Who Can Benefit?
Types of Asset Financing
Asset-based financing is a line of credit secured by the company's assets (eg, accounts receivable, inventory, plant and equipment). Unlike conventional bank financing, which is based on a company's cash flow, asset-based financing takes a broader look at a company and at its real worth. It takes into consideration not just cash flow, but the full value of all income-producing assets. For this reason, asset-based financing can provide the company with (i) a larger credit line than may be available with conventional lines of credit, and (ii) a continuous flow and a faster turnaround on the working capital.
Prime candidates for asset-based financing are medium-sized growth companies in manufacturing, wholesaling and other asset-intensive areas of business. Among such companies, asset-based financing can prove particularly advantageous for:
- new, high-growth companies whose success has outstripped their ability to support further growth;
- established firms with a solid record of profits that have an opportunity to expand into a new field or product line, but lack the capital to support the expansion;
- companies with strong potential requiring more financial support for a longer term than traditional lenders will allow;
- firms that wish to acquire another company but lack the capital needed to do so on a conventional basis; and
- companies that want to use all their assets to facilitate optimum borrowing power.
Asset-backed financing is a specific method of raising off-balance sheet finance that uses the performance of specific assets to fund the return on the debt securities issued. There are many different types of asset-backed financing, but most of them involve the sale of performing assets (known as 'receivables') to a special purpose company, which then issues some form of debt to outside investors. The interest on the debt is funded by the income stream flowing from the receivables and the repayment of capital is secured on the assets transferred. The original owner receives an initial cash payment from the special purpose company in exchange for the transfer of the assets.
The advantage of this method of raising finance is that investors own a freely tradeable debt security of the special purpose company (which is why this particular technique is known as securitization), and not merely a proportional interest in the underlying assets. For the original owner, this technique turns a future income stream into an immediate cash payment.
Asset-backed financing involving commercial property is not new. The first property assets to be securitized were residential mortgage loans. The asset-backed market includes many different types of receivables, including lease income streams. Property-related receivables are ideal for securitization as the income stream tends to be predetermined, both in terms of amount and timing.
To generate working capital or to meet specific short-term cash needs, small businesses may use certain short-term assets as collateral for commercial loans. The most common types of asset-based financing are the following.
Accounts receivable financing
This form of financing is a type of secured loan in which accounts receivable are pledged as collateral in exchange for cash. The loan is repaid within a specified short-term period as the receivables are collected. As the business collects the receivables, the proceeds are used to repay the loan or line of credit.
Accounts receivable financing is most often used by businesses facing short-term cashflow problems. The major source of accounts receivable financing for small businesses are commercial finance companies, although banks will also consider receivables as security for a business loan.
Accounts receivable are typically 'aged' by the borrower before a value is assigned to them. The older the account, the less value it has. Delinquencies in the accounts and the overall creditworthiness of the account debtors may also affect the loan-to-value ratio.
A monthly interest rate on accounts receivable is calculated by applying a daily percentage rate to the receivables outstanding each day (the less the outstanding receivables, the lower the interest charge). A default on payment can result in the financier seizing the pledged accounts receivable.
When the company applies for an asset-based loan, the company pledges assets to secure a loan from a bank or a commercial finance company. The company still owns its assets, but if the company does not make good on its payments, the lending institution can seize them.
Asset based loans are typically for companies with less-than-perfect credit. As with all commercial lending, rates are negotiable. Lenders will look at a company's credit record, how long the company has been in business and whether a company's assets are liquid.
Accounts receivable and inventory are common collateral, but any asset might qualify. The loan-to-value ratio drops rapidly for older accounts.
Inventory financing is similar to accounts receivable financing, except the business's existing inventory is used as collateral for the secured loan. The company can anticipate a conservative valuation of a company's inventory. The key factor is the merchantability of the inventory (ie, how quickly, and for how much money, could the inventory be sold).
The loans are typically short term and the interest rates are similar to those for accounts receivable lending. The most common use of inventory financing is for the purchase of new inventory, especially when an upcoming season requires that the company keep additional inventory in stock.
Securitization is the process by which pools of cash-generating assets are converted into securities, often rated investment grade, that can be sold to investors. In its basic form, securitization involves the sale or transfer of assets by the originator to a bankruptcy-remote special purpose vehicle (SPV), which is then funded by issuing securities to investors backed primarily by these assets. The income received from the assets will then be used by the SPV to make the required payments of interest and principal under the debt instruments to the investors. The originator usually also acts as an administrator to service and collect any receivables due under the assets sold to the SPV. For these services, the originator is usually paid a fee by the SPV consisting of the profit from the assets sold to the SPV (ie, the surplus income from the assets not required to service interest and principal).
Liquidity support may be included to cover the risk of the income generated from assets sold to the SPV being insufficient to meet the principal and interest payments on the securities. Such liquidity support also acts as a credit enhancer and could increase the rating of the debt securities issued by the SPV.
