Receivables Securitization and Capital Structure

While this funding method has historically been limited to larger, blue chip companies, it now represents a viable funding alternative for mid-cap and non-investment grade companies as well. Accordingly, in looking at capital structure and liquidity matters, corporate treasurers of mid and large-cap companies alike should be assessing the role that securitization can play in helping corporations to meet their financial objectives.

Securitization: Not Just Off-Balance-Sheet Debt

Receivables securitization is a well-established funding method whereby assets such as trade receivables, credit card receivables, or other financial assets are packaged, underwritten and sold in the capital markets in the form of asset-backed securities. Essentially, a pool of assets is sold into a funding vehicle that in turn issues debt securities, using the proceeds of the securities to fund the purchase of the securitized assets. Ultimately, the cash generated by those assets will be used to service the securities that were issued.

Globally, asset securitization is a significant source of liquidity for corporations and financial institutions. In the US alone, asset-backed securities outstanding (including asset-backed commercial paper) exceed $4 trillion. It is also a popular funding method in Europe where annual issuance of asset-backed securities exceeds €240bn.

Often, however, securitization is erroneously viewed as an alternate form of debt, largely because there are numerous similarities between the two forms of funding.

Key similarities between debt funding and securitization funding include the following:

• Securitization programmes ultimately raise funds in the capital markets by issuing debt securities.
• Securitization programmes are priced like debt: that is, the cost of funds in securitization is generally calculated as a spread over London inter-bank offering rate (Libor) or some other fixed income market benchmark.
• Securitization, like debt, represents a source of capital that is non-dilutive to shareholders.
• Securitization funding programmes are often arranged by the same organizations that provide debt funding (i.e. banks and investment banks).
• The level of funding available under a securitization programme is based on asset levels and advance rates, similar to some revolving debt structures.

However, viewing securitization simply as off-balance-sheet debt is inappropriate as there are material differences between traditional debt and securitization. First, and perhaps most significantly, a securitization generally entails a true sale of assets between a seller and a buyer. This has numerous effects that are inconsistent with viewing securitization as debt:

• The securitized assets are removed from the seller’s balance sheet. This is not simply an accounting trick to obscure certain elements of the balance sheet, but rather a true reflection of the fact that those assets have indeed been sold.
• There is no repayment of principal required. In a debt facility, the borrower must repay the principal amount, regardless of whether the receivables are collected. In a securitization, the securitizer is not responsible for principal repayment; rather the purchaser of the assets must rely solely on collections and any predefined reserve amounts when looking for repayment.
• Beyond this, while there are obviously circumstances that will cause a securitization based funding to cease (i.e. amortize), the amortization of a securitization programme is unlike a debt facility in that amortization may indeed create financial difficulty for a securitizing company, but it is not an act of bankruptcy as a default on debt would normally be.

Clearly, these are fundamental differences between securitization and debt. Securitization can provide significant benefits to aid in a company’s overall financial strategy. So, since securitization is clearly not debt, it should therefore provide a set of benefits that are distinct from debt. Receivables securitization can be an effective funding tool to enhance financial performance on a variety of fronts. It can be used to improve capital efficiency, enhance corporate liquidity, and to reduce financial risk.

Improve Capital Efficiency

A fundamental benefit of securitization is that it allows a company to monetize a low-yielding, yet significant balance sheet asset – accounts receivable – and deploy the resultant proceeds to a higher yielding corporate priority. Regardless of whether the capital is reinvested in the business or repatriated to debt or equity holders, return on capital is improved.

Accounts receivable, as an asset on the balance sheet yield, as a best case, zero. Therefore, with receivables earning zero, the remaining productive assets of the company must, in aggregate, return more than the cost of capital in order for a company to meet its overall return on capital targets.

So, when accounts receivable are monetized through securitization, one low yielding asset is replaced with another one: cash. This action, by itself, does little to improve capital efficiency. Where this can become interesting, though, is when the cash is either redeployed or repatriated.

