Participants in the specialized lending markets are talking about the growing dominance of hedge funds and other alternative sources of capital. Many believe this is a misconception. Diversity Capital’s David D’Antonio reviews the common forms of debt leverage in the markets and how readily available they are.
Subordinated Debt
Subordinated debt is a form of capital junior to senior debt and is usually available from a variety of providers, in a range starting at $10 million and up. These types of loans have a three-to-seven-year life and interest rates that start around 11%, with interest payable monthly or quarterly. Many of these facilities have equity-like characteristics with warrants or triggers, which allow providers to benefit from the success of the borrower over time, for providing this type of liquidity.
The benefits to the borrower include the ability to obtain additional senior leverage on this subordinated debt. For example, a private commercial lender that obtains a $15 million subordinated note can, in some cases, obtain six times the leverage for a total of $90 million in on balance sheet leverage. Some companies obtain further leverage by borrowing on a limited recourse basis, further boosting their leverage, both on and off balance sheet. For example in the case of a 10% recourse facility, the $15 million subordinated debt could provide a hypothetical on balance sheet leverage of:
$15 million in subordinated debt
Six-times leverage (on balance sheet debt)
10% recourse debt
90% nonrecourse debt shown in a note on financial statements
This type of structure can provide $900 million in potential leverage managed by the originator. These levels appear to be high, not considering the other charactericts of this structure and the commitments, which have to be provided by the holder of this type of debt. Benefits of subordinated debt include:
Subordinated debt usually doesn’t have the direct ownership position, but in some cases the providers do sit on the board of directors, and can provide valuable insight and guidance to fast growing companies.
Originators can leverage subordinated debt with senior debt or other types of leverage such as a commercial paper facility or limited recourse debt.
Most lenders will allow this type of debt to be counted as capital for leverage purposes as long as it exceeds certain agreed upon maturity dates and terms.
Usually these debt facilities do not require repayment of principal until maturity.
Subordinated debt is usually viewed as a positive by other debt holders allowing for more flexible terms in other forms of debt capital.
Subordinated debt can usually be used for general corporate purposes, allowing increase flexibility and the ability to enter more markets.
Most subordinated debt is unsecured, thus alleviating the need for collateral. Some recently closed facilities required a junior lien on collateral pools.
Legal costs could be significant and completion can be lengthy.
Subordinated debt requires a strong outside auditor and fully audited financial statements.
Limited Recourse Debt
Limited recourse debt is a common form of debt used by leasing companies and commercial lenders, which allows further leveraging by these originators. This is a common form of debt, which has allowed many high growth, niche lenders to manage their own portfolios while limiting on balance sheet debt. Another benefit of this type of facility is the fixed rate interest coupon, which is usually offered by lenders and the limited costs of setting up these structures. Some common characteristic of this type of facility include:
A fixed rate at the time of take down, matching cash flows from the loans & leases
“Perfect payment” structure, set up as a fixed payment schedule, due at the same date each month
Servicing by the originator, without notification to the leasee or borrower
Pre-securitization or commercial paper type facility — allows the originator to manage all the cash flows and communication with the clients/lessees
All late fees and restructuring fees are retained by the originator
The facility is similar to a commercial paper program —it requires similar reporting on delinquency, cash collection, performance on a static pool basis and other structured market type reporting (This type of discipline is a pre-curser to a larger facility, and can help a growing company practice and refine internal controls and reporting before entering the commercial paper markets. This type of history is valuable to potential lenders and investors.)
The structure allows for substitutions, thus maintaining the original payment structure, resulting in fewer costs due to prepayment costs
Legal costs are reasonable, usually ranging from $10,000 to 20,000
Quick ability to close, with a typical time frame of less than 30 days and, in some cases, two weeks
These structures don’t require a separate special purpose entity (SPE) to be set up (even though some companies do elect to set up one anyway)
Gain on sale or finance method of income recognition, which allows the originator to manage income and how it is treated on the income statement
Covenant packages that require monthly and quarterly reporting
Fully audited financial statements are needed for strong execution
Senior Debt
Senior debt is the mainstay of the industry, and is provided by a multitude of banks and other providers. These facilities usually are structured as warehouse lines, which allow originators to put together pools of assets for financing in other facilities. Some facilities have term loan provisions with fixed rate availability. Some common characteristics include:
Full recourse on the balance sheet and the originator has to provide extensive reporting to the funding source. In addition, well-structured facilities usually require a lock box, a blanket lien and a collateral custodian. In the case of titled vehicles, the use of a titling trust is usually required and it allows for easier movement of the collateral when it is pledged to a third party.
