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Securities-based lending: an unknown solution for nonprofits.

Some of the most successful owners, executives, and investors remain unaware of a potent tool that nonprofits can use: securities-based lending. As its name implies, a securities-based loan is a line of credit secured by eligible securities contained in a brokerage account. The two major types of securities-based loans are purpose loans and nonpurpose loans; however, this discussion will focus only on the nonpurpose variety. These can be used for any suitable need, except to purchase, carry, or trade marketable securities or to repay margin debt that was used to purchase, carry or trade securities. This is an important distinction with implications for maintenance requirements (discussed later).

In order to best advise nonprofit entities, CPAs should be familiar with what this method is, how it works, and its benefits and drawbacks. They should also be alert to the potential uses and misuses of securities-based lending.

How Does It Work?

A lender evaluates the eligible securities contained in the applicant's brokerage account and advances a percentage of the underlying securities' market value in the form of a loan or line of credit. The lender determines each security's advance rate, which is a function of its risk (e.g., volatility or fluctuations in value). The more volatile the security, the less one can borrow against it. Thus, a U.S. Treasury bond will typically receive a higher advance rate than a blue-chip stock. This is because the security serves as the lender's protection in the event of a default. If a lender advances 100% of a stock's value and the stock prices falls on day one, the lender immediately has a portion of the loan at risk.

A simple example can illustrate this concept. Suppose a nonprofit has a $20 million investment portfolio, composed of 50% blue-chip stocks and 50% U.S. Treasury bonds. The line of credit may look like the examples in the Exhibit. The nonprofit pledges the $20 million investment portfolio and receives a $15.5 million line of credit, or 77.5% of the portfolio's market value.

Although borrowers must maintain sufficient collateral relative to the size of the outstanding line of credit (see the ensuing discussion on maintenance requirements), they are generally free to make their own investment decisions with respect to asset allocation, rebalancing, purchases, sales, and investment vehicles.

How Are Payments Structured?

Each security is assigned a maintenance rate in addition to an advance rate. The maintenance rate is the threshold value of the securities; once the maintenance rate is exceeded, principal repayments begin. Although maintenance formulas may vary, one common example is the line of credit divided by 100% minus the maintenance rate. Returning to the example in the Exhibit, assume that the blue-chip securities are assigned a maintenance rate of 30%. If the charity withdraws the full $6.5 million available on its blue-chip securities, the maintenance requirement is $6.5 million divided by 70% ($9,286 million).

In other words, the stocks could decrease in value by more than 7% ($10 million to $9,286 million, or $714,000) before any principal repayments would be required; therefore, generally no principal or interest payments are required as long as adequate capital is maintained (discussed later in more detail). Often, unpaid interest is added to the outstanding balance and factored into the maintenance calculation.

How Is Interest Charged?

The interest rate charged may be based upon a number of factors, including, among other things, the amount of the lending facility. Typically, the larger it is, the lower the interest rate charged. Interest is only charged when the line of credit is used. In addition, there are generally no penalties or charges if the line is unused. Furthermore, rates can be variable, which may be based, in part, on the appropriate London Interbank Offered Rate (Libor) index, or fixed, for a specific duration. In the previous example, if a nonprofit receives an interest rate of 2% and the lull $6.5 million line of credit is used for 31 days, the interest expense would be $6,500,000 x 2% x 31 days out of 365 days, or $1,104.

Other Benefits

The following represent additional benefits of securities-based lending:

* In the authors' experience, securities-based lines of credit have lower interest rates than traditional forms of financing, such as installment loans or home equity lines of credit.

* Also unlike traditional forms of financing, securities-based lines of credit have a streamlined loan process, thus enabling qualified applicants to access the liquidity in as little as several business days.

* A personal guarantee may not be required.

* There is a roll-up feature--that is, more than one account can be used to secure a line of credit.

The Need for Proper Planning

Although in favor of the responsible use of leverage, the authors would

urge CPAs who advise nonprofits considering a securities-based line of credit to fully understand the instrument and have a plan for the following:

* Demand versus committed facility. Demand loans can be called at any time, whereas committed facilities are contractually guaranteed until the facility's maturity date, unless there is a default. This distinction can be critical during times when liquidity evaporates (e.g., the 2008 credit crisis).

* Variable rate risk in a rising interest rate environment. Borrowers should understand and model their ability to make payments if interest rates rise.

* Management of portfolio volatility versus the size of the outstanding loan. A borrower should be experienced (or work with advisors who are experienced) in managing and modeling portfolio risk and assessing the size of the line of credit with respect to the risk. In an extreme case, if a borrower has an all-equity portfolio and draws upon the lull line of credit, there is a very high likelihood of a maintenance call because of the inherent volatility of equities.

* Exit strategy for repaying the loan. At some point, the line of credit must be repaid. The authors recommend having an exit strategy for repayment right from the very start. This area is one in which the authors have seen the most misuse of lending in general and securities-based lines in particular.

