‘Sono il factotum della citta!’

Santo Volpe, Chief Investment Officer of Eden Rock Capital Management, the London funds of funds manager, writes on asset-based lending as a hedge fund strategy

Gioachino Rossini, The Barber of Seville Santo Volpe, Eden Rock Capital Management
Originally published in the November 2004 issue

To traditional minds asset-based lending as a hedge fund strategy is a new phenomenon. The rapid growth of assets in the arena this year is no surprise as many investors are keen to find an “alternative to alternatives”. With little, if any, correlation to the financial markets or to hedge funds themselves, the asset-based lending strategy is an attractive one. However, the strategy does present difficulties for some investors. The absence of any tradeable securities deters some investors. The fact that there is no primary or secondary market place for the underlying loans has implications for valuation and liquidity. On average most asset-based lending funds have 180-day liquidity and some have annual liquidity. Capacity, or the lack of it, precludes some larger investors from allocating to a limited number of single-manager, asset-based lending hedge funds. Nevertheless, a prudent and effective approach to investing in the asset-based lending space can produce solid and consistent returns with very low volatility.

What is Asset-Based Lending?

Factotum is from Medieval Latin, from the Latin fac totum, “do everything,” from facere, “to do” + totus, “all.” The origin of factoring, predominantly a North American industry, dates back to the early nineteenth century. Factors evolved from the U.S. selling agents of European textile mills. The mills used the agents to sell their fabrics in the U.S. and paid the agents a commission on sales. The agents also carried out other tasks which included warehousing, shipping and invoice administration. As transaction volumes increased, so too did the number of prosperous selling agents. They began taking on the job of establishing credit terms and advancing funds to the mills. The factor, more or less, administered all aspects of the transaction and provided the finance – hence, factotum. The roots of the oldest documented factoring firm can be traced to 1810 and several others were established in the first half of the nineteenth century. Even today a large portion of U.S. traditional factoring is in the textile and fashion industries. Factoring as a hedge fund strategy is relatively new. The majority of the 50 or so asset-based lending hedge funds emerged in the last 4 years.

Traditional factoring involves the advancing of funds through the purchase of a company’s receivables without recourse to the goods being sold. The factor notifies the company’s customer and collects the proceeds directly from the customer. The factor assumes the credit risk and is pinned with a loss in the event of a default. A slight modification of the basic model is when the lender, rather than purchasing a receivable, takes assignments of the receivables as security. If the buyer defaults it’s the seller who must pay the lender. Normally, the lender will have provided an adequate cushion to allow him to liquidate and receive full payment.

From this basic model a myriad of structures has evolved with a corresponding group of perplexing names to describe the strategies: full-recourse financing, discount factoring, purchase order financing, real-estate financing, inventory financing, floor plan financing, payroll factoring, bridge financing, secondary re-factoring, single invoice factoring, resource factoring, invoice discounters etc. Additionally, other hybrid strategies have emerged. Three years ago student loans became the 4th largest sector of the U.S. asset-backed issuance. The life-settlements strategy has recently found its way into the hedge fund universe. This year the fastest growing areas are credit card receivables and structured legal finance, where the lender advances money to a borrower who has a pending legal settlement. Additionally, auto-finance pooling and commodity finance are both growing rapidly.

Due Diligence – Where to Begin?

Unlike other strategies that make up a typical portfolio of hedge funds, a high degree of diversification is required when investing in asset-based lending hedge funds. Essentially, more underlying managers means more underlying loans and the risks associated with the strategy are greatly mitigated without bringing down returns – therefore, the more the better. A portfolio of asset-based lending hedge funds should have at least 100 underlying loans at any one time with varying maturities. In addition to the number of loans, diversification is required in the types of collateral securing the loans. Collateral can include accounts receivable, inventory, machinery, patents, real estate, trademarks, royalties and actual shares in the borrowing company.

Prior to investing in a manager an investor must evaluate the manager’s ability to administer the loans with detail. As they say, “the devil is in the detail,” and a major part of the due diligence process must be spent examining the contingency clauses of the loan documentation. Depending on the strategy, other questions might be: “what happens if there is a dispute between the buyer and the seller over the goods or delivery? How would that affect the position of the lender? In credit card receivables how does the collector ensure compliance with the Fair Debt Collection Practices Act 1996 (FDCPA)?” The due diligence process for asset-based lending is going to differ with each strategy. A standard process applied to all managers is sub-optimal. For example, in auto finance pooling, where there can be over 100,000 loans on the books, default modelling and loan administration are crucial. In inventory lending documentation and dispute risk are the focus. In commodity finance special attention should be placed on the warehouse endorsements. Agency dependent managers need to demonstrate their ability to deal with a potential problem with the agent. What happens if an agent becomes insolvent? With how many agents does the manager deal? Though due diligence on asset-based lenders may seem a quagmire, a diversified portfolio, well researched, together with 100% transparency in the underlying loans can provide an adequate degree of comfort with good stable returns.

Let’s have a look at some actual deals recently undertaken by some asset-based managers.

