Making Loans: Asset-Backed vs. Cash-Flow Lending

Disclaimer: I have no connection to or investments currently with any of the companies mentioned in this article, although I may in the future.  Do your own due diligence before making an investment decision.  It’s your money; you’re the best person to decide what is best to do with it.

Lending money may not make you wildly wealthy, but it can provide a nice income stream and even outperform public equities over several years, if done correctly.  Much like anything else in the investment world, there are many different ways to lend money as an investment, each with their own unique characteristics and each with appropriate market entry and exit points.  However, while there are many different lending strategies, you can safely divide these strategies into two camps: asset-backed lending and cash flow lending.

Let’s discuss the different types of loans.  You are able to invest in several types, and the availability of underlying credits continues to grow.  In cash-flow lending, as the name suggests, the lender lends money to a borrower based on their ability to pay out of expected future cash flows.  For an individual, the expected future cash flows will come from earned income, most likely through a job or other paid employment.  For a company, the expected future cash flows will come from revenue and profits.  In asset-backed lending, the loan is not secured by future cash flow, but rather through the liquidation value of the asset itself.  The expectation of asset-backed lending is still to be repaid through future cash flow, but with a pre-specified piece of collateral that can be seized and sold if the borrower does not make payments.

Also, keep in mind that I’m discussing loans specifically, not bonds.  Loans represent direct lending to a company, while bonds are an example of companies borrowing from the public.  Investment-grade or high yield corporate bonds, as well as US Treasury bonds are good examples of an entity borrowing directly from the public.  There are other subtle differences as well, but for the purpose of this article, I’ll focus on loans only.

Before delving into the investment side of things, I’ll illustrate the difference between cash flow lending and asset-backed lending with a personal example.

Credit Card vs. Mortgage

If you are an average American and own a home, then you’re likely familiar with both a credit card and a mortgage.  These two types of lending are perfect examples of cash-flow lending versus asset-backed lending.  For credit card providers, they will look at your credit score (whether you’ve paid back loans in the past or not) as well as your employment and income (whether you will be able to do so in the future or not).  Buying a new couch or drinks at a bar are not considered assets that are borrowed against, and the credit card company has no legal claim to any of your assets.  That is why the loss the credit card company takes if you default and do not pay them (loss given default, or LGD) is quite high.  In most cases, the LGD may be 70-90%, as the only real payment a credit card company receives for a defaulted credit card is either recovered funds through litigation and other legal work or the amount of money that a collections company will pay.

For mortgages, the math from a lender is quite different.  There is a reason that a mortgage lender will only provide 70-90% of the total home value.  They expect to seize the home and sell it to make themselves whole if you default on your mortgage.  For non-recourse states (about a dozen states in the country), the bank cannot come after any other assets beyond the home when they give you a mortgage.  Mortgage providers are primarily concerned with home value, and only lend up to a certain amount against that value.  This helps them ensure that you have skin in the game with a fair amount of equity, but more importantly, it provides them a downside buffer if they have to sell the home.  Remember that if you default on your mortgage, you still accrue interest and penalties.  Plus the bank will have selling and legal costs (e.g. foreclosure), so even if they underwrite a mortgage at 80% loan-to-value, they may still not break even if you default.

The above example illustrates another key point.  Asset-backed lending tends to be at a lower rate, because the security of a specific asset that can be seized and liquidated makes the loan more secure.  A credit card interest rate tends to be higher than a mortgage.  However, the specific asset as well as the underlying borrower will determine the relative pricing differences (interest rate and fees) in the loans.  For example, a super-prime, ultra-wealthy client will likely have a very modest interest rate on a credit card due to the strength of the borrower and other services the financial company may provide the individual.  On the other hand, a sub-prime borrower buying a house in a poor neighborhood will likely struggle to find a mortgage at any rate.  While asset-backed lending tends to be cheaper financing, that is not always the case.

Both cash-flow lending and asset-backed lending can be done in our personal investment portfolios.  Let’s take a look at some of the available options and the difference between the two.

Cash-Flow Lending: The Investment Perspective

As described above, cash flow lending is a loan to a borrower based on the expectation that future cash flow (revenue or income) will pay back the loan with interest.  From an investment perspective, you can either invest in personal cash-flow loans or in company-based cash flow loans.

Personal cash-flow loans available for investment are generally the peer-to-peer or marketplace lending loans from the likes of Prosper and Lending Club.  Much like any other loan, there are different interest rates and different levels of risk based on the quality of the borrower.  The marketplace lender makes a loan to an individual and then turns around and sells those loans to investors.  In most cases, the marketplace lender doesn’t have much of a balance sheet, nor holds the loans for any length of time. Instead, the marketplace lender is really only in the loan for the origination fee and the servicing fee (servicing is the function of collecting payments from the borrower and disbursing them to the investor, which of course has a fee).  Their goal is to get as many new loans as possible and to service as many loans as possible.

For these types of loans, I have only one piece of advice: buyer beware.  There are several reasons for this.  One, institutional investors have flocked into this space, so competition has increased.  These institutional investors can write far larger checks that either you or I can, and as such can get things like forward flow agreements and rights of first refusals.  Effectively, institutional investors can get dibs on all new loans and you’re getting what’s left over.

Also, these types of loans are new within the last ten years, and have not really been tested through a market downturn.  Let’s say a borrower loses their job in the next recession and has to pick and choose what payments get made.  Rent and utilities will be high on the list, as keeping a roof over your head and the lights on is pretty important.  The car loan will likely be high on the list, because you need it to get to job interviews or to your new job and mass transit just isn’t readily available and convenient for most of the country.  Your credit card is your cash flow life blood, as it allows you to buy groceries to eat and gas to fill the car.  And then finally, you have this loan that you got six months or a year ago, that has another 24-30 payments left, but has no recourse and is not going to impact your day to day life if you stop paying.  Which loan would you default on first?