* Securities-based lending risks. Borrowers should be aware that securities-based lending involves a high degree of risk and that market conditions can magnify any potential for loss. Most importantly, borrowers need to understand that 1) sufficient collateral must be maintained to support their loans and to take future advances; 2) they may have to deposit additional cash or eligible securities on short notice; and 3) some or all of their securities may be sold without prior notice in order to maintain account equity at required collateral maintenance levels. Borrowers will not be entitled to choose the securities that will be sold. These actions may interrupt a borrower's long-term investment strategy and may result in adverse tax consequences or in additional fees being assessed. In addition, borrowers must be aware that 1) lenders reserve the right not to fund any advance request due to insufficient collateral or for any other reason except for any portion of a securities-based loan that is identified as a committed facility and 2) lenders reserve the right to increase a borrower's collateral maintenance requirements at any time without notice and maintain the right to call securities-based loans at any time and for any reason.

Potential Application

CPAs with a full understanding of the mechanics of a securities-based line of credit can explore its potential uses. The following sections address several real-life scenarios.

A source of liquidity during market corrections. Although a full review on not-for-profit financial management is outside the scope of this article, several observations are worth noting to fully appreciate this application:

* Nonprofits generally must have a growth-oriented (i.e., more volatile) investment portfolio. If they spend several percentage points per year on fulfilling their mission, want to maintain their purchasing power, and need to pay asset management expenses, they must generate a specific return to do so. This is typically not feasible via "safe" (i.e., low-volatility) investments.

* When the economy declines, nonprofits generally get hit twice: their investments decrease and their contributions dry up because donors are feeling the same economic squeeze.

* Many nonprofits hesitate to invest for the long term because they need to fund projects in the short term.

Assume that a nonprofit entity must invest for the long term in order to be successful but is reluctant to do so because of the unexpected short term. Furthermore, this organization faces a potential liquidity challenge during periods of economic contraction (part of every market cycle). This represents a perfect use of a securities-based line of credit as bridge financing to create liquidity during short-term periods of distress. This gives nonprofit leaders the confidence to invest properly for the long term without incurring the risk of selling securities for losses to cover short-term cash flow needs. In the authors' opinion, every nonprofit with a long-term investment fund should consider whether a securities-based line of credit would be suitable to help them cover short-term liquidity needs.

An alternative to holding large amounts of cash (in a low-interest-rate environment). The comfort of liquidity bears a large price tag. Although these authors are strong advocates for maintaining an adequate reserve fund, it is their experience that many nonprofits hold entirely too much cash on their balance sheet The irony is that fiduciaries believe they are protecting the institution through this approach, when they are doing just the opposite, in the authors' opinion. Holding too much cash, especially in today's historically low interest rate environment erodes the purchasing power of institutional resources and carries the opportunity cost of foregone income and growth. Securities-based lines of credit can help fiduciaries faced with this dilemma by reducing the amount of cash they hold on their balance sheet.

Bridge financing for real estate transactions. As seen in the first application above, securities-based lines of credit are an excellent source of short-term bridge financing. The quick and low-cost nature of securities-based lines of credit could be preferable to more traditional real estate financing under the following circumstances:

* During the contemporaneous purchase and sale of property, where the purchase of new property is consummated prior to the sale of existing property

* When the sale of existing property requires expensive renovations

* When construction financing is expensive or unattainable (a securities-based line of credit can be used to build the property and can be replaced with traditional financing once completed)

* If being a cash buyer will make a purchase offer more competitive (the securities-based line of credit can be used to purchase the property and can be replaced with traditional financing once the sale is completed).

Misapplication of Securities-Based Lending

Perhaps more important than knowing when to use a securities-based line of credit is understanding when not to use one. Although they can be a valuable source of bridge financing, securities-based lines of credit should not be viewed as a permanent source of long-term funds without an exit strategy. In other words, nonprofits should not use them as a means to go over budget year after year. Continuing to withdraw funds from an available line of credit without a strategy for repaying the accrued balance is not an effective use of a securities-based line of credit or a sustainable business strategy.

Although the risk of misapplication exists, securities-based lines of credit can be a useful strategy that nonprofits and their advisors should consider. When used properly, the cost efficiency, speed, and flexibility of a securities-based line of credit can make it one of the best liquidity tools in a nonprofit's arsenal.

Gary Stevens, CPA, CPWA, is a senior vice president, financial advisor, and partner, and Daniel Griesmeyer, CPA, CIMA, is a financial advisor and partner, both in the New York SoundView Group at Morgan Stanley Wealth Management, Jericho, N.Y. The views expressed are those of the authors and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC (member SIPC) or its affiliates.

The information contained in this article is not a solicitation to purchase or sell investments. The strategies and outcome described

within this article may not be attainable for all clients. Issues relating to a client's financial resources, creditworthiness, financial condition, or collateral value may affect the loan process, as well as a client's eligibility for a securities-based loan.

Sample Lines of Credit

Asset                 Market Value   Advance Rate   Line of Credit

U.S. Treasury bonds   $10,000,000    90.0%          $9,000,000
Blue-chip stocks      $10,000,000    65.0%          $6,500,000

Total                 $20,000,000    77.5%          $15,500,000
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Title Annotation:Finance: financial management
Author:Stevens, Gary; Griesmeyer, Daniel
Publication:The CPA Journal
Geographic Code:1USA
Date:Aug 1, 2014
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