What is Asset-based Lending and How It Works?

What is Asset-based lending?

Asset-based lending is the business of loaning money in an agreement that is secured by collateral. An asset-based loan or line of credit may be secured by inventory, accounts receivable, equipment, or other property owned by the borrower. The asset-based lending industry serves businesses, not consumers.

More commonly, however, the phrase is used to describe lending to businesses and large corporations using assets not normally used in other loans.

Typically, the different types of asset-based loans include accounts receivable financing, inventory financing, equipment financing, or real estate financing Asset-based lending in this more specific sense is possible only in certain countries whose legal systems allow borrowers to pledge such assets to lenders as collateral for loans.

Summary

  • Asset-based lending refers to a loan that is secured by an asset.
  • Examples of assets that can be used to secure a loan include accounts receivable, inventory, marketable securities, and property, plant, and equipment (PP&E).
  • Lenders commonly use the loan-to-value ratio to determine the amount of money they are willing to lend.
Asset-based lending refers to a loan that is secured by an asset.

Advantages of Asset-based Lending

Asset-based lending offers the following advantages to the borrower:

  • Asset-based loans are easier and quicker to obtain than unsecured loans and lines of credit;
  • Such loans generally include fewer covenants; and
  • Asset-based loans generally come with a lower interest rate compared to other funding options.

Asset-based lending provides the following advantages for the lender:

  • Asset-based loans are less risky as it is collateralized with an asset (or assets); and
  • If the borrower defaults on the loan, the lender can obtain the assets that were used to secure the loan and liquidate them to settle the amount outstanding.
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How Asset-Based Lending Works?

Many businesses need to take out loans or obtain lines of credit to meet routine cash flow demands. For example, a business might obtain a line of credit to make sure it can cover its payroll expenses even if there’s a brief delay in payments it expects to receive.

If the company seeking the loan cannot show enough cash flow or cash assets to cover a loan, the lender may offer to approve the loan with its physical assets as collateral. For example, a new restaurant might be able to obtain a loan only by using its equipment as collateral.

The terms and conditions of an asset-based loan depend on the type and value of the assets offered as security. Lenders prefer highly liquid collateral such as securities that can readily be converted to cash if the borrower defaults on the payments.

Loans using physical assets are considered riskier, so the maximum loan will be considerably less than the book value of the assets. Interest rates charged vary widely, depending on the applicant’s credit history, cash flow, and length of time doing business.

Example of Asset-based lending

For example, say a company seeks a $200,000 loan to expand its operations. If the company pledges the highly liquid marketable securities on its balance sheet as collateral, the lender may grant a loan equaling 85% of the face value of the securities.

If the firm’s securities are valued at $200,000, the lender will be willing to loan $170,000. If the company chooses to pledge less liquid assets, such as real estate or equipment, it may only be offered 50% of its required financing, or $100,000.

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In both cases, the discount represents the costs of converting the collateral to cash and its potential loss in market value.

Usage of Asset-based lending

Asset-based lending is usually done when the normal routes of raising funds are not possible, such as the capital markets and normal unsecured or mortgage secured banks. This is often because the company has exhausted other capital raising options or needs more immediate capital for project financing needs.

Asset-based loans are also usually accompanied by lower interest rates, as in the event of a default the lender can recoup its investment by seizing and liquidating the assets tied to the loan.

Many financial services companies now use asset-based lending package of structured and leveraged financial services. Many banks, both national investment banks (e.g. Citi, J.P. Morgan, Wells Fargo, Goldman Sachs, Morgan Stanley, et al.) and regional banks, offer these services to corporate clients.

Asset-based lenders are known for taking out tombstone ads in much the same way as investment banks.

An example of asset-based loan usage was when the global securitization market shrank to an all-time low after the collapse of investment bank Lehman Brothers Holdings Inc in 2008. Within Europe in 2008, over 710 billion euros worth of bonds were issued, backed largely by asset-based loans, such as home and auto loans.