US policy inconsistency tips the scales in favour of asset based lending

The Trumpian administration embraces the classic quote that ‘inconsistency is the only thing in which men are consistent’. That said it is unlikely that Horace Smith anticipated the extent to which such a philosophical concept would be embraced. 

Yet for private credit investors the uncertainty and market volatility created by such inconsistencies results in an environment where having the right types of loan exposures becomes even more important. 

 Against such a backdrop, self amortising asset backed private loans may make more sense and provide additional diversification within a more conservative fixed income portfolio.

Broad types of loans

When considering types of loans these can be classified into three very broad types.

The first is traditional direct lending which is also referred to as unsecured lending. These are loans where the lender is relying on the borrower’s creditworthiness to approve a loan. A key example of such loans are publicly issued corporate bonds which, being debentures, are not secured by collateral thereby making the issuers credit rating of central importance for the lenders.

In contrast to traditional lending there are two types of ‘secured’ lending.

The first is asset-based lending (‘ABL’) where loans are secured against tangible (‘hard’) or financial (‘soft’) assets which act as collateral against the loan. Tangible assets include any physical asset with measurable value such as equipment, real estate, or even a mineral resource. Financial assets include ownership of a contractual claim on some real asset such as accounts receivable, intellectual property, or royalties / license agreements.

The second type is cash flow based direct lending (‘CFL’) where, rather than taking collateral, a loan is effectively ‘secured’ against the operating income (i.e. EBITDA) of a borrower or a specific project.

The major difference between CFL and ABL revolves around the key focus of the lender when assessing the viability of the loan. CFL focusses on the projected future cash flow of a company or project when deciding on the viability of a loan. 

Such loans are suitable for companies with higher projected cashflows and or operating margins but little in the way of tangible assets. CFLs may be secured against assets though given the nature of the types of companies seeking such loans any additional security will normally consist of assets outside the operating company such as owner equity or personal guarantees/assets and so may be less tangible in value. 

By contrast ABLs focus much more on the liquidation value of assets on the borrowing companies balance sheet making the cashflow of the borrower of less concern. Such loans are more attractive for companies with deteriorating or even negative CFs but substantial balance sheet assets. 

ABLs lenders will calculate the expected liquidation value or appraisal value of assets and then lend at a percentage of this value ('Loan to Value' or 'LTV'). This creates a borrowing base which affords a margin of safety against future depreciation. Though both types of lending may be secured against assets the focus of the lender and hence the types of covenants determining lender rights will be different.

Amortising vs non amortising secured loans

A further distinction is that secured loans can be identified as being amortising or non-amortising in nature. Amortising loans are where capital is repaid periodically over the life of the loan and so the loan exposure declines over time. 

By contrast non amortising loans are where the principle comprises a single or bullet payment made at the end of the life of the loan. The difference in payment profile will usually be determined by the need to link the nature of the loan repayments and its cashflows with those of the underlying security to ensure a sufficient level of protection is maintained. Accordingly, both ABL and CFL can be either amortising or non-amortising in nature. 

Notably where ABLs are secured against financial assets such as loans will tend to be amortising as the underlying nature of the collateral is itself amortising in nature. To simplify the discussion going forward it will be assumed that ABLs are amortising in nature.

ABLs provide additional diversification

The differing cashflow and security characteristics of ABLs means that they can add diversification to a portfolio comprising a more traditional credit allocation.

The main areas that set the two strategies apart are the collateral used to back the loan, the repayment of the loan, the source of risk, the borrowing capacity, the factors that drive recovery rates, and the downside protection in the structure of the loans.

Though there are many differences and nuances, from an investor's perspective the three main characteristics of ABLs which assist in reducing risk are :

• Loan amortisation

The self-amortizing structure of asset-based loans reduces the exit risk of the investment and in turn the exposure to risks seen in capital markets, refinancing, or sale of positions. The shorter duration nature of these assets also provides greater liquidity for investors within an open-end/evergreen fund structure.

• Added protection from collateral

As stated, loans are directly secured against assets acting as collateral, with an LTV that protects against the depreciation of the asset values posted as collateral. Further protection is provided by the flexible borrower base whereby if asset value decreases, the borrowing base moves in unison, which assists in protecting lenders from any asset deterioration or increases in LTV.

• Lower correlation to other asset classes

Due to these differences in characteristics ABL returns offer additional levels of diversification to a portfolio, as seen by private ABLs having the lowest average correlation to the other major asset classes amongst the group, at 0.66.

With heightened global uncertainty a greater dispersion in outcomes regarding individual loans and loan types is likely to occur. In such an environment, loans which provide greater investor protection via (a) higher levels of security and (b) self amortisation reducing loan life may become more important considerations for less risk tolerant investors. 

Given these characteristics tend to underpin many ABL transactions they are likely to play an increasingly important part in investor portfolios against such a macro financial backdrop.