Alternative Financing Instruments Asset-based lending

 Asset-based finance  Typically, 4 types of asset classes are

secured under ABL: accounts receivable,
 includes asset-based lending, factoring,
inventory, equipment and real estate.
purchase-order finance, warehouse
receipts and leasing, differs from  The amount the firm can borrow depends
traditional debt finance, as a firm obtains on the appraised value of the selected
funding based on the value of specific assets, rather than on the overall
assets, rather than on its own credit creditworthiness of the firm.
standing.
 The asset-based loan agreement often
 Working capital and term loans are thus allows for a revolving arrangement,
secured by assets such as trade accounts whereby, if the borrower needs other
receivable, inventory, machinery, advances, these can be secured by more
equipment and real estate. assets, such as more receivables, as others
are collected and paid off.
Asset Based Finance
 Hence, as the borrower generates
 The key advantage of asset-based finance
receivables from new sales or builds more
is that firms can access cash faster and
inventories, these assets are generally
under more flexible terms than they could
eligible for inclusion in the ‘borrowing
have obtained from a conventional bank
base’.
loan, regardless of their balance sheet
position and future cash flow prospects.  This arrangement requires constant
monitoring of collateral by the lender to
 Furthermore, with asset-based finance,
control and manage the credit risk. The
firms that lack credit history, face
lender audits the borrower’s assets daily,
temporarily shortfalls or losses, or that
to monitor and secure the performance of
need to accelerate cash flow to seize
the loan.
growth opportunities, can access working
capital in a relatively short time. Risk of Asset-based lending
 In addition, asset-based financiers do not • The asset-based lender is exposed to risks
generally require any personal guarantee that are specifically related to the securing
from the entrepreneur, nor that s/he give mechanisms such as:
up equity.
• Collateral risk, i.e. the risk that the
 On the other hand, the costs incurred collateral securing the loan will decline in
and/or the complexity of procedures may value after loan inception and be
be substantially higher that those insufficient to liquidate the loan.
associated with conventional bank loans,
• In the case of account receivables, for
including asset appraisal, auditing,
instance, the asset can be diluted by credit
monitoring and up-front legal costs, which
notes (for returns, errors or damages),
may reduce the firm’s levels of profits.
write-offs (i.e., for bad debt), payment
 Also, funding limits are often lower than discounts, as well as customer rebates and
in the case of traditional debt. allowances (Benchaya and Anderson,
2010).
 • Collateral illiquidity, i.e. the risk that the Advantages of Asset-based lending
process to liquidate the collateral will be
• The use of assets to generate cash flow
time-consuming and costly, detracting
presents advantages for start-up
from the ultimate returns.
companies, which have limited credit
• Accounts receivable are considered to be history, but also for fast-growing firms,
highly liquid assets, whereas inventory which can respond more rapidly to their
may be more difficult to value, monitor short-term cash needs than through
and liquidate; traditional debt channels.
• Legal risk; i.e. the risk of incurring costly legal • ABL can serve in particular the needs of
mistakes, due to inadequate legal documentation SMEs that are at a growth stage or that
or mismanagement of the loan facility. face seasonal build-up of inventory or
receivables, whose value can be hardly
• In light of the above risks, particularly of
reflected into traditional loans that have
the expected asset value dilution and
already been underwritten.
losses, asset-based lenders typically lend at
a discount to the actual value of the • In this regard, ABL allows for more
secured assets. flexibility than traditional lending in
accessing a credit line, whose limit can be
• For accounts receivables, a loan-to-value
expanded quickly, as the value of the
ratio (LVR) of 80-85% is considered
underlying assets change.
normal (Caouette et al., 2008).
• For instance, in the case of a revolving
• On the other hand, in the case of less
credit facility secured by receivables, the
liquid assets, the LVR can be significantly
outstanding loan amount may fluctuate on
lower. For instance, if inventory is the
a daily base, providing a significant degree
secured asset the lender might extend a
of flexibility to the borrower to finance
credit of up to 40% of the estimated value.
evolving working capital needs.
Interest on Asset-based lending
• The lender’s close monitoring of the
• The interest rate applied on the loan also secured assets’ value also implies that
reflects quality and liquidity of the assets, highly leveraged firms, or firms that have
and is often higher than the rate on experienced recent losses, can obtain cash
conventional bank loans. flow more easily than it is generally the
case for conventional lending.
