Asset-based lending

I am traditionally a bond investor and am happy with returns of 6-8% per annum from a portfolio of different bonds. I was contacted recently about an alternative, low-risk investment fund that invests into 'asset-based' lending as opposed to traditional bank lending. What are the advantages and disadvantages of asset-based lending as this is a completely new concept for me?

In its simplest form, asset-based lending refers to any kind of lending secured by an asset or other collateral. This means that if the loan is not repaid, then the asset (or collateral) is taken over. In this sense, a mortgage is an example of an asset-backed loan.

More commonly however, the phrase is used to describe lending to businesses. A business can obtain asset-based lending by using its liquid, current assets (such as accounts receivable and/or inventory) or its fixed assets (such as plant, property, and equipment) as collateral.

The loans are generally secured against assets, which substantially exceed the amount of the loan. Typically a lender will only advance 60% of the value of the security.

Asset-based lending therefore relies on the value of the underlying asset (or collateral) and not the credit risk of the borrower. This is different from normal bank lending.

A bank will normally look first to the cash flow for repayment, then to collateral. For businesses with solid assets but poor cash flow this can present a problem.

This gives an asset-based lender the opportunity to make a loan at attractive rates of interest with sound collateral as security. Asset-based lending is therefore usually done when the normal routes of raising funds, such as the capital markets (selling bonds to investors) or bank lending, is not possible or too expensive.

Asset-based lending is usually accompanied by high interest rates, and can be very lucrative for the lender.

Benefits for investors

Returns from asset-based lending are cash-based and short-term. This means that there are no gilts or bonds or other financial instruments that can be adversely impacted by weakness in global financial markets.

There is also no stock market exposure. Put another way, returns are not correlated with either bond or equity markets.

As a result, asset-based lending returns are consistent and volatility is minimal. Returns are Libor based and increase as interest rates rise.

Problems and risks

Asset-based lending managers are difficult to access and capacity is limited. In addition, because asset-based lending involves dealing with loans, collateral and complicated legal documentation, a high level of due diligence and research is needed before any investment can be made with a manager.

The two key risks in asset-based lending are default risk and fraud risk. It is therefore essential to invest only with those managers who have the skills set to manage these risks.

In addition it is important to dilute these risks by investing across a wide range of different managers and strategies to achieve a highly diversified portfolio of loans.

Returns from investment funds that invest into this strategy are very steady. Over the past five years, returns have been typically 8-9% per annum in US dollars with certain funds showing a positive return every single month over five years. These funds can therefore offer a solid core to most portfolios.

(I would like to thank readers who pointed out my typing mistake in last week's article on the adoption of the euro. My final paragraph should have read: "Maltese lira notes and coins will remain redeemable at the irrevocably fixed conversion rate at the Central Bank of Malta, for ten years (not one year) in the case of notes and two years in the case of coins, after the end of the dual circulation period which, if the euro adoption proceeds according to plan, should be end-January 2008.")

Past performance is no guide to the future and, except where amounts are guaranteed, the price of your investments (and the currency in which it is denominated) may fall as well as rise. Your personal tax situation will depend on residence. Always consult a professional adviser. This article does not intend to give investment advice and its contents should not be construed as such. Readers are encouraged to seek professional advice on their personal financial situation.

Mark Hollingsworth is the director of Hollingsworth International Financial Services - licensed by the MFSA to provide investment services under the Investment Services Act 1994 (IS/32457). Address any financial questions to: Mark Hollingsworth, c/o The Sunday Times, PO Box 328, Valletta CMR 01. Alternatively, he can be contacted on 2131-6298/9984-2614 or e-mail mh@hollingsworth-int.com

www.hollingsworth.eu.com