With the bank lending squeeze continuing to bite, corporate securitisation offers companies an attractive funding alternative. Businesses stand to gain lower financing costs, increased levels of liquidity, a broader funding base and reduced dependency on banks.
In a tight credit environment, treasurers are forced to become more inventive when it comes to meeting the funding requirements of their business. Corporate securitisation can be an important step towards closing the liquidity gap for companies – and it is seen as a viable source of financing for corporates with accounts receivables of $50m or above. But what is corporate securitisation? Which company assets can be securitised? And what are the benefits that can be gained?
Corporate securitisation is the process of pooling selected assets from the company’s balance sheet and transforming them into tradable, interest-bearing securities for capital market investors. In 2011, European securitisation issuance was €372 billion, according to a recent report by the Association for Financial Markets in Europe (AFME) – a mere fraction of the €1,014 billion issued in the United States during the same year. However these figures fall far below the heights reached in 2007. The global financial crisis dealt the securitisation industry a heavy blow from which is has yet to recover.
“After the crisis, the market has gone back to basics,” says Rick Watson, Head of Capital Markets at AFME. “In both Europe and the United States, the predominant asset classes are the simplest, with proven track records such as residential mortgage-backed securities, auto loans, cards and leasing.”
Nuts and bolts
There are two steps to consider in the securitisation process for a corporate. The first begins when a company wishes to raise finance. Let’s take the example of a paint manufacturer. The paint manufacturer, known as the originator in this case, removes selected assets from its balance sheet and then pools them to form what is called a ‘reference portfolio’. For corporates the assets in question are often accounts receivables – but, technically speaking, any assets that generate a steady flow of cash can be securitised. Other examples include:
The pool of assets is then sold on to an issuer, which is usually a large bank. The transformation also legally separates the selected assets. This isolates them from any potential bankruptcy of the originator. By selling its asset pool, our paint manufacturer receives payment for the assets in one lump sum, rather than spread out over time. This payment can be put towards alleviating any cash flow difficulties or liquidity troubles the originator may have. The issuer often sets up a special purpose vehicle (SPV), specially created to take on the assets.
An acronym to remember
To many people, the acronym ‘SPV’ is just one of several introduced to the world by the financial crisis. But an important idea lies behind the three letters. An SPV is a legal entity set up by a financial institution – usually a bank – to carry out a particular activity, often the securitisation of asset pools.
The SPV is not a normal business operation. It has no employees. Nor does it have a physical location. Indeed, it is structured in such a way that it cannot become bankrupt. It is perhaps taking these factors into account, that the National Bureau of Economic Research in America dubbed SPVs ‘robot firms’ in a 2007 report.
The administrative function of an SPV is performed by a trustee who follows strict rules when it comes to receiving and distributing cash flows. The typical legal form of an SPV is a limited partnership or limited liability company. Prior to the crisis, SPVs were popular because they allowed issuers to benefit from a lower cost of capital.
SPVs have undergone increasing scrutiny in the last decade. For instance the energy firm Enron used 3,000 SPVs to keep its off-balance sheet debt hidden from the eyes of prying investors. A subsequent financial scandal brought down the company. SPVs also played a role in the downfall of the investment bank Lehman Brothers in 2008. Both companies are now in the dustbin of history. But it is likely that SPVs will continue to play a significant role in the future world of business.
The second step of the securitisation process is more nuanced. In order to finance the acquisition of the asset pool, the SPV issues tradable, interest-bearing securities to capital market investors. These securities, known as asset-backed securities (ABS), allow investors to lay claim on the cash flows backed by the asset pool (the trade receivables of our paint manufacturer).
In many cases the originator still collects the cash flows and passes them on to the SPV or investors, via a trust fund and minus a servicing fee. These two steps describe what is called the ‘originate-and-distribute’ approach.
No two investors are the same. Indeed, many investors have different levels of risk tolerance. As a result, issuers slice up the asset pool and tailor securities so that they have specific levels of risk attached. These slices are known as ‘tranches’. The idea was to make securitisation appealing both to cautious pension fund managers and risk-loving traders. Securitisation structures often take the form of a three-tiered cake: tranches range from junior, mezzanine and senior levels.
By using various forms of credit support, issuers can create securities with different levels of seniority. The three-tiered structure concentrates expected losses in the junior tranche, which absorbs the initial losses until it is depleted, followed by the mezzanine tier, which is in turn followed by the senior tranche.
