Put your assets to work.
In 1985, Sperry Lease Finance Corp. issued an equipment lease transaction in the public market, creating the first asset-backed security, according to the Dean Witter Asset-Backed Securities Reference Guide. In a little over a decade, asset securitization has come of age in terms of investor acceptance, its position as a cost-effective financing alternative and its role as a staple of large underwriting houses.
The enormous public asset-backed securities market is dominated by two asset classes: credit card receivables and auto loans. Within each of these asset classes, asset-backed deals have become so commonplace that they resemble one another structurally.
The smaller, private asset-backed securities market receives less media attention, but it's actually more dynamic than the public market. Private asset-backed securities deals are typically tailored for a predetermined investor or group of investors, allowing for greater structural flexibility. Until recently, for example, most private placements were backed by equipment leases, trade receivables, health care receivables and subprime auto loans. In 1995, however, some transactions were backed by asset types that could be considered obscure: health-club initiation-fee receivables, home water purification system sales contracts, airline ticket receivables and distressed, nonperforming consumer loans. These are just a few examples of receivables securitized for the first time.
The trend toward such a wide array of asset types opens the private asset-backed securities market to companies that may previously have considered themselves excluded. Now, companies with virtually any type of receivable can be sold off a firm's balance sheet and securitized. Northwest Airlines used ticket receivables for asset-backed securities; Pacific Lumber used trees.
Strong investor demand has opened a wide window of opportunity for would-be issuers of asset-backed securities. If you've been considering an asset-backed issue, here's a map of the marketplace and the hurdles faced by first-time issuers.
THE LAY OF THE LAND
In 1995, public issuance of asset-backed securities reached approximately $110 billion, an industry record and nearly a tenfold increase over 1985, when just seven asset-backed securities transactions were completed at an approximate value of $1.4 billion. With that kind of acceptance and financial strength, this financing technique should be considered an established alternative to straight corporate debt. Indeed, for larger issuers in the public market, asset securitization usually offers a AAA pricing complement to current funding sources.
As a result of the market's acceptance and the historical performance of these securities, investor returns have gradually gotten smaller. Consequently, an increasing number of investors are considering relatively smaller and lower-rated private placements that offer enhanced yield.
For a private issuer, asset-backed finance can be a major strategy in the company's overall business plan. The growth of the private market offers some companies the opportunity to issue off-balance-sheet debt at a cost that's competitive with typical bank lending. But the use of asset-backed finance varies depending on a company's financial position, life-cycle stage (growth vs. mature), market niche and investor/bank relationships.
The concept of asset-backed finance is nothing new. Commercial banks and finance companies have been doing asset-based lending for years, taking assets and receivables as collateral. The key difference is that, for an asset-backed financing, the transfer of assets (for both accounting and bankruptcy purposes) is structured as a sale. For tax purposes, the structure may be either a sale or a loan, as determined by the originating company's tax consultants. In the event of bankruptcy, the assets are separated from the originator.
This separation from the originator's credit risk allows the rating agencies to assign an asset-backed rating that's higher than the originator could attain on a stand-alone basis. Of course, this assumes the deal is structured to meet rating agency criteria.
Generally, asset-backed issuers can be categorized by company size and debt rating: large/investment-grade (BBB or higher), mid-size/borderline investment-grade (BB to BBB) and small or nonrated (or B). Larger issuers, such as Chrysler, GMAC, Citicorp and Household Finance are regularly in the public market with AAA deal sizes greater than $500 million. The primary concerns for these issuers are greater balance sheet liquidity and improved corporate ratings as a result of the positive impact of securitization. In addition, some of the stronger-rated issuers come to market simply to maintain a presence and access to this funding source.
Mid-size companies are often driven by the competitive cost of funds a rated issue can usually offer. Also, these issuers may want to diversify their current lender base. If the deal size is greater than $100 million, then the offering is typically in the public market; anything smaller is usually placed privately. More important, BB-rated mid-sized companies can usually issue asset-backed securities at AA to AAA ratings since agencies rate the security separately from the originating company. As a result, these companies can maintain or enhance their ability to compete with stronger-rated companies having a lower cost of funds.