• Furthermore, a service charge to cover the
costs of administration of the account adds • Conventional lenders do not rely on
to the costs for the borrower. specific assets to support their loan and are
not closely monitoring any underlying
• Over time, the increased competition
collateral, typically require borrowers to
within the industry has also contributed to
maintain a conservative financial position
bringing down the costs of asset-based
over the loan terms.
lending, as a variety of players entered the
market, including traditional commercial • Through ABL, companies with strong
finance companies, hedge funds and cash- accounts receivables and a solid base of
rich companies seeking to diversify their creditworthy customers can overcome
business.
 temporarily lending constraints or  Factoring is thus a transactions funding
accelerate access to working capital. technology, based on ‘hard’ data, similar
to asset-based lending, as the financing
• For this reason, ABL is usually considered
depends on the value of an underlying
to be a transitional source of financing, to
asset, rather than on the creditworthiness
weather temporarily cash flow shortfalls,
of the firm.
when the firm does not qualify for
traditional bank lending, or to take  However, it is different from asset-based
advantage of growth opportunities. lending in the following aspects: i) it
involves exclusively the financing of
• Asset-based lending is also appropriate to
accounts receivable, rather than a broader
fund businesses at times of transition and
range of assets; ii) the underlying asset is
restructuring, such as in the instance of
sold to the factor at a discount, rather than
mergers and acquisitions, management
collateralized; iii) it is a bundle of three
buy-ins and by-outs, when there is a need
financial services, i.e. a financing
for increased liquidity in a short time.
component, a credit component, and a
• In the case of acquisition, it is possible to collections component, as in most cases
use the assets of the company being the borrower outsources to the factor its
acquired to finance the acquisition itself. credit and collection activities (Berger and
Udell, 2006).
• This can be especially advantageous when
the value of receivables or inventory of the  Factoring also differs from conventional
target firm is significant in relation to the bank lending and asset-based lending, in
price of acquisition. that it does not generate debt on the firm’s
balance sheet and there are no loans to
Factoring
repay.
 A supplier short-term financing
 By selling accounts receivables to a factor,
mechanism, whereby a firm (‘seller’)
the firm is able to rapidly convert accounts
receives cash from a specialized institution
receivable into another asset, cash.
(‘factor’), in exchange for its accounts
receivable, which result from the sales of  Through factoring, thus, it is the factor
goods or provision of services to which assumes the costs implied by
customers (‘buyers’). collecting information about buyers, which
explains the specialization of factors on
 In other terms, the factor buys the right to
specific industry segments, to develop
collect a firm’s invoices from its
more accurate market knowledge and
customers, by paying the firm the face
credit-risk assessment (Soufani, 2011).
value of these invoices, less a discount.
Purchase Order Finance
 The factor then proceeds to collect
payment from the firm’s customers at the • POF is a highly targeted form of asset-
due date of the invoices. based finance, intended to allow a firm to
fill a particular customer order, thus to
 The interest ranges from 1.5% to 3% over
seize the market opportunities that would
base rate and service fees range from 0.2%
be lost due lack of financial resources to
to 0.5% of the turnover (Milenkovic-
buy inputs and deliver the output.
Kerkovic and Dencic-Mihajlov, 2012).
• POF funds the production stage of an • This mechanisms requires more intensive
SME’s activities, as it consist in a working monitoring of the firm’s operation and the
capital advance to cover part of the financier assumes the risk in the case that
production of a good or service demanded the firm will not be able to meet the order,
by one or more specified customers. as well as the risk related to payment
deficiencies by the customers.
• Through POF, the SME obtains a verified
purchase order from a customer and • Interest rates and fees are typically higher
estimates the direct costs required to than with other forms of asset-based
produce and to deliver the product, which finance.
may include labour, raw materials,
• Also, the financier can take guarantees and
packaging, shipping, and insurance.
other collateral, such as inventory and bills
• POF is submitted to a financier, which of exchange, to mitigate risk.
bases the credit decision on whether the
Pre-Export Finance
order is from a creditworthy customer or is
backed by an irrevocable LC (cannot be • Pre-export finance transactions are similar
cancelled during some specified time to POF operations, but are specifically
period) from a reliable bank and on applied to export orders. They consist of
whether the SME can produce and deliver the extension of financing against orders
the product according to the terms of the that have been placed and confirmed by
contract. foreign buyers, after the lender has
evaluated their creditworthiness.
• If the loan is approved, the financier
advances a share of the total order value, • In addition to risks implied by a traditional
typically paying the approved costs POF operation, the financier needs also to
directly to the suppliers. Once production evaluate the political and legal risks
and delivery are completed, the accounts implied by the cross-border transaction,
receivables from the customer are either such as the risk of expropriation,
assigned to the financier, as in the case of sanctions, discriminatory change of law or
factoring, or the payment is directed into the impact of local insolvency law.
an account under the financier’s control.
