What is asset-based lending?

Asset-based lending, or asset-based financing, is a type of secured lending that forms part of the asset class known as private credit, which is privately originated loans to companies.

How does asset-based lending work?

Asset-based lending uses an asset—or multiple assets—as collateral for loans that are typically around $1 million to $50 million, and most often sought by small to midsize companies. Asset-based lenders are mostly nonbank financial institutions, such as asset managers, that are typically sole lenders. This is unlike banks that provide larger-sized loans often funded through a loan syndicate.

Similar to the broader private credit segment, asset-based lending is relationship driven where professional networks established over years are used to find opportunities to lend to companies with specific borrowing needs. An asset-based lender is responsible for:

• Researching companies and sectors
• Sourcing opportunities
• Assessing borrowers’ needs and requirements
• Assessing assets suitable for use as collateral, including setting acceptable loan-to-value (LTV) ratios and using other financial ratios to value assets
• Formulating loan agreements and establishing appropriate covenants—special terms placed on borrowers that form part of the loan agreement

What is an LTV ratio and why is it important?

An LTV ratio measures a loan amount as a percentage of an asset’s value. A common example of an LTV ratio is a residential mortgage. Most mortgage providers offer 80% LTV, meaning they will provide a mortgage loan of up to 80% of the value of a property. The rest must be funded, usually through a cash deposit. An LTV ratio is one of the financial ratios used in asset-based lending; another is loan coverage ratio (LCR). These, and other metrics, are used to value assets, set terms and manage risk.

Loan-to-value calculation

LTV =    Loan amount

             Appraised value of asset

In asset-based lending, there’s no industry or asset-standard ratio for valuing assets. Each lender determines an appropriate LTV or LCR, which can differ based on industry, company size, asset type, and liquidity. Therefore, an asset manager’s knowledge and experience of an industry make a significant difference in negotiating and structuring deals.

Asset-based lending vs. cash flow lending

Asset-based lending is different from—but also potentially complementary to—traditional cash flow lending. Cash flow lending is unsecured as there’s no specific asset used as collateral for the loan. Instead, past and projected cash flows are used to determine loan eligibility and terms. In unsecured lending, the creditworthiness of the borrower is given high importance as it helps determine default risk. With a secured loan, a borrower’s creditworthiness is still important but to a lesser extent as a loan is backed by an asset. 

Benefits of asset-based lending

For investors, there are multiple potential benefits of incorporating asset-based lending into a diversified portfolio, these may include:

• Differentiated source of returns—Asset-based lending offers investors an alternative source of return to traditional high-yield and corporate bond markets.
• Higher potential yield—An illiquidity premium affords investors the opportunity to realize a yield advantage over comparable quality public credit. Additionally, the floating-rate structure of asset-based loans means that returns have the potential to increase in rising interest-rate environments.
• Customized terms—As asset-based lenders are typically sole lenders, rather than part of a syndicate, the ability to customize covenants and terms is high. This provides additional risk management benefits as risks can be identified, mitigated, and/or priced into a loan.
• Risk management—Asset-based loans are senior in the capital structure, meaning that investors, as holders of senior debt, are first priority in terms of repayment. As loans are secured by an asset, this additionally helps to lower overall risk.
• Potential inflation protection—Tangible assets typically increase in value as inflation rises, therefore there are potential asset appreciation benefits in higher inflationary environments.
• Through-cycle opportunities—Companies seek loans for different reasons through economic cycles, including growth or distressed funding in bull and bear markets, as well as funding for short-term operating needs. This provides a steady stream of through-cycle investment opportunities.

What are the risks of asset-based lending?

All investments carry some degree of risk. Within asset-based lending, key risks may include:

Limited liquidity

Although assets used as collateral for loans can be sold in the event of a default, the esoteric nature of many assets means that a readily available sellers’ market may be limited. In addition, the time horizon for this type of investment is usually the term of the loan—around three to five years. These factors contribute to asset-based lending being classified as a semi-liquid investment.

Default risk

Any type of lending carries the risk of a borrower defaulting on payments. In secured lending, default risk is managed through requiring a specific asset as collateral, which helps to lower overall risk. Additionally, as asset-based loans are considered senior debt, investors have first priority repayment in the event of a default.

Concentration risk

Concentration risk is the risk of having exposure to one type of industry or sector. Diversification applies to asset-based lending in the same way that it applies to diversifying within equities and bonds. Exposure to a range of sectors, industries, and companies is important when considering an investment.

Choose wisely

Asset-based lending is a growing segment of the wider private credit market, and it’s highly fragmented due to its complexity. Some of those complexities include sourcing deals. Private credit in general is relationship driven and requires strong networks to find investment opportunities. Other complexities include structuring loans and covenants that attract borrowers, while managing risks and enhancing returns for investors. In this respect, the choice of asset manager is critical as experience within different industries, strength of origination networks, and depth and skill of an investment team may make a significant difference in achieving successful investment outcomes.

Traditionally, private credit and asset-based lending has been the preserve of institutional investors. But it’s increasingly opening to a broader investor base through the introduction of semi-liquid investment vehicles such as feeder funds, interval funds, and unlisted closed-end tender offer funds that allow smaller investment allocations. Partnering with an asset manager that has experience and proven expertise is critical to accessing the investment opportunities offered through asset-based lending.

Find out more about asset-based lending investment opportunities with John Hancock Investment Management.