Asset-Based Lending Shifts to Owning

Before the financial crisis crested in early 2009, hedge funds employing the conservative strategy of asset-based lending enjoyed a boom. As debt markets and bank credit dried up, asset-based loans (ABLs) backed by all manner of collateral, from receivables to real estate liens to inventory, became a sought-after source of capital.

Inevitably, the credit crunch caught up with ABLs too. Borrowers’ inability to refinance when loans came due, compounded by a collapse in asset-to-loan ratios and unprecedented investor withdrawals, forced most ABL managers to restrict withdrawals or suspend their funds.

The overall impact was severe. Peter Laurelli, a vice president at data provider HedgeFund.net, reports that there were 92 funds in HFN’s ABL index at the end of 2008, but only 51 at the end of 2009. (HFN’s database, though not comprehensive, reflects the broader trend.) “More than 150 asset-based-lending funds that had three-year or more track records, with at least $100 million, are winding down or reorganizing into new funds,” observes Jonathan Kanterman, a managing director at New York–based Stillwater Capital Partners, which manages ABL hedge funds and an ABL fund of funds.

Although current opportunities for asset-based lending have never been better, according to Kanterman, the financial crisis and subsequent fall in asset values have prompted a distinct shift in strategy from lending against assets toward owning them outright. Stillwater’s $450 million in ABL hedge funds is invested roughly 50 percent in loans and 50 percent in underlying assets; before the crisis loans made up about 90 percent of the funds.

The experience of Perella Weinberg Partners is similar. The New York–based firm launched its Asset-Based Value Opportunity strategy in April 2008. From the start, however, portfolio manager David Schiff realized that with valuations falling drastically, the fund’s performance could be enhanced by holding assets as well as lending against them. Thus the fund today not only has a book of franchise, auto, commercial and industrial loans, it also holds assets that include aircraft, railroad cars, energy royalties and commercial real estate.

As the financial crisis deepened, Schiff discovered that instead of originating loans, the fund could do better buying secondary loans at deep discounts from distressed owners, including banks in receivership and hedge funds liquidating assets. He reasoned that steady income streams could be unleashed once the assets were divorced from the troubled institutions.

According to the database BarclayHedge, Schiff’s fund soared more than 50 percent in 2009 and was up 4.22 percent through the first four months of this year. Originally capitalized at $100 million, the fund is worth several times that today, Perella Weinberg says, without disclosing details.

Schiff says his success stems from looking beyond a company’s balance sheet or debt service ratio and understanding an asset’s unencumbered value and how it changes across the economic cycle.

Asset ownership clearly alters the model that has long made asset-based lending so compelling, trading relatively dependable fixed-income returns for the risks of owning the underlying asset outright. Yet ABL managers who are making this strategy shift contend that, at least in the near term, the financial crisis has changed industry fundamentals and thus how managers can best profit from them.

Asset-based lending has always been something of a curious sideshow in the alternative-investing circus. The loans could be against anything from film distribution rights to law firms’ shares of class-action settlements — some 30 categories in all. Yet the returns tend to be reliable, if modest by hedge fund standards. According to HFN, the mean ABL hedge fund returned 12.7 percent in 2007, 5.27 percent in 2008 and 6.19 percent in 2009. Survivorship bias no doubt boosted those performance numbers, but the fact is, the industry never stopped making money, even during the crash.

Stillwater, which manages $750 million, down from $1 billion at its peak in October 2008, pursued a typical strategy. It focused on loans of less than 12 months to importers and exporters and energy remarketers that were looking for temporary loans against receivables, as well as medium-term loans of 12 to 36 months to law, real estate and life insurance firms against settlement fees, property and life policies, respectively.

As with other ABL funds, realized losses were not a big issue for Stillwater. The real problem, says Kanterman, was that banks pulled credit lines from funds of funds that had invested with Stillwater and other funds; this in turn forced the funds of funds to liquidate their positions. And that created a cascading effect, he explains.

Suddenly, funds of funds were forced to redeem their assets from underlying ABL funds, and not enough liquidity or new money was coming into the individual funds to offset the tremendous outflow. In October 2008, some 25 ABL funds of funds with a combined $4.3 billion in assets reported data to HFN; as of the first quarter of 2010, that number had dropped to five, with less than $92 million in assets.

To meet the redemptions, of course, ABL funds hastily sold off their most liquid and desirable loans. Still, that wasn’t enough, so to protect investor equity and asset values, many decided to gate their funds, suspend redemptions or even shut down their funds. “Unlike equity managers who can sell off highly traded stocks to meet redemptions, the liquidity of ABL funds is structured along loans of various maturities,” explains Kanterman. “Even in a stable economic environment, positions can’t be quickly unwound, especially longer-term real estate assets.”

After a scare like the credit crisis, owning assets as well as lending against them can look like a tolerable risk. Los Angeles–based Himelsein Mandel’s Ruby Fund, with $317 million in assets, is a specialty ABL fund that provides financing for the premium payments of high-value life insurance policies held in trust for wealthy elderly people.

Guaranteed by the insured parties and the policies themselves, these 27-month balloon payment loans generated net annualized returns for Ruby of 18.85 percent between 2006 and 2008.

As the markets collapsed, the fund found its aging clients were less inclined to maintain policies whose primary purpose was to cover their estate taxes. Yet if the policies were terminated before death, they had little cash value, so an increasing number of policyholders sought to sell their policies on the secondary market and found they could collect 15 to 20 percent of the policies’ face value.

Ruby, often forced to acquire policies in lieu of cash payments, soon saw a compelling opportunity in owning, rather than only lending against, the policies, and it obtained credit to help guarantee the premium payments. This transformation, however, came with initial costs that reduced Ruby’s 2009 return to 10.7 percent. But the fund now sees the policies as bond proxies that could pay hundreds of basis points more than the secured debt of life insurers.