Cash & Liquidity ManagementInvestment & FundingCapital MarketsThe Many Advantages of Asset-Backed Commercial Paper

The Many Advantages of Asset-Backed Commercial Paper

Asset-Backed Commercial Paper (ABCP) is an effective and efficient means of financing of all types of receivables, as well as practically any other predictable cash flow. By providing working capital secured by trade or term receivables and warehousing assets prior to a term securitization, the ABCP market can accommodate financing growth strategies and a variety of other corporate needs and motivations. At over $700 billion, the asset-backed market includes financings addressing every need and type of cash flow, many uniquely designed for this market.

How ABCP Works

ABCP is very different from corporate backed commercial paper. While both are short-term debt, that is where the similarity stops. Corporate-backed commercial paper is unsecured short-term debt, an obligation of the company. ABCP is secured and has little bearing on who the company is that is selling the assets. In some cases, the ABCP market is available to corporate borrowers who could not access the corporate-backed commercial paper market or could not raise funds at rates as attractive as ABCP rates.

There are several types of ABCP programs, all commonly known as ‘;Conduits.’ One type is credit arbitrage, which is basically borrowing short and lending long. Another type is the Structured Investment Vehicle, similar to market value CDOs. The largest type, which is the one we will discuss here, is referred to as a Multi-Seller Conduit because there are many sellers that contribute assets into one program that raises the funds in the name of the program. In a Multi-Seller Conduit, many originators of assets, or sellers, provide pools of assets as collateral for the conduit. The conduit sponsors (typically large banks) administer the program and raise money from commercial paper investors to fund the asset purchases.

Just as in the ‘;term’ financing market, Special Purpose Entities (SPE’s) are used to efficiently isolate the assets. The SPE is structured to have minimal capital and no employees, and exists only to buy the assets from the seller as a true sale, which enables the all important bankruptcy remoteness to be achieved. The SPE then transfers the assets to the ABCP conduit, where they are then owned by the conduit that funds itself in the ABCP market. The seller usually remains as the servicer of the assets, handling the billing, collecting, customer service and overall management of the portfolio that has been sold.

Maintaining Ratings

In the commercial paper world, the highest ratings are A-1+ (S&P), P-1 (Moody’s) and F-1 (Fitch). These ratings are applied to the notes issued by the conduit, not the individual portfolios that generate the cash flows. The ratings also are supported by the conduit sponsor through liquidity facilities and credit enhancement, as well as the monitoring of the conduit’s assets by the sponsor.

To maintain the highest ratings at the lowest cost, the conduit sponsor requires the seller to absorb any first-losses using credit enhancement in a first-loss position that is retained by the seller. The size of the enhancement is determined by the sponsor and the rating agencies based on historical data on the portfolio and structures that have been tested over time.

The seller usually provides the first-loss credit enhancement through ‘;over-collateralization,’ where the amount advanced will be less than the full value of the assets sold or pledged to the conduit. The amount that is not funded is the over collateralization and goes back to the seller once the notes are fully paid off. It is a ‘;Seller’s Interest’ that remains the property of the seller but it and any cash flow will be subordinate to the conduit’s interest. Over collateralization also covers asset dilution, program costs and, for non-coupon bearing assets, interest for the ABCP investors in the event of a default. The enhancement amount will depend on the credit quality and liquidity of the assets. Once the assets are purchased by the conduit, the over collateralization amount is the limit for which the seller is at risk (any seller recourse can threaten the bankruptcy remoteness). ABCP sponsors are risk adverse and monitor asset quality closely for possible deterioration and assume this duty very seriously. The overriding intent of this approach is to create a low cost, efficient funding source that has minimal exposure to risk. Strong portfolio surveillance is an integral part of the risk mitigation techniques employed by the sponsors.

ABCP Flexibility

The seller has a great deal of flexibility in the terms and amounts financed using ABCP conduits. The amount sold into the conduit can be increased as funding needs grow or can be reduced as funding needs decrease. Some sellers use ABCP conduits like a revolver, adjusting the amount sold based on need. If net receivables are increasing, more receivables can be sold to the conduit (up to a facility limit). If receivables are decreasing or sold into a term securitization, the funds generated from the cash flows can be used to pay down the ABCP investors.

Thomas Glanfield is a New York-based partner in Ernst & Young’s Structured Finance Advisory Services group.

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