The securities are structured so as to be paid primarily from cash flow on the assets, plus any available credit enhancement, rather than by the originator. Securitization therefore allows banks to manage their credit risk and capital more effectively.
In principle, any asset that has the following characteristics may be securitized:
- it generates a regular and relatively certain income stream;
- it has standard terms;
- it has an historically low delinquency rate;
- it has a long maturity period; and
- it is appropriately serviced.
Traditional asset types include mortgage loans, credit cards, auto loans, lease receivables, high yield debt (commercial bank loans), trade receivables and future flows.
An asset securitization in Singapore would require the application of:
- securities law;
- company law;
- bankruptcy law;
- tax law;
- Monetary Authority of Singapore (MAS) regulatory requirements; and
- accounting rules.
Only the pertinent issues relating to asset securitization in Singapore will be highlighted here.
Transfer of assets
The assets to be sold to the SPV should not require the consent of the debtor before the originator may effect the sale. Under Singapore law, assets are freely transferable, and there are no governmental or regulatory requirements applicable to the transfer of assets from the originator. However, the marketing of, or the giving of advice in relation to, unit trusts of the transferred assets or debt instruments by the SPV that are backed by the transferred assets or proceeds will be regulated by prospectus, listing and licensing regulations.
Certain securities need to be registered to confer effective security to the SPV. The assignment of debt obligations secured by a bill of sale must be registered as a transfer of the bill of sale. A transfer of mortgage should be registered with the Registry of Land Titles and Deeds to ensure perfection of the transfer. This transfer will be endorsed on the title deed or certificate of title for the relevant piece of land.
Confidentiality and secrecy requirements that could be imposed by law or contract relating to the assets will affect the transferability of the assets to be sold by the originator. If the originator is a bank, Section 47 of the Banking Act (Cap 19) imposes a statutory duty of secrecy and confidentiality. Unless documentation relating to the asset to be securitized expressly authorizes the bank to disclose information to an assignee, no disclosure may be made. For other financial institutions seeking to sell their receivables, the common law duty of confidence may restrict the ability of the originator to transfer the assets.
Where a mortgaged property is purchased using Central Provident Fund monies, the fund is given a statutory charge over the property purchased. Where other institutional funding is used in the purchase of the property, the fund will usually enter into a deed of priority with that institution, so as to be given first priority.
The question of whether the sale of the assets by the originator to the SPV would attract stamp duty must be considered. The Stamp Duties Act (Cap 312) has abolished stamp duty on all instruments of conveyance, assignment and transfer other than those relating to stocks, shares and real property.
Tax is payable for any income of any person accruing or received in Singapore, or derived or deemed to be derived from Singapore. Interest payments are therefore subject to tax regardless of whether the SPV receiving the interest is an onshore or offshore vehicle. Furthermore, interest payments from any person to an offshore SPV would attract withholding tax of 15%. Where there is a double taxation agreement between Singapore and the country of which the recipient is a tax resident, the rate provided in the double taxation treaty would apply.
Administrative services provided by an originator to a SPV is a taxable supply that will be subject to a 3% goods and services tax.
Certain provisions in the Companies Act (Cap 50) and the Bankruptcy Act (Cap 20) allow a liquidator of a Singapore originator to avoid or set aside a transfer of assets to the SPV.
A securitization deal should be structured in order to ensure that under applicable insolvency laws, the sale of the assets will not be avoided because of the originator's insolvency. The SPV should also be structured as a bankruptcy-remote entity for the protection of investors in the asset-backed debt securities issued by the SPV.
The MAS has circulated guidelines for securitization to banks in MAS Notice 628 which was issued on September 6 2000, pursuant to Section 54A(1) of the Banking Act. The notice has taken into account feedback from the industry and existing securitization transactions. It applies in relation to any securitization transaction, to any bank acting as:
- provider of credit enhancer or liquidity facilities;
- manager; or
The notice seeks to define the general requirements for banks participating in securitization transactions (eg, disclosure and separation). For instance, any bank participating in a securitization transaction must take reasonable steps to disclose to investors in writing the nature and extent of its contractual obligations in the securitization transaction. There must also be a clear separation between the bank providing credit enhancement or liquidity facilities with the SPV.
The notice guidelines also set out the capital treatment of securitized assets to ensure that banks hold appropriate capital against the risks they accept. Thus, a bank that has securitized its assets will be granted capital relief only where the transfer of risks and rewards of the securitized assets has been effective and complete.
For further information on this topic please contact Petrus Huang or Lauren Li at Drew & Napier by telephone (+65 531 2208 / +65 531 2213) or by fax (+65 535 4864 / +65 531 4864) or by e-mail (petrus.huang @drewnapier.com or [email protected]). The Drew & Napier web site can be accessed at www.drewnapier.com.
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