Purchase Order Finance
• Similar to factoring, when the financier
• POF can serve the needs of growing firms,
receives payment, it deducts the amount
with little access to working capital and
advanced and interest or fees, and remits
poor cash flow, which receive orders that
the balance to the SME (USAID, 2009).
are larger or more frequent than their
• POF allows the SME to transfer the credit current capacity to pay suppliers upfront.
risk to a more creditworthy customer,
• POF is generally not a replacement for
which is often a larger firm or a
conventional financing. Rather, as it
government agency. However, the advance
provides rapidly large amounts of new
rate is generally lower than in the case of
capital (Maselli, 2000; USAID, 2009)
factoring, as POF implies higher costs and
risks for the financier. Warehouse receipts
• Warehouse receipts (WHR) are an asset- value chain about products’ quality and
based financing mechanism, whereby availability.
loans are secured by commodities
Warehouse receipts for Whom?
deposited at a certified warehouse.
• WHR are suitable for producers and
• Under this arrangement, commodity
traders of commodities that lack credit
producers and traders deposit commodities
history or other collateral to access lending
at a warehouse, which offers secure
finance.
storage and issues a receipt that certifies it
is in possession of a specified quantity of a • The financial services provided by the
commodity that meets specified standards. system combine with other potential
benefits, such as access to reliable storage
• The receipt can then be used by the
and hence the possibility to sell the
depositor as collateral for a loan, whereby
product over time, rather than solely at
the lender places a lien on the commodity,
harvest periods, when prices of
so that this cannot be sold before the loan
commodities may be especially low.
is repaid (USAID, 2009).
Warehouse receipts
• The amount that the firm can borrow is
typically a share (50-80%) of the stored • WHR is especially advantageous for
commodity value. The costs implied by the producers and traders of storable
mechanisms for the borrower include agricultural commodities such as grain,
interest, taxes and storage fees. sunflower seeds and sugar.
• Beside the warehouse operator, the WHR • In these sectors, the use of stored
system engages specialized service commodities as collateral represents a
providers, such as those offering both solution to enhancing agricultural lending,
depositors and lenders certification and and provides a valuable addition to the
inspection services, to ensure the traditional use of real estate and land as
warehouse meets necessary standards for loan collateral (Höllinger et al., 2009).
safe and secure storage.
• For small producers, however, storage fees
• In addition, insurance companies generally may be too high.
provide protection against commodity
Leasing
losses at the warehouse.
• Leasing is a common mechanism to
• As the warehouses typically maintain
finance use and purchase of equipment,
records about producers’ performance, this
motor vehicles and real estate by firms.
system may also work to build information
on current and potential borrowers, which • Parallel to other forms of asset-based
can be useful to financial institutions over financing, underwriting depends on the
time, especially when other credit history value of an underlying asset and on the
information is lacking. ability of the firm to generate sufficient
cash flow from business operations to
• Also, as the system is based on consistent
meet regular payments, rather than on its
standards, their incorporation into receipts
overall creditworthiness as assessed
improves knowledge in the market,
reducing information asymmetry along the
 though financial statements, credit history agreement, but the ownership is
and fixed assets. transferred only upon the full payment of
the purchase amount.
• Typically knowledge about results of
business operations is used by the • An “operating lease” is typically of a
financier to generate indicators of the shorter duration than the useful economic
adequacy of prospective cash flows life of the asset and the customer has no
(Gallardo, 1997). possibility to purchase it at the end of the
contact, or can acquire at a higher price
• A lease is an agreement whereby the
than under a finance lease. An operating
owner of an asset (lessor) provides a
lease is thus essentially a rental contract
customer (lessee) with the right to use the
for the temporary use of an asset.
asset for a specified period of time, in
exchange for a series of payments. • In comparison with conventional bank
financing, in a lease contract no or limited
• The lessor remains the legal owner of the
up-front cash down-payment or security
asset throughout the contract, and
deposit is required.
ownership may or may not be transferred
to the lessee at the end of the contract. • In this way, leasing can finance a higher
percentage of the capital cost of equipment
• Under a “financial lease”, the customer
thereby allowing the business entity to
carries the risks and rewards of the asset’s
preserve its cash resources or existing
ownership.
bank facilities to meet working capital
• The lessee benefits from the economic life needs
of an asset in a similar way to a legal
Trends of ABF
owner and takes on related risks, such as
maintenance and insurance • Asset-based finance is a popular form of
responsibilities. finance for SMEs, whose diffusion has
substantially increased over the last
• Typically, financial leases are used by
decades.
firms to finance long-lived assets, instead
of resorting to long-term borrowing for • At the same time, as awareness increased
acquiring these assets. and access to other bank debt has become
more difficult for many businesses,
• A “hire-purchase” contract works in a
demand for asset-based instruments has
similar way to a finance lease, as the
significantly increased since the 2008-09
customer pays for an asset in regular
global financial crisis.
installment, while benefiting from its use.