Deal 1

Magazine Publishing

The company publishes a monthly magazine designed to target women from 21-34 years of age. This demographic represents one of the largest segments of the U.S. population and comprises more than 33 million consumers. The magazine is on the “cutting edge” (to use trade parlance) in its format, photography and editorial content. The current circulation is approximately 225,000. The magazine is published 11 times per year and attracts high end, credit worthy advertisers and advertising agencies. The manager’s collateral consists of a first lien on all accounts receivables and inventory and blanket liens on all other assets. The accounts receivables turn in less than 60 days. The manager’s investment yields the fund 28%.

Deal 2

Insured Medical Receivables

The manager structured a receivable credit line with an experienced and successful corporation engaged in the purchase of insured medial receivables. Unlike the acquisition of uninsured medical receivables in the form of consumer installment contracts, this activity involves the acquisition (on a straight purchased basis) of insured medical receivables from physician groups throughout the country.

Typically, when groups of smaller doctors provide services to patients, an account payable is generated to the doctor from an insurance carrier. This receivable lacks the characteristics of a standard receivable because of its long-dated nature – anywhere from 70 to 125 days. This long duration tends to place a significant burden on a physician’s cash flow. Consequently, smaller practitioners often seek to factor this receivable in order to meet payroll, rent and other operating expenses.

In order to properly assess and value each receivable, it is essential that every conceivable medical procedure be priced correctly before purchase. Proper pricing not only involves verifying the validity of the receivable but one must also determine the extent of the medical procedure, the state in which service was rendered and the pricing regimes of various insurers. The manager’s partner not only verifies in order to mitigate fraud, he also employs a database which is continually updated in order to provide accurate pricing across geography, procedure and insurer. In addition, he maintains servicing platforms in two separate locations. Each time a receivable is purchased the doctor remains on full recourse and advance rates are conservative in the 60-70% range.

Deal 3

The borrower is a cable systems and networks company that focuses on rural markets, pursuing a roll-up strategy through an acquiring entity and then selling the combined companies at a premium. The lender financed the borrower via a two-year, senior secured term loan. The payout is structured as interest only for the first twelve months and then moves to a twelve month amortization. The coupon is significantly above normal banking rates and pays approximately 23 current and 13 deferred, payable at maturity.

The structure was cross-collateralized and secured in excess of the loan value by greater than 3x based on liquidation values. The facility was secured by a first lien on all assets of the borrower, a pledge of all the equity interests of the acquiring entity, a second lien and pledge of the principals’ personal cash equity investment in another entity (cash value above loan amount), a first lien and pledge of an account receivable from a recent purchase of the acquiring entity (valued above loan amount), and personal guarantees from the principals.

The reasons for a loan of this type, from an investment perspective, are straightforward. The borrower was pursuing a well thought out acquisition strategy, and the collateral value was a significant multiple over the loan value. In a worst case scenario the lender felt comfortable that all collateral and protections provided full principal repayment, with interest, even in the event of liquidation.

Deal 4

Service Sector Finance

The manager participated in a receivables purchasing program to finance a company engaged in the procurement, delivery, and installation of self-sustaining base camps, food services, and other logistic supplies for the United States military. In the fourth quarter of 2003, the manager was successfully bought out of its position, at par plus a break-up fee by a major American commercial bank. From inception to closing, the IRR on the transaction was approximately 18.0%.

Formed in 1989, the borrowing company began operations with a contract to supply generator lighting sets to the United States Army in Saudi Arabia. Following the successful completion of that assignment, the company was awarded further contracts during Operation Desert Storm and the rebuilding of Kuwait. In addition, the company provided logistical support services for the Army and United Nations in Somalia. Following the tragedy of September 11, 2001, and the subsequent build-up to war, the company was one of only a handful of US-based companies capable of providing the rapid support that the U.S. army needed as it built its command and control facilities in the Persian Gulf, Afghanistan, Kuwait and eventually Iraq.

Soon after the United States’ failed bid to secure United Nations Security Council support for an invasion of Iraq, the company received a significant contract to supply bottled water to the U.S. Army Central Command. The company approached several traditional sources of liquidity (no pun intended) but all were unwilling to provide receivables financing due to the company’s negative net worth statement from the prior year. The banks simply refused “to go the extra mile” to see that the credit risk of lending to a company with a negative net worth was overwhelmingly mitigated by the quality of the obligor (the U.S. government), the terms and conditions of the receivables agreement, and the strong relationship enjoyed between senior management and obligor.

At the time of underwriting, the manager, through its participating position, advanced eighty five percent of the face value of the United States Department of Defense-backed receivables to the company, creating a fifteen percent equity cushion. Durations were limited to forty-five days and all cash collected by the company was deposited into a lockbox account. Additional strengths of the transaction included significant company operating history, experienced management, strong contracts with the United States military, and personal and corporate guarantees. In addition, the participants received a first lien on all accounts receivable and a general lien on all other assets.

So What Are the Risks?