The ability to fund transactions and portfolios in a quick, efficient method.
The ability to fund other non-traditional loans and leases that provide an originator the ability to differentiate themselves from other finance companies.
Senior debt is a necessity in obtaining other facilities such as commercial paper or limited recourse lines.
Senior debt facilities usually take one to three months to process and close, and have extensive legal documentation and reporting.
Fully audited financial statements are necessary.
Nonrecourse Financing
Nonrecourse financing is a popular method of liquidity management for fast growing lessors and specialized lenders. Many originators use this method of financing to de-leverage their balance sheets or manage large exposure to single clients. This is a very large market with almost unlimited liquidity. Many different parties provide this type of funding including most banks and large independent leasing companies. Some popular characteristics and benefits include:
Gain on sale recognized on a cash and balance sheet basis
Reduced leverage on the balance sheet
Reduced recourse and potential losses
Many lenders to provide private label billing
In some cases, the lender allows the originator to continuing servicing, including disposition of assets
Loss of servicing and contact with the obligor is a negative
Audited financial statements not necessary
Commercial Paper/Term Securitization
Commercial paper and term securitization is a very effective mode to leverage an originator’s balance sheet in a large-scale method. Facilities offered by banks usually start around $100 million and are used as a pipeline to the term markets for high-volume originators. These facilities have been used by large leasing and specialty finance companies for the past 20 years, and allow these entities to put large pools together and enter the term securitization market. Public and private companies such as Marlin Leasing, NewStar and CapitalSource have used these facilities to expand managed portfolios in a cost effective and efficient way. There are some aspects to consider when determining if this is an effective tool for a growing specialty finance company.
Is your company large enough to use this facility? Typically you have to start out with a $75 to $100 million facility. In order to qualify for this size facility, a specialty lender would need a minimum of $7-10 million in tangible capital.
Does your company have the need for static pool analysis and history of five to ten years of portfolio performance?
Do you have adequate computer and software systems?
Does you company need diverse origination capability?
Does your company have strong outside auditors with at least three years of fully audited financial statements experience in place?
Can you provide multiple credit facilities including warehouse and term loan facilities with detailed history of use?
Can you cover significant legal costs?
Can you spare the large amount of management time and costs associated with the facility?
Do you have at least three to six months to set up and fund the facility?
Conclusion
Current liquidity in the markets for debt is strong across all levels. Banks continue to aggressively price facilities and advance at high levels. One of the larger issues facing borrowers is the lack of understanding by bankers and lenders, and their inability to process credit requests in a timely manner. Banks also have a limited appetite for credit to a single borrower and thus, in the case of full recourse warehouse lines, they usually can not lend more than $20-30 million and have to syndicate beyond that level.
The equity markets are receptive to both existing and new specialty finance companies that can demonstrate diverse debt facility management. Hedge funds have had a limited impact in the specialty finance markets, with little or no focus in the equipment leasing area. Most hedge funds that we have contacted have indicated they want large exposures for high yields, thus limiting their interest to a smaller segment of the specialty finance markets.
I believe it is a positive environment for lessors and niche lenders to build a large serviced portfolio with a variety of facilities and lenders. This strategy should result in a high valuation when the owners decide to sell or take their companies public.
David D’Antonio is a managing director of Diversity Capital LLC. Diversity Capital (divcapital.com) is headquartered in Cinnaminson, NJ, and is a nine-year-old firm, which specializes in asset-backed advisory, origination of structured credit facilities for specialty finance companies, portfolio financing, M&A advisory, crisis management, individual transaction structuring and portfolio liquidation/workout. Diversity has assisted in financing for a variety of companies including commercial, consumer and other specialty finance companies. D’Antonio can be reached by e-mail at [email protected].
David Burton,
Partner,
Norton Rose Fulbright US LLP
April 5, 2024
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