Asset-backed lending is widely understood to involve structured credit transactions secured by collateral of varying types and quality. Traditional deals backed by so-called hard assets are very common, and rely on the liquidity and value of the assets to backstop them. Asset-backed lending at times is executed in another format, some call “wholesale lending.” Wholesale lending is nothing more than a larger lender lending to a smaller specialty finance company. In asset-backed transactions, under the wholesale lending umbrella, the collateral is “financial” assets like leases or other instruments, which offer investors the opportunity to pick up additional yield at lower levels of risk.
Managers sometimes do not take the issue of collateral seriously enough, especially in attractive economic environments where credit quantity is more important than credit quality. Yet experienced asset-backed investors know collateral is the most paramount component of every transaction. When properly constructed within a debt facility, it is the fastest and most complete recourse available to the lender in case things go awry, so it must be comprehensively analyzed, modeled and monitored to ensure it adequately covers the underlying facility.
Collateral takes many forms and is rarely the same in any two deals, highlighting the customization possible with transactions in this space. Obviously, the more valuable and/or liquid the assets are, the less of them a lender may need, and vice versa. This is especially true when the collateral for a transaction is comprised of hard assets, i.e. actual physical things like machinery, inventory, products and other forms of tangible property that can be readily monetized in the case of a default.
However, in wholesale lending, loans are made to specialty finance companies and other owner/managers of financial assets. These companies are lenders in their own right, subsequently loaning the capital from the debt facility to borrowers of varying credit qualities.
By essentially lending to the lender, the originator of the debt facility is secured against default by these underlying loans, or rather the rights to the future cash flows they represent. Structurally, these facilities are best done through bankruptcy-remote special purpose entities that can provide protection and attractive unlevered returns.
These transactions fare well when compared against rated securitizations of similar loans, such as traded credit tranches of subprime auto installment loans. Provided the collateral pool is deep enough to ensure proper diversification, the private transaction can exhibit profit enhancement on the order of 600 basis points. This excess spread is earned by accepting the illiquidity of a private transaction.
Moreover, a key component of such transactions is enhanced risk mitigation. One of Old Hill’s portfolio managers, Peter Faigl, is an expert in this aspect of wholesale lending. He structures debt facilities in such a way as to lower the effective loan-to-value (LTV) of the outstanding debt. In this way, the lender risk can be dramatically reduced.
For instance, assume a specialty finance company originates loans with an average LTV of 80%. The wholesale lender then provides a debt facility to the company with an advance rate of 80% on underlying loan balances that are less than 60 days past due, and 30% on those between 60 and 120 days past due. By combining the protection of the specialty finance company’s original LTV with the scaled ones of the structured debt facility, the effective loan-to-value for the originator of the facility is essentially never higher than 64%, and in some cases, significantly lower.
When coupled with tools such as floating rate coupons, origination fees and rate floors that can be included in the facility, this type of construction can adequately secure a wholesale lender, even at 2008-2009 levels of delinquencies and defaults. The investor, meanwhile, earns risk-adjusted returns that are well north of average.
Wholesale lending to specialty finance companies is slightly more complicated than transactions backed by hard assets, and requires a more sophisticated approach to risk management. Underlying loans are often made to sub-prime customers unable to get credit through traditional channels, making comprehensive collateral analysis and monitoring a necessity in order to adequately protect lender’s principal.
However, when structured correctly, by experienced lenders armed with the requisite resources, the result is exposure to fixed income instruments that can deliver significant yield pickup over comparable securitized assets. As a niche within the broader asset-backed universe, wholesale lending combines the advantages of low volatility with strong collateral protection and tremendous structuring flexibility – all of which helps ensure capital preservation while also delivering attractive, uncorrelated returns.