Corporate cash flow lending, on the other hand, is generally done as a floating rate loan and on the basis of a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization).  For any asset lite business, EBITDA is nearly the same as Profit Before Tax (PBT).  For asset heavy industries, it’s a little different, because depreciation and amortization can be significant expenses.  EBITDA is used in a similar fashion that Net Operating Income is in real estate: it’s a way to compare companies across the spectrum without regard to how the balance sheet is structured.  For small companies of say, under $5 million in EBITDA (yes, that’s still a small company), a bank may only provide a maximum amount of leverage (all borrowings combined) of 2 times EBITDA, or $10 million.  For larger companies, that number can be 4-6 times EBITDA.  Along with most every other loan, a company must maintain certain covenants, which are restrictions against or requirements for future actions.  For example, covenants typically include the need to have annual audited financial statements, a minimum interest coverage and maximum borrowing, and restrictions against future dividend payments to equity owners.  As part of the credit cycle, borrowing levels are low and covenants are tight when credit is tight, and as the credit cycle continues and credit becomes more available, higher borrowings and easier covenants become the norm.  There is currently a wide availability of capital and we are in the latter part of the credit cycle.

Corporate cash flow lending investments for you and I are generally made through either business development companies (“BDCs”) or senior bank loan funds (“bank loans” or “leveraged loans”).  For institutional investors, there are a large number of middle market lenders available for investment, which are essentially just private BDCs.  A BDC is a middle market lender that operates a closed end fund available for small and large investors to buy and sell shares on an exchange.  The BDC charges an investment management fee on capital (between 1-2%) and an incentive fee (the “carry”) of between 10-20% of profits above a 7-8% return.  BDC fees are outrageous, but they are a fairly easy and liquid way to tap into the middle market lending space.  In addition, BDCs can use leverage to increase the returns of their portfolio.  They are generally able to get a dollar in leverage for every dollar in equity, so have a leverage ratio of 50% to total outstanding loan value.

Another way to tap the market is through a more direct route, using bank loan ETFs, closed end funds, or mutual funds.  Instead of buying the bank loans through a BDC you can buy them more directly and more transparently.  What you lose is the active management (in the case of ETFs, this could be a good thing or a bad thing) and the ability to gain leverage.  What you gain is generally lower costs.

In all of the above cases, remember that investing in corporate cash-flow loans is related to investing in high yield debt.  Most of the companies that receive these loans are smaller or mid-sized, higher risk companies.  High yield debt is riskier than bank loans, and as a result, return on average between 1-2% more per annum (in normal years).  Also, a company can more easily “call” a bank loan than a high yield bond and retire or refinance the debt.  However, these bank loans have many advantages over high yield loans.  They are higher in the capital structure (more senior, and thus get paid before the high yield loans in the event of a default), and the floating rate provides some protection when interest rates rise.

Now let’s turn our attention to asset-backed loans and where they differ from cash-flow loans.

Asset-Backed Lending: The Investment Perspective

Asset-backed lending is exactly what it sounds like, a loan secured by certain and specific assets.  Investing in asset-backed loans can be as simple as buying a mortgage fund or ETF.  After all, a mortgage is simply an asset-backed loan backed by your home.  The mortgage market is government backed and hyper competitive, leaving lower expected returns for the investor, with lower risk.   However, there are alternatives available that can offer more attractive returns.

Many private debt investments are backed by assets.  Asset-backed loans can be made to companies that are generally cash strapped, and cannot get typical cash-flow based loans.  Most, although not all, of the time, these companies are cash strapped because they are going through a period of high growth and do not currently have the EBITDA to support more cash-flow borrowing.  The collateral from these loans can range from accounts receivable, inventory, and equipment, to patents and royalty streams.  Finding these investments can be attractive, because as long as the loan can be paid off by the fire sale value of the collateral, then you are covered on your principal and still earn an attractive rate of return.

Another favorite asset-backed lending investment involves the hard money lending sector for real estate investors.  The average fix and flip investor does not buy a home with 100% equity financing.  Instead, they get a short 1-2 year loan.  The loan is often at a fairly high rate (10% or more), but given the cost of the loan interest relative to the total project, the short time frame, and the expected profit from the flip, these investors are willing to pay.

Asset-backed lending, in general, is harder for the typical investor to access than cash-flow lending.  However, given the relative differences in expected return and downside protection, locating and doing proper due diligence on these assets can be worth it.

Loans & Optionality

Investing in loans will not increase your positive optionality.  By definition, a loan has limited upside and full downside risk.  However, when done properly, investing in shorter duration loans with attractive yields can provide a solid base to pay for some of the upside optionality.  Upside optionality can be expensive, but a portfolio of low drawdown-risk, higher yielding debt can be used to finance the purchase of upside optionality.

Loans can be divided into two categories: cash-flow based loans and asset-based loans.  Cash-flow based lending is by far the larger of the two and includes anything from high yield bonds to BDCs and leveraged bank loans.  It can also include marketplace lending to individuals.  Asset-based loans, on the other hand, are tougher to find but can provide strong downside projection and as high, if not higher, yields.

In a related post, I’ll focus on building out a portfolio of shorter duration, asset-backed loans.  Combined with buying call options at the current low volatility levels, this type of portfolio can provide strong upside potential with limited downside.

Keep building my friends.

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