Asset-backed Securities – Why Your Source of Capital Could Be Right in Front of You

 

What comes to mind when considering potential sources of security to finance a business? More likely than not, the type of assets that pops as collateral for secured financing is the first item on the balance sheet: land and buildings.

Yet businesses are constantly looking for alternative ways of raising capital. Large companies, for instance, rely on their reputation, financial stability and creditworthiness to issue securitized debt such as corporate bonds. However, there are other emerging avenues which involve using assets found further down the balance sheet: plant and machinery, equipment, motor vehicles and trade receivables.

Asset-backed securities are one such avenue.

  1. What are asset-backed securities and how do they work?

Asset-Backed Securities (ABS) are bonds secured by a pool of underlying assets.

Like other secured debt, ABS involve the establishment of a form of security over assets. However, unlike other secured debt, ABS are structured in a way that the pool of assets is de-linked from the company seeking to raise capital such that the financing is wholly based on the quality of the assets and a decline or fall in financial credibility of the company does not affect the rights of investors in the securities.

Suppose company XYZ Limited has various assets: land and buildings, plant and machinery receivables, lease equipment receivables, motor vehicles receivables, credit card receivables and trade receivables. To raise capital through an ABS, a special purpose vehicle, say QRS, would be set up for the purpose of acquiring specific assets with a predictable cash flow. QRS would finance the acquisition of those assets by issuing securities (the asset backed securities) to investors and these securities would be serviced from the cash flows of those assets.

  1. What types of assets are used and which industries may use them?

The types of assets that have been used for ABS financing are varied. The running thread for these assets is that they must be income-generating. For instance, in the US, royalties, student loans and home ownership loans are applicable. In Kenya, the types of assets envisaged are consumer and commercial receivables such as plant and machinery receivables, lease equipment receivables, motor vehicles receivables and credit card receivables. For example: equipment leasing companies in the construction and manufacturing industries may use their industrial equipment; financial institutions may use their loan and advances income and credit card receivables; insurance companies may use their premium receivables; oil and gas companies may use their inventories and trade receivables; and any of these companies may use their lease rental investment properties if any.

  1. Have ABS been used in other countries and how much did they raise?

While ABS is novel in Kenya, it has been used successfully in other countries for a number of decades.

In the US in early 1985, the Sperry Lease Finance Corporation, a special-purpose organization set up by Sperry Corporation (now Unisys), sold to institutional investors USD192.4 million in fixed- rate notes collateralized by computer leases. This enabled Sperry to revamp its efforts to lease new equipment. In 2016, a total of USD 76.4 Billion was raised in the US through ABS. In the UK, ABS have been reported to be a favourable financing option in light of the volatility of the financial markets in UK following its decision to leave the European Union. This is because in ABS financing, even if the borrower is experiencing a decline, the ABS structures remain unaffected as they are de-linked from the borrower. Across the world in Australia, the total amount of liability from domestically issued ABS financing for the year 2016 stood at USD 775 million (1.02 billion Australian Dollars).

Closer home, there are examples of past and recent use of asset-backed securities financing.

South Africa is illustrative. Its first ABS financing was in 1991: a USD 4.5 million (SA Rand 60million) issue by Safsin Bank over installment rental loans. Since then the ABS financing route has grown in leaps and bounds, covering assets such as aircraft, trade receivables, lease receivables, credit card future cash flows and autoloans. Interestingly, part of this growth was accelerated by a change in banking regulations in 2001 which triggered companies to seek alternative capital raising options. In June last year, a South African asset rental company, MW Asset Rentals (RF) Ltd sponsored a USD 187.5 million (SA Rand 2.5 billion) Lease Receivables Backed Note Programme. It was able to raise USD 77 million (SA Rand 1.03 billion) backed by an asset exposure of USD 48 million (South Africa Rand 640 million).

Conclusion

A bird in hand is worth two in the bush. Asset backed securities offer an opportunity for businesses to use the receivables they have to obtain financing to generate more receivables. It is fast emerging as a tried and tested means of using what you have to get what you do not have.

For the investor, ABS are an additional investment opportunity other than government securities, equity and corporate debt. For the company raising capital, ABS are an avenue for using the assets it uses in its business to raise capital in addition to the traditional capital raising avenues. ABS are also attractive to investors in debt securities as they are credit-enhanced due to the strict parameters applied to insulate the assets from insolvency exposure to the borrower.

In Part II of this Article we will take a more localized look at ABS in Kenya including the legal framework, structure contemplated and the tax and legal status complexities and pitfalls of ABS financing.

CG Mbugua

Partner, Mboya Wangong’u & Waiyaki

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