Asset-based lending hedge funds: The alternative’s alternative

Few corners of the credit markets were able to sustain themselves during the financial crisis and emerge strengthened. As a rule, the health of lending institutions and the issuance of debt instruments rose and fell together during the post-turn-of-the-century credit boom and ensuing credit crunch and recession. A notable exception to this dynamic were asset-based lenders and relative newcomers to the industry – hedge funds that make asset-based loans (ABL funds).
 
Asset-based lending: From theory to practice
Just as hedge funds are a type of alternative investment fund when compared to traditional asset-managers focused on long-only strategies with publicly traded instruments, asset-based lending is a type of alternative lending strategy when compared to commercial loans that are extended on the basis of the strength of a borrower’s financial statements. Asset-based loans generally provide working capital or other relatively short-term financing needs to small and medium-sized businesses. Asset-based lending is a type of secured lending, or a loan whose repayment is provided at least in substantial part by collateral pledged against the loan and which typically takes the form of accounts receivables or inventory. Secured lending more generally is one of the many types of lending often utilised by small and medium-size enterprises, which also includes trade credit, leasing and relationship lending. Asset-based lending is more than just a loan secured by collateral, however. Asset-based lending also involves the lender basing its determination of how much credit to extend primarily upon the value of pledged collateral and actively monitoring the collateral for the duration of the loan.
 
Because asset-based lending is a type of financial intermediation, it can be better understood by first taking a step back and looking at the role that secured lending plays in financial intermediation more generally. Financial intermediaries, of which lending institutions are the most basic type, are generally understood to exist because of informational asymmetries between lenders and borrowers. Lenders are in an informationally disadvantaged position compared to borrowers when it comes to the borrower’s activities and true financial health. Screening borrowers at the outset of the loan making decision helps to ensure that the risks posed by borrowers, however great or small, are properly taken into account in the price and other terms of the loan. Monitoring borrowers after credit is extended is another mechanism to reduce informational asymmetries about lenders, especially when lenders increase or otherwise change their risks after obtaining a loan. Finally, the ability of lenders to actually recover their funds can help reduce the costs from a lack of borrower information that ultimately results in an actual failure to pay.
 
Lending against secured assets helps lenders to screen, monitor, and recover their loans. Although riskier borrowers tend to pledge collateral, borrowers with collateral of insufficient value, liquidity or quality can be screened at the outset as not being creditworthy. Granting a lender a security interest in collateral may reduce a lender’s monitoring costs since a secured lender is less interested whether a borrower has increased its overall company-level risk if the loan is adequately collateralised. Asset-based lenders in particular will first look to liquidation of the pledged collateral as a source of loan repayment if the borrower defaults on the loan.
 
Despite asset-based lenders not generally being required to monitor borrowers for an increase in overall risk, the practice of asset-based lending revolves around an intense form of collateral monitoring. Although financial statement lenders often use collateral to secure their loans, active monitoring of collateral is what sets asset-based lending apart from lending that looks to the company’s general operations as the source of loan repayment. Asset-based lenders reduce informational asymmetries by frequently monitoring a borrower’s collateral. Monitoring activities include processing reports, such as accounts receivables collection schedules and on-site field examinations which are used in part to prevent borrower fraud. The purpose of collateral monitoring is to ensure that the amount of the funds extended to a borrower is in line with the lender’s determination of appropriate loan-to-collateral values. Asset-based loans are typically priced on a floating rate basis and come in the form of a revolving line of credit. The amount of funds actually made available to a borrower depend upon its “borrowing base”, that is, the assets eligible as collateral and a discount rate applied on the collateral to provide a cushion against unforeseeable risk. 
 
Asset-based lending hedge funds
The asset-based finance industry traditionally consisted only of commercial finance companies operating independently of other institutions, finance companies that are owned by banking institutions and non-bank firms and business divisions of commercial banks. Although hedge funds have made asset-based loans for over a decade, shortly after the turn of the century the funds began to noticeably increase their involvement with asset-based lending. According to the HedgeFund.net database, ABL funds managed approximately US$15.6 billion in assets as of February 2009 compared to less than $1 billion in 2004.
 
Several factors drove the growth of ABL funds. Perhaps most importantly, ABL funds grew along with the rest of the hedge fund industry and largely for the same reasons: institutional investor demand for returns less correlated with traditional assets classes and a growing familiarity and comfort with hedge fund strategies, including asset-based lending. Within the hedge fund sector, asset-based lending provided hedge fund managers traditionally focused on trading financial instruments an investment strategy less crowded than the more common hedge fund strategies such as long/short equity, global macro and fixed-income arbitrage.
 
As measured by their returns and correlations, ABL funds have indeed emerged as an alternative strategy within the alternative universe of hedge funds. From January 1997 to February 2007, ABL funds had the lowest correlation of returns to a wide range of hedge fund strategies and also to the equity markets, according to HedgeFund.net. ABL funds were also one of the few hedge fund strategies to have meaningfully positive returns in 2008. While hedge funds overall posted losses over 15 per cent and equity markets dropped by about 37 per cent in 2008, ABL funds returned 5.28 per cent for their investors that year, according to HedgeFund.net. ABL funds continued their low correlation with equity markets in 2009 with a return of 6.16 per cent.
 