Smaller companies that securitize are either young (two to five years old) and in a growth-mode, or they are relatively mature, having reached a plateau in their market niche. In either case, asset-backed finance is a growth strategy. The young company uses the proceeds to free up existing lending arrangements in order to pursue greater market share. The mature company uses the proceeds in the same way, but in anticipation of expanding into new product markets. In either case, such asset-backed issues are private placements and, if rated, more cost effective than private equity or debt.
The potential for an asset type to be securitized depends on the predictability of its cash flow. In other words, the fewer the risks to cash flow, the more likely investors and agencies are to be comfortable with the asset. Receivables' delinquency and default are the more familiar risks, as is dilution (an unconditional "put" of the receivable back to the originator). But a more problematic risk, and in some cases a deal-killer, can occur in the form of executory contract risk.
If the originator of a receivable has an obligation to support the underlying asset, such as a maintenance agreement embedded in an equipment lease, then executory contract risk exists if payments can be stopped or partially offset for lack of or loss of that support obligation. What makes this risk difficult to mitigate in any structure is its unpredictability: there is no way of anticipating the likelihood or timing of its occurrence. Consequently, investors (and the rating agencies) tend to shy away from receivables such as service contracts, professional fees or leases having maintenance and support provisions critical to the asset's operation.
Because rated transactions offer the most benefits to issuers, the receivables' history is one of the main considerations for a rating agency. The role of the rating agency is to determine how much credit enhancement (such as a cash reserve or subordination) is required to achieve whatever rating level the issuer desires. The key to this process is measuring the variance in cash flow and causes of disruptions (delinquency, default and dilution) over time. The more receivables history available, the more confident the rating agency is in arriving at this figure. To compensate for a lack of history, the rating agency increases protection levels by lowering the rating or increasing credit enhancement.
The major buyers of asset-backed securities are also the buyers of straight corporate debt. The public market has gained depth, thanks to investors who are becoming as knowledgeable of asset-backed securities as they are of mortgage-backed. In fact, transactions backed by autos, credit cards and home equity have probably become more desirable because they exhibit less of the prepayment volatility inherent in mortgages.
Given the current historically low interest rate environment, public AAA/AA asset-backed issues continue to offer a slight yield spread advantage over comparable AAA/AA straight corporate issues. The combination of market acceptance and yield advantage has kept any supply/demand imbalances from occurring. The number of deals coming to market has increased steadily over the last few years.
This seller's market for public placements has trickled down to affect asset-backed private placements. In the early days of securitization, major buyers were larger insurance companies and money managers. These investors had the expertise and resources to analyze each new asset type or latest structural modification. Yield spreads were much wider than they are today.
As public issues have become fairly standardized, the yield advantage to investors has remained with smaller issuers or the esoteric assets found in the private market. The fact that investors are rushing to purchase more private placement asset-backed securities for enhanced yield is compressing all the yield spreads. Some call this a sign of an overheated market, while others call it a long-term trend in the way small and mid-size companies attain financing.
Regardless of who's right, most investors, prior to investing, are aware that the credit issues surrounding asset-backed private placements are different from straight corporate debt. Because the credit risk of the issuer itself is removed via the asset-backed structure, the analysis focuses on the risk characteristics of the collateral or assets. The more experienced investors have the resources to perform this type of research, while smaller or first-time investors tend to rely more heavily on the rating agency.
Not all asset-backed transactions carry credit ratings. The large public issues are almost always rated because the majority of those investors require ratings as part of their investment policies. Also, smaller issuers can register as public transactions and go unrated, though the instances are rare. Private placements are typically rated because the majority of buyers are insurance companies that use the rating to assess capital reserves against their investments.
