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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2005

Asset-based lenders shift focus

It’s hardly a secret that banks do not lend to everyone. While this has always been the case, it has become much more apparent in recent years.

A wave of bank mergers has led traditional lending institutions to clean up their balance sheets and focus efforts on their largest and most-creditworthy borrowers. This development has created a vacuum and resulted in a dilemma for smaller, non-investment-grade borrowers who are attempting to grow their businesses.

Every vacuum represents an opportunity. So who has been picking up the slack? The niche asset-based lender.

Traditional lenders have been inflexible about their specific lending guidelines. Their sole concern has been whether borrowers can service a debt (i.e., make monthly payments). This is because banks traditionally have not been in the business of foreclosing on collateral or reselling foreclosed property.

This inflexibility has created a profitable niche for asset-based or liquidation lenders. Niche asset-based lenders exist in many shapes and sizes and structure deals in a variety of ways. Most commonly, these lenders use private loans that are highly collateralized. For asset-based lenders, the key component in evaluating potential deals is the asset value, not whether the borrower can make monthly payments. Examples of asset-based loans are hard-money loans and those secured by real estate.

While organizations that provide loans secured by real estate have existed for decades, the deal flow has grown exponentially in the past few years. More recently, managers have started offering investors access to such deals via hedge-fund structures by allocating to niche asset-based lending strategies.

In the event of a default, the concern for asset-based lenders is how quickly the lender can own that asset and can market it in excess of its cost or loan. In addition to the asset’s value, other important factors are location of the real estate, prior experience with this type of loan and the borrower. The borrower’s credit quality is secondary, at best.

Of course, this entails added due diligence that needs to be thorough and goes well beyond the financial analysis. Professionals who conduct the due-diligence review should have extensive experience and perspective in evaluating asset-based transactions.

The review should include:

  • Visiting the site to evaluate management and staff, obtaining permission to conduct background checks on the key people and checking multiple references; 
  • Understanding completely how the asset and collateral values are determined and understanding available processes to independently verify the asset values continually;
  • Determining that the necessary documentation that supports the ownership of the collateral is in place and evaluating the quality and liquidity of the collateral; and
  • Knowing that the policies, procedures and systems are in place to reduce the possibility of fraud.

There are several rules to the underwriting procedure for asset-based lending. The first is to know the exit before agreeing to fund a transaction. The second is to understand why a hard-money loan is required — e.g., is a quick closing required? Does the asset have value even if the borrower’s credit does not support the loan?

An example of a quick-closing situation would be a purchaser who has a significant non-refundable deposit at risk. If the purchaser’s planned loan or equity cannot close in time and the seller is unwilling to extend the closing, the purchaser risks losing the entire deposit by not closing. Under such circumstances, the underwriting entails the value of the asset or assets (additional collateral may be required) and the realistic time frame for repaying the hard-money loan.

Another factor would be if borrowers’ credit could not support the loan when a property is in foreclosure with significant verifiable equity. A hard-money loan that includes reserves for current payments could allow borrowers to repair their credit and refinance or sell the property and realize the equity.

The ability to find and structure the right transactions that result in an acceptable rate of return and risk profile is key. With hard-money loans, speed is of the essence. It is imperative for management to be able to quickly assess the risk and to close rapidly.

Prudent management is critical in order to avoid a bubble and not take in too much capital from investors. This may result not only in the dilution of returns but also in the potential for deal-chasing, which increases the portfolio’s risk profile.


 


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