Wouldn’t it be nice if every time someone asked you to borrow $100, they gave you their iPOD to hold onto as collateral?  I’m sure they would be much more compelled to actually pay you back as opposed to conveniently “forgetting” to do so.  Seems like a simple concept, wouldn’t you say?  Well, as simple as it is, it’s actually a concept that has many investors retreating to the basics during this troubled economy.  Now more than ever, ABL’s (or Asset Based Lending investment funds) are gaining attention and significant momentum simply due to demand from both the lending and investment industries.  Say goodbye to the days when lenders would give you money because you had a decent credit score and a nice smile.  Now they want you to actually be accountable and have skin in the game.  How dare they expect such a thing!

Asset based lending simply refers to any financing offered to a borrower that is secured against their assets, and if the debt is not satisfied the asset is seized by the lender.  The most common example of asset based lending is a mortgage that is secured against a piece of property.  However, in the hedge fund and alternative investment world, asset based lending can refer to much more than loans on just real estate.  ABL considers assets such as business inventory, accounts receivable, company equipment and machinery, intellectual property, marketable securities, equity ownership in a company, and of course real property (IE, real estate).  Funds usually specialize in lending on a specific type of asset, and the risk for their investors varies depending on what they’re collateralizing against.  For instance, loans that are underwritten using a business’s accounts receivable as the underlying asset are typically higher risk compared to loans that are underwritten using an income-producing apartment building.  The former assumes that the business will be receiving money owed by customers and ultimately has the business to fall back on if the receivables are not received.  The latter assumes rents will be paid and ultimately has the building to fall back on if rent is not paid to the borrower.  Loans against property are typically considered lower risk because they are secured against a physical asset, that being real estate, which typically holds its value over time.

So, why such a demand in this current economic cycle?  With banks continuing to shut down their lending operations because they are so leveraged on their portfolios, the only lenders left  are those profitable ABL funds that offer loans with higher interest rates under their stricter terms.  Banks can no longer compete because of their lack of liquidity and their unprofitable margins from their extremely low rates.  Hence, the credit crisis.  Banks were too loose with their guidelines, providing highly-leveraged financing at very low rates, while ABL fund required more skin in the game, more security to back-up the loan, and rates that allowed them to remain profitable, even if a portion of their loan portfolio went into default.  Now borrowers are either forced or in many cases choose to turn to alternative financing, private lenders and ABL funds to acquire the financing they need.  As a result, alternative financing is becoming less of the alternative and more of the norm, and thus positioning itself to become the conventional financing of the future (and near future at that).  These ABL’s can pick the “cream of the crop” loan and distressed debt opportunities, and demand even more collateral from their borrowers with stricter terms than before, thus making the ABL funds much more resilient and secure as they continue to take over the capital markets.  ABL has not only become the financing option for most borrowers as of late, but their demand from the lending industry has translated into a alternative investment opportunity for many investors looking to get their money placed into a more predictable and sound investment vehicle.  If you think about it, the demand for money on one side of the fence presents an opportunity for the supplier on the other side of the fence.  It all goes back to the Golden Rule (whoever has the gold makes the rules!).

So, let’s return back to the idea of providing a $100 loan for a friend secured by their iPOD, a tangible asset I think we can all agree is marketable.  Let’s say the fair market value of the specific unit in question is $150.  If someone were to put up their $150 iPOD to borrow $100 from you and they were to skip town, you would still be sitting pretty (assuming you did your due diligence to make sure the unit was in good shape, functioning, etc).  Well, in this scenario, you would be holding an asset with a 67% LTV, or Loan-To-Value (simply loan amount divided by the value of the asset), meaning there is a 33% equity buffer available to protect you from a loss, and even present additional profit.  This puts a whole new spin on things the next time your cousin-in-law asks for a small loan at the next family barbecue, doesn’t it?  Try talking a little asset based lending with him and then see how much he needs the money.