master trust structure may be used whereby a continuously replenishing asset pool backs multiple series of notes). Compared to a term loan or revolving credit facility, ABS allows risk to be spread among multiple investors distributed through the capital markets, allowing a broader range of investors to participate and potentially providing greater liquidity. ABS may be distributed broadly in a public issuance or to a limited number of sophisticated investors through a private issuance. Note that in each case, as securities, the issuances are subject to applicable regulatory requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934, including disclosure and risk retention requirements.

Key elements include:

• Tranching: The portfolio is divided into tranches with varying risk and return profiles, attracting different types of investors.
• Credit Enhancements: Techniques such as over-collateralization, reserve accounts or third-party guarantees can improve the credit rating of the securities.
• Greater Liquidity for Investors: Notes issued in an ABS transaction, particularly one where the securities are rated, are more liquid than loans advanced in connection with a term loan or revolving credit facility.

Traditionally an important funding source for asset originators, ABS is also an attractive and important financing channel or exit option for asset owners. Additionally, asset managers may work with one or many originator platforms to pool collateral for sponsored ABS transactions, for which they may receive a management fee as well as residual returns.

Stay tuned to THE CRED for more of our multi-part series on ABF. Next up in Part 3: moving beyond the basics, we will discuss innovative financing solutions utilizing the basic structures in new ways, including borrowing features from other areas of structured finance.