The originator's decision to seek a rating generally depends on the targeted investor base. An asset-backed transaction, however, which is characterized by its bankruptcy-remote and true sales structure, can attain a rating higher than the originator itself. Therefore, it makes sense always to seek a rating, especially if the originator is a below-investment-grade company. This is because the reduction in borrowing costs can offset any economic gain via a structure not subject to the rating agency's criteria.
What are the costs that a company contemplating a private asset-backed issue for the first time can expect to face? Certainly there are expenses similar to any private placement. Engaging an investment banker and legal counsel for structuring, placement and documentation will probably cost more than for a similar-size debt issue. And companies may incur other costs that are not as clear-cut.
One hidden cost involves servicing the assets and receivables, which is of critical importance. Although the bankruptcy risk of the issuer is removed from the transaction, the smooth receipt of cash flow is essential to paying investors interest and principal promptly. Rating agencies place great emphasis on servicing capabilities because bankruptcy is still a risk if it causes servicing to cease or become impaired.
Another cost to consider involves auditing by a third party, generally a Big Six accounting firm. To mitigate risk, the issuer may decide to retain an accounting firm to prepare audits of servicing methodologies, procedures and related information systems to ascertain their effectiveness over the life of the issue. Audits or reunderwriting of receivables by an outside third party may be required to verify the collateral and credit standards reported by the issuer. Also, during the life of the issue, ongoing procedural audits will be required to assess ongoing servicing systems and procedures.
Still another expense could arise if an asset type is unique or requires specialized servicing. In that case, the transaction may require a supervisory servicer. This third party must be able to step in quickly to assume the servicing role in the event of the issuer's bankruptcy. The trustee may assume this function, but the cost for this enhanced oversight service is more than standard trustee fees for straight corporate debt.
One further hidden cost may be that of working with a single investor, perhaps most common with smaller issues. Typically, with asset-backed private placements, investor involvement in deal structuring is usually more direct and assertive. In some cases, the issuer may have to bear the legal and due diligence expenses of the investor.
Finally, there are the rating costs. They include fees for the rating service as well as for the economic costs imposed by the amount of credit enhancement needed for the desired rating level.
Although the costs and increased scrutiny may not seem worth the time or effort, for some companies, issuing asset-backed securities in the private market makes strategic sense in the long-term. A major benefit is diversifying the company's source of funds so that it doesn't have to rely on one lender.
The first transaction will always be the most difficult and the most costly. But if an originating company has the history and ability, then most of the requirements of investors and rating agencies should be fairly easy to handle. Only companies that are weak in history and operations will find the rating requirements burdensome. In other words, if the rating agency is not comfortable with the company's history, the deal won't get done. Finally, if the asset/receivables perform as expected (or better) and the company shows profitable growth, the potential for future issues with lower credit enhancement or higher ratings will surely offset the initial costs.
RELATED ARTICLE: ROLL CALL OF SECURITIZED ASSETS AND RECEIVABLES
Airline ticket receivables Airplanes Auto leases Auto loans Bank credit cards Commercial properties Computer dealer/wholesale floor plan loans Delinquent property tax liens Diverse small businesses Equipment leases Factored/asset-based loans Farm equipment loans First mortgages secured by raw land Franchise loans Health care billings Health club initiation-fee dues High technology Home equity loans/lines of credit Insurance premium loans Life insurance payouts (for terminally ill) Manufactured housing loans Medical Musical/studio Office copiers/fax Oil/gas fields Pools of bonds; loans; securities Parking ticket receipts Private label charge cards Railcars Recreational vehicle loans Residential mortgages Shipping containers Student loans Taxi medallions Timber land Timeshare loans Tractors and trailers Trade receivables (manufacturers and distributors) Unguaranteed portion of SBA loans Utility receivables
Mr. Arora, vice president, co-manages asset-backed private placement ratings for Duff & Phelps Credit Rating Co. in Chicago. You can reach him at (312) 368-3166. Mr. Leszczynski, former group vice president at Duff & Phelps, is currently vice president at the Industrial Bank of Japan in Chicago. You can reach him at (312) 855-8364.
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|Date:||Mar 1, 1996|
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