ABL funds have also grown along with the asset-based lending market more generally, which has also steadily increased in size since shortly after the turn of the century. While traditional lenders curtailed their lending activities from the onset of the credit crunch in 2007, asset-based lending never slowed and grew at about 10 per cent annually from 2002 through 2008. In 2007 and 2008 in particular, total asset-based loan volume outstanding was $545 and $590 billion, respectively, according to the Commercial Finance Association. Not surprisingly, the recent spurt in asset-based lending is precisely because of decreased lending from traditional sources.
 
Hedge funds were uniquely positioned to devote capital to asset-based lending since as a whole the industry was not as heavily exposed to losses from the toxic mortgage-related securities invested in by banks and other financial institutions. The troubles of large asset-based lenders CIT Group and GE Capital also made available more opportunities for ABL funds. Competition from ABL funds has been felt by traditional asset-based lenders, who have changed their credit standards and lost personnel to the funds. But more significantly, ABL funds’ willingness to take on risk has enabled traditional asset-based lenders to make larger loans. ABL funds and traditional asset-based lenders often partner in deals with ABL funds taking on the riskier aspects of the loan package.
 
The second-lien evolution

The employment of innovative investment strategies has been a hallmark of the hedge fund industry since their inception. And ABL funds’ approach to asset-based lending is no exception. ABL funds have innovated in the asset-based lending sphere in two primary ways. First, ABL funds are more likely to move beyond accounts receivable, inventory and other typical types of collateral used to secured asset-based loans. Hedge funds have more readily extended asset-based loans secured by collateral such as receivables backed by claims involved with workman’s compensation and litigation outcomes and also to franchise loans, real estate, energy development projects, intellectual property and film-related assets.
 
Second, ABL funds are more likely to use a wider variety of asset-based lending financing techniques than the more rigid and formula-based approach of traditional asset-based lenders. Foremost among ABL funds’ innovative lending strategies are the use of second-lien loans. Second-lien loans are secured by collateral and have priority over unsecured lenders and equity investors but are subordinate to first-lien loans made by other secured lenders on the same (or portions of the same) collateral. Second-lien loans were historically a very limited use type of financing utilised by companies to provide temporary capital or pay down existing debt in restructuring and ‘rescue financing’ situations.
 
But beginning in about 2003, the second-lien loan market was transformed by ABL funds to become substantially more widespread and used for more general financing needs and transactions such as recapitalisations, dividend payments, leveraged buyouts and stock recapitalisations. The volume of second-lien loans increased from $8 billion in 2003 to more than $29 billion in 2006, according to the Loan Pricing Corporation. Borrowers found second-lien loans attractive because they could be quickly obtained, their terms are flexible, did not necessarily require the borrower to give up any ownership or control, and, prior to the financial crisis at least, had an overall lower cost of capital. The lower cost of capital resulted from a second-lien lender’s priority over mezzanine lenders and enhanced rights in bankruptcy as a secured lender. The more widespread use of second-lien loans may have further reduced informational asymmetries by bringing in an additional group of monitors also concerned with collateral quality. Second-lien loan issuance has come to a near standstill since the financial crisis, however, while unsecured mezzanine finance has grown in attractiveness.
 
The key legal issue confronting all asset-based lenders is to preserve a perfected interest in the collateral over the course of the loan and thereby legally protect the lender’s claim to the collateral. With the existence of second-lien lenders, an inter-creditor agreement must specify the effect of a default or bankruptcy with respect to payment and lien priority among the asset-based lenders. First-lien lenders will seek to have their rights against the second-lien lender as free and clear as possible and to control the common collateral and the actions of the second-lien lender with respect to the common collateral and borrower. ABL funds in the position of second-lien lenders will, for their part, seek to preserve some control over the common collateral and borrower and hence the likelihood of being repaid. Inter-creditor agreements typically do not block payments to second-lien lenders and impose relatively short standstill periods post-default after which the second-line holder can exercise its remedies against the borrower or the collateral. Inter-creditor agreements are subject to a substantial amount of legal uncertainty in part because of the lack of a consistent and developed body of law surrounding the agreements and unsecured lenders increasingly attempting to secure their loans with second-liens.
 
Challenges and the road ahead
ABL fund investing has never been without its drawbacks. The typical three to five year asset-based loan is too long for the investment horizon of typical hedge fund investors, which may require ABL funds to use gates and other liquidity restraining devices investors often find unattractive. Many ABL funds were caught up in the declining loan values and investor redemptions that came along with the financial crisis and others were forced to close due to the Peterson Group fraud. Hedge fund lenders may also have conflicted interests since they have the ability to take positions with financial instruments that may be inversely correlated to the health of borrowers. Second-lien loans may also leave borrowers with little value if collateral is liquidated, and the utilisation of second-liens with equity kickers may be unduly dilutive to owners. Uncertainties surrounding the second-lien loan market also raise questions about the future of what was once a highly active component of the ABL fund sector.
 
Nonetheless, the core strengths of ABL funds remain. Borrowers are attracted to the funds’ flexibility, ability to quickly deploy capital and willingness to bear unique risks. Asset flows are returning to hedge funds and hedge fund investors should remain interested in the positive and uncorrelated returns of ABL funds. Asset-based lending and the second-lien loan market are also poised to thrive in 2010 and beyond. Borrowers’ ongoing need for capital outside of traditional channels make it likely that ABL funds will play an increasingly prominent role as genuine alternatives within the world of alternative investment funds and lending institutions.
 
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