Important Information Regarding Asset Based Loans
The term asset based loan refers to any type of loan where an asset is presented by the borrower as collateral or security to support the loan. Ownership of this collateral will transfer to the lender if the borrower defaults on the loan. This form of loan is also referred to as an equity loan or a secured loan. Private mortgages and receivables factoring are two well-known forms of asset based finance.
The above definition is very broad. It includes many individual types of consumer loans such as a mainstream home mortgage loan from a retail bank. In practice, asset based financing is used to describe smaller lending segment focused on commercial, not consumer, borrowers. In this narrower sense, asset based financing refers to loans secured by tangible assets including real estate (especially commercial property), product inventory, accounts receivable, plant & equipment, machinery, commercial fleet vehicles (trucks, cars, forklifts, etc) as well as intangible assets such as patents, trademarks, documented technology and other forms of intellectual property.
Mainstream lenders usually set a loan amount with reference to the prevailing market price of an asset not its fundamental value. This can be unattractive for borrowers if the fundamental asset value is above the market price. In these cases, conventional loans can be unnecessarily restrictive and penalize borrowers that have identified opportunities to acquire assets at discounts versus fundamental value.
An experienced property investor has identified an opportunity to acquire commercial real estate for $20.0 million as a distressed sale from a forced seller. The investor calculates this price to represent a discount of $16.0 million versus a $36 million fundamental property value.
When evaluating loan applications, asset based lenders rely heavily on assets offered as collateral. This security is typically assigned a high weighting relative to the sustainable or underlying cash flow of the borrower. As a result, lenders set low priority on obtaining income or cash details flow from borrowers.
The bank has a policy of limiting its exposure in any one property to a maximum of 70% of its value. It deems the value of the property to be the $10.0 million purchase price. Implicitly, in rejecting the loan proposal, the bank rejects the view that the property is really worth $18.0 million.
Hedge funds may also engage in high value, asset based loans centered on large, discrete, and specialized assets. They typically participate in these transactions not as a stand-alone activity but rather to support a wider trading or transaction strategy. To illustrate, a firm that owns and operates a positive cash flow project needs new capital to increase capacity. It enters discussion with a hedge fund to arrange a loan with the project as collateral. The fund grants the loan after identifying the project is of interest to a number of potential buyers and assessed these buyers are likely to pay a premium above the loan amount extended to the current owner. Adverse market conditions eventually force the borrowing company into loan default; the hedge fund takes possession of the project and immediately divests it at a profit.
In conclusion, asset based finance can appear competitively structured even to top grade, high quality borrowers. A critical issue to consider is the meaning placed on the term appraised value. Conventional lenders tend to consider appraised value as being equal to prevailing market or purchase price. By comparison, asset based lenders may be more prepared to accept that the purchase price can be below the fundamental value of an asset.