I was reminded of the importance structured finance holds in modern finance when I came across the news about Electronic Arts (EA) being taken private by a consortium of PIF, Affinity Partners and Silver Lake for $55BB with a huge chunk ($20BB) being provided by JPMorgan, and rather than building a fully blown out LBO model to look at the possible returns, I decided to use this fortuitous opportunity to talk about structured finance- a modern financing technique that I am chronically intrigued by- and its vitality to the overall economy of the world.
The ideal position to start a discussion of this variety would be the definition of structured finance and the typical features that collectively categorize a transaction under the umbrella of this financing technique, but there isn't an academically or universally accepted definition for structured finance. Some believe it to be a structured credit transaction which is also known as "Securitization" in which illiquid assets are pooled together to make them more liquid (think MBS, CMBS, ABS and CDOs); while others believe it to be any transaction other than the typical loan transaction; I on the other hand, believe a transaction to be a structured finance transaction if it has the following attributes:
- Nominal equity contribution:
- One of the features of structured finance is that the sponsors end up contributing a nominal amount of capital compared to the overall cost of the project.
- Ring-fenced:
- Another prominent feature of a structured finance is that it is ring-fenced which is a fancy way of saying that the lenders or providers of capital have no recourse or cannot pursue the sponsors in case of default or lapse of obligatory payments.
- Cash flow based lending:
- The third identifying feature of structured finance is that the lenders provide capital, among other things, based on the underlying assets' ability to generate cash flows.
Nowadays, structured finance is the pre-eminent avenue for raising capital when dealing with projects that involve assets that are extremely expensive, require an exorbitant amount to build, can take years to complete and can be in operations for multiple years if not decades. Structured finance is the perfunctory course of raising capital and reaching investors in industries such as PE, asset finance, project finance and securitization.
We can examine structured finance transaction from two distinct points of view: lenders and sponsors. Parties part-take in a structured transaction for various reasons, let's look at some of the reasons why sponsors prefer a structured finance transaction over a vanilla corporate transaction.
- Cash flow based lending:
- As mentioned before, if the sponsors are looking to raise capital for an asset or a project that has the potential to generate steady and healthy cash flows in the future then it might behoove them to raise capital that is backed by the cash flows of the project or the asset rather than accumulating it on their balance sheet. This comes in handy for instances when sponsors might already be over their ideal leverage in their capital structure or they might be restricted by various covenants levied against them by their existing lenders.
- Capital structure optimization:
- Debt is generally considered to be the cheaper form of debt due to the fact that it sits at a higher position on the totem pole when compared to equity but also because interest paid on debt is tax deductible and it reduces the taxes an enterprise pays, and due to this reason, most companies end up raising a lot more capital then effectively needed foolishly thinking that the benefits far outweigh the cons, but in the long-haul, being over-levered can prove as daunting and fatal as missing out on indentured obligations. Imagine a scenario: the management has come across a project or an asset, development or acquisition of which could lead to monumental growth in the future, but they are already heavily levered and therefore are either unable to raise more capital or they might be able to but at a far higher and deathly gearing then normal, what would their ideal course be? Should the management abandon the idea or should they raise capital despite threatening terms? The ideal solution would be to set up an SPV, contribute a nominal amount of capital and raise the remaining needed cash through the asset or the project's ability to generate cash flows. This ability has generally been the primary reason of financial disintermediation in the recent years where capital providers are connecting with seekers without the typical middlemen.
- Debt maturity:
- Structured finance transactions involve the development, operation or acquisition of assets and projects that cost an exorbitant amount to build, have a long operational life and could be movable assets such as planes trains and these assets tend to have decades long operational lives, as a result, debt raised under structured transactions can have maturities that could theoretically go on for 10+ years. This elongated maturity allows an ample amount of time for sponsors to develop and construct the project that they are dealing with rather than having to worry about necessary obligations and covenants.
- Tax benefits:
- Most of the structured finance transactions also allow sponsors tax benefits that they can then utilize to raise more capital. This is prevalent in renewable energy projects in the US where the sponsors, due to the high cost of development and construction, tend to have losses in the early years of the project and these losses result in tax benefits that the sponsors in return can use to raise capital colloquially referred to as tax equity. Additionally, renewable energy projects also have investment tax credits (ITC) and production tax credits (PTC) that can also extend avenues for additional capital.
- Liquidity:
- Structured finance also allows companies and sponsors to use their existing assets in operations to raise more capital. For instance, if a firm has a large amount of accounts receivables or a bank has loans outstanding (considered assets because banks are owed their capital plus interest) they can ideally pool their assets together and sell securities that are backed by the underlying assets and their potential future cash flows in a process known as "