If it is redeployed in a corporate investment that yields the cost of capital, the net effect will be that the capital employed in the business will have remained constant, but the absolute returns will increase as a result of zero-yielding accounts receivable being replaced by a cost of capital-yielding investment. Overall, the return on capital increases.

If the proceeds of securitization are not reinvested but are in fact used to reduce the capital employed in the business, return on capital will also increase. The reason for this is simply that the company has retained all of its productive assets and simply monetized its non-productive assets – accounts receivable. As long as the cost of securitization is less than or equal¹ to the company’s weighted average cost of capital, return on capital increases.

Enhance Liquidity

Because securitization programmes can often provide a superior advance rate compared to credit facilities, companies with a relatively large volume of receivables can use securitization to enhance their overall liquidity. High growth companies, distributors, seasonal businesses and service companies generally all require significant working capital investments and their credit facilities often lag the growth in their businesses.

In these companies, receivables become the company’s most significant asset and any inability to fund them can become a serious inhibitor of growth. However, by securitizing receivables, the companies can achieve maximum liquidity for their receivables and then look to credit facilities to address any incremental liquidity requirements.

It is true that when a company securitizes its receivables it may see its availability of credit decline – since there are now fewer assets available to support the credit facility – but normally any reduction in the credit facility would be more than offset by the increased liquidity provided by the securitization programme.

Reduce Financial Risk

Securitization of receivables can also help companies to reduce the level of financial risk in their businesses. This is accomplished by diversifying liquidity sources, adopting different and simpler covenant packages, and achieving reduced funding price volatility.

When a company securitizes receivables, it diversifies its liquidity sources beyond the traditional debt and equity sources. And by having multiple sources of liquidity, a company reduces the likelihood of losing its liquidity based on a single credit event. For companies that rely primarily on bank funding, simple violation of a covenant, or a credit committee’s decision to reduce exposure in a particular industry sector, can create a significant liquidity crisis. Companies that have a diversified source of liquidity will be less at risk.

Further, securitization programs generally have simpler covenant packages than are typically found in credit agreements. Credit facilities typically impose significant requirements and restrictions on companies’ financial and business operations. By contrast, securitization programs tend to focus more so on the performance of the securitized assets and less on the corporate performance.

Lastly, companies that securitize will reduce financial risk by reducing the price volatility of their ongoing funding. Credit spreads, particularly for non-investment grade companies, can fluctuate widely throughout the economic cycle. Over the last 18 months for example, we have seen spreads for single-B and double-B companies move by 100 to 150 basis points. By contrast, spreads on securitization programs tend to be much more consistent, fluctuating by only a few basis points. Therefore, companies that use securitization funding are exposed to much less pricing volatility and therefore have very little financial risk relating to re-pricing of liquidity.

Most large corporations and financial institutions have been securitizing for years; smaller corporations are now increasingly employing it.As outlined earlier, securitization is a funding method that has existed for over 20 years and is widely accepted in the global financial community. Historically, though, practicalities relating to implementation costs, rating agency requirements, and investment banking practices have limited its use to financial institutions and large corporations.

In recent years, however, there has been an increased level of securitization funding being employed by smaller companies. Now, companies with more modest portfolio sizes and lower credit ratings are able to access securitization funding. Where previously one would require a portfolio size in excess of $100 m, transaction sizes can now be as low as $20 m. Where previously it was a prerequisite for companies to maintain an investment grade credit rating in order to securitize, they can now access securitization funding as a non-investment grade or even unrated company.

The implication for treasurers, particularly those that operate in the vast mid market space, is that there are now more options available to them when looking at liquidity sources.

Securitization, which is employed by most blue chip corporations, represents a true alternative to traditional debt and equity. It is clearly not equity, and it is also not debt. It can provide its own distinct benefits and, as we are increasingly seeing, both large and mid-cap companies are employing securitization as part of their capital structure.

¹Actually, the return on capital can increase even if the cost of securitization exceeds cost of capital, as long as the percentage reduction in capital exceeds any percentage decline in absolute return.

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