To help investors decide the creditworthiness of ABSs, credit rating agencies – such as Standard & Poor’s, Moody’s and Fitch – offer individual ratings for each tranche, from AAA downwards. Taking all these factors into consideration, securitised instruments can be generally defined by the following three characteristics:
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The pooling of assets.
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The decoupling of the credit risk of the collateral asset pool from that of the originator. This occurs by means of the transfer of the underlying assets to an issuer’s SPV.
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The tranching of liabilities, with different levels of seniority and risk exposure.
Did you know?
In the popular press, securitisation is often caricatured as a manifestation of financial capitalism gone wrong. More often than not, it is presumed that ‘greedy financers’ invented securitisation as a simple means to make more money. But securitisation was actually a public sector innovation. In 1970 the Government National Mortgage Association, an American government agency dubbed ‘Ginnie Mae’, invented mortgage-backed securities (MBSs) for investors.
Before, market participants had to contend with trading whole loans or unsecuritised mortgages in a generally illiquid market. Securitisation had a tremendous impact, facilitating the transfer of capital from those who had it, to those who needed it. Ginnie Mae succeeded in introducing more liquidity into the market. Other government agencies, such as Fannie Mae and Freddie Mac, soon followed suit. The corporate world took note. By the 1980s, other income-producing assets had begun to be securitised, and since then the securitisation industry has experienced extraordinary growth. Who knew that such a useful public sector innovation would come to haunt the American economy nearly four decades later?
Securing the benefits
So much for the securitisation process. What advantages does it offer? Companies stand to gain a number of benefits from corporate securitisation.
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Lower financing costs
Securitised assets benefit from a lower risk profile. This is because receivables typically have a higher credit quality than the originator itself. They are also legally separated from any potential bankruptcy of the company. The end result is lower interest costs. Without securitisation, the business would finance itself through borrowing based on its own creditworthiness.
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Corporate balance sheet benefits
Since the reference portfolio is legally removed from the company’s balance sheet, the corporates gearing (ie, debt-equity ratio) is reduced, all other things being equal. The business can then better comply with its financial covenants with regard to on-balance sheet borrowing.
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Increased levels of liquidity
Instead of receiving payments spread out over time, corporates gain from receiving a lump sum immediately, thereby alleviating any cash flow difficulties. Business can receive cash for their accounts receivables within days of the invoice being issued. This allows the company to increase its financial flexibility in uncertain economic times.
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A more diversified capital structure
As financial institutions continue to deleverage, bank lending will remain difficult to obtain. Corporates are often beholden to the decisions of their banking counterparties, particularly in the aftermath of the credit crunch. Trade receivables securitisation adds some leeway in this problem and can help corporates reduce their dependency on banks.
Corporate securitisation is often used as part of a wider financing plan. In 2009, for example, Honeywell International tapped the trade accounts receivable market as part of its corporate debt solution – a strategy that went on to win a ‘Highly Commended Award’ at Treasury Today’s Adam Smith Awards 2010. More recently, in response to a challenging year, the American tobacco manufacturer Alliance One doubled its trade receivables securitisation facility to $250m in May 2012 to boost its working capital at hand.
But not just any corporate can start securitising its trade receivables. There are a few factors to consider. First, size does matter. Companies considering securitisation usually have receivables of $50m or above. Second, they should have strong administrative systems and robust credit and collection practices. These can go a long way in ensuring a smooth securitisation process. And third, some industries are more favourable to securitisation than others – manufacturing and distributors often find it easier than most to securitise.
And there is another important factor to consider. Regulatory changes, such as Solvency II, will make it more costly for European insurers and pension funds to hold securitised products, among other assets, on their balance sheets. Moreover, capital rules are changing, with Basel III making it more expensive to lend. Corporates can expect demand for securitised assets to dampen in the near future.
Nevertheless, corporate securitisation plays a vital role in the funding landscape. Since the credit crunch ended, “Securitisation has provided over €103 billion in funding for SME loans, as well as a significant source of funding for consumer auto loans and leases, dealer floor plan loans and commercial mortgages,” says Watson at AFME.
Regardless of regulatory changes, corporate securitisation remains an attractive option for many businesses. The current lending squeeze means that the cost of credit is increasing. Corporate securitisation helps facilitate the flow of capital from those who have it, capital investors, to those who need it – the company.