• In the UK, the Asset Based Finance
• However, hire-purchase is a type of
Association (ABFA) has reported a 10%
installment purchase, with a well-defined
growth for the industry over June 2012-
purchase option for the customer, who
June 2013.
agrees to pay the cost of the asset over
time, including principal amount and • Both small and large firms are contributing
interest for the period the asset is used. to this positive trend, with advances to
small firms recording a 6.2% growth in the
• In this case, the purchaser acquires the
second quarter of 2013.
property of the asset on signing the
• Asset-based lending has been expanding in between 1998 and 2004 (Klapper, 2006)
many OECD countries. In the United and by 98% between 2005 and 2011 (FCI,
States, the Commercial Finance 2013).
Association (CFA) has recorded steady
• However, most of the factoring business is
increase in new credit commitments
concentrated in Europe, which accounted
among asset-based lenders in 2011-12.
for 60.9% of the global volume in 2012,
• In Canada, the Canadian Finance & with the four largest countries (UK,
Leasing Association (CFLA) estimates the France, Germany and Italy) accounting for
asset-based financing and leasing industry about 50% of the volume.
to be the largest provider of debt financing
• In the same year, the US and Japan
to business customers and consumers in
accounted for 3.6% and 4.6% of the
the country after the traditional lenders.
worldwide factoring volume (FCI, 2013).
• The 2014 Survey on the Access to
• During the 2000s, factoring has been
Finance of Small and Medium-sized
growing steadily in emerging economies,
Enterprises (SAFE), conducted by the
as recorded by Factors Chain International,
European Central Bank and the European
a global network of leading factoring
Commission, shows that, “leasing or hire-
companies, which represents about 80% of
purchase” ranks high among SME sources
the global cross-border factoring volume.
of finance.
• In particular, the factoring industry has
• The 4th Regional Survey on Banks and
experienced important growth in China,
SMEs in Latina America, conducted in
recording an increase in world share from
2012 by the Inter-American Development
0.5% in 2004 to 9.4% in 2010, when it
Bank on 106 banks across 20 countries,
overcame the United States and Japan in
illustrates the range of products offered by
terms of factoring volumes.
banks to SMEs, and highlights in
particular the increasing importance of • Overall, factoring in Asia has grown
asset-based instruments such as leasing steadily since 2009; in 2012, it represented
and, to a lesser degree, factoring. 26.8% of world volume.
• Leasing is supplied to SMEs by 24% of World factoring volume, by region, 2006-12
the surveyed financial institutions, whereas
factoring is provided by 9% of the banks
(IDB, 2012).
• According to a survey conducted in 2012
by the International Chamber of
Commerce (ICC) on more than 200 banks
located in 110 countries, trade finance is in
high demand.
• Factoring is a key instrument in trade
finance. Worldwide, the factoring industry
has grown rapidly since the 1990s: the • According to a 2011 survey-based report,
factoring volume increased by 88% in 2010, leasing was the most popular
 source of external finance, accessed by firms rely more importantly on
40% of SMEs, compared to 38% that had cash/equity.
accessed a bank loan with maturity greater
Source of funding for fixed asset investment by
than three years, 37% that had used a bank
European SMEs
overdraft, and 13% that had funded
investment through factoring.
• A similar picture is provided by the
Eurostat survey on SME finance, which
shows that, in 2010, of the surveyed SMEs
searching for finance, 55% had accessed
leasing and 16% had used factoring
(OECD, 2012b).
Investment by funding type, European SMEs,
2010

• The survey by Oxford Economics (2011)

further highlights the greater use of leasing
by larger SMEs (over 50% of medium-
sized firms, compared to 40% of small
firms and about 30% of micro firms),
which can be explained by the overall
more limited access by micro firms to
external finance.
• The evidence about “penetration rates”
(total value of assets leased over
investment) shows that SMEs use leasing
to finance a greater proportion of their
investment (16.7%) than business firms on
average (12.9%). Also in relation to this
indicator, medium-sized firms appear to
use leasing more intensively, while micro-