The often, seemingly obvious assumption made by observers is that the main risk is default. This is not necessarily always the case. In some situations due to the structure of the collateral the lender might even continue to advance money to a troubled counterparty. The affects of defaults vary enormously depending on the strategy. To a traditional non-recourse factor, a default is a serious event. The lender must provide for adequate protection when deciding on what will be the percentage of loan to value, and also on the valuation itself. To a pooled auto finance lender, with over 100,000 loans on the books, defaults are a part of daily life. In his case he must accurately predict expected default rates.

A more realistic concern is the risk of legal dispute. A lender may guarantee payment to a borrower based on a receivable and that receivable might be from a credit worthy counterparty. But the guarantee does not cover disputes over merchandise or delivery. In such a situation the factor will revert to the borrower for reimbursement. While this might not necessarily involve a loss of capital, the capital may be tied up as a result of the legal process. As noted above, paying attention to detail in the loan documents is imperative. Oversights are not acceptable at the fund manager level.

Some investors express concern over the method of calculating the monthly return. Their implication is that there is room for a manager to “massage” the monthly numbers. This is certainly a valid concern. Especially if the loans have long maturities, and a substantial element of the due diligence process should be devoted to NAV calculations. However, when the loans are of short duration, i.e. 1 to 3 months, the ability to smooth the numbers is greatly reduced.

Lastly, there is the risk of fraud. Historically, this was the biggest risk to the factor, though quite a lot improved with the introduction of uniform lending legislation starting in the 1950s. Prior to then fraudulent borrowers would accept loans from different lenders pledging the same assets. Although the number of these frauds has declined, thorough due diligence is paramount to the factor.

The question is always asked: “What is the worst-case/disaster scenario for this strategy?” The answer is a macro event equivalent in proportion to what happened during the Great Depression following the stock market crash of 1929. Not only would the borrowers default, but the lenders would be holding assets with little chance of selling them at any reasonable price. Basically, the worst case scenario is a 100-year event, and given the tools and skill set of most due diligence officers, probably out of their control.

Why Does the Strategy Exist? Why Don’t the Banks Do It? Why Turn to Hedge Funds?

Neither main street banks nor Wall Street banks are heavily involved in factoring. In North America there are a few large players and a lot of small players. Many banks are not interested in making very short term loans to companies that do not meet the credit requirements of the bank. A large portion of these asset-based loans are of less than 12 months duration. Many of the loans are made to companies when one or more of the following conditions apply: inventory levels are high – operating cash is tied up in receivables – no fixed assets are available for collateral. None of these conditions are regarded as favourable by a typical bank loan officer. Asset-based lenders are able to lend at attractive rates due to this general lack of interest from the banking community.

The shift to hedge funds is a relatively new development. The shift can be explained primarily by a structural imbalance within the investor base. Hypothetically, Mr Jones, a small factor in Ohio who has been operating comfortably for the last 5 years, might come across a number of attractive opportunities and wishes to raise investment capital. He first turns to friends and family, then to colleagues, then to friends of colleagues. He might raise some capital, but deal flow is good, and he wants to expand his business. He might stroll down to the local bank, only to walk away empty handed. He might get through to the right person at an investment bank, only to be told to go away. If he’s fortunate he might come across a private equity manager that might fund him with as much as he needs. However, this funding comes with a heavy price tag as he will most likely have to give up substantial equity in his business. Now the only institutional money that Mr Jones has any chance of raising, is the same money that is chasing the same deals as he is – from one of the big factoring houses. It is for this reason that the shift to sourcing hedge fund capital is a logical and natural one.

By putting his business into a hedge fund structure, provided he can manage underlying liquidity, Mr Jones now has access to an abundant new source of investment capital. Hedge fund investors seek uncorrelated absolute returns, and Mr Jones can deliver them. That is why a number of factoring hedge funds have emerged over the last 18 months. Many of them have been in business doing exactly the same thing for years. This trend is likely to continue, and we will see more and more asset-based lending hedge funds emerge.

How Long Will It Last?

A concern among investors is that asset-based lending returns have been gradually decreasing over the last 3 years. The explanations given are the decline in interest rates and more and more competition. The first explanation is valid. Asset-based loans are typically floating-rate loans. As interest rates go down so do the returns. Equally, the reverse is true. In a rising interest rate environment asset-based loans return more. However, the competition explanation is less convincing. This author believes that there will continue to be ample deal flow not just in the United States but globally. Couple this with more and more small trade finance companies turning themselves into hedge funds. The quintessential key will be choosing the good from the bad among an ever-increasing universe of asset-based lending hedge funds.

Santo Volpe is CIO of Eden Rock Capital Management Limited in London and oversees the investment team that manages the firm’s four fund of hedge funds. The Solid Rock Fund was launched in July 2002 and won the award for ‘Best New Fund of the Year’ at the InvestHedge awards in 2003. The latest fund launches, Eden Rock Finance Fund LP (US Onshore) and Eden Rock Structured Finance Fund Ltd (Offshore), were incepted in August and November 2004 respectively. Both these funds are funds of asset based lending funds, diversified across in excess of 150,000 underlying loans. Eden Rock manages approximately $300 million and all fund programs are open to new investment. Santo has been an active investor in alternative strategies for 14 years, having headed up a proprietary trading operation of Refco prior to establishing Eden Rock Capital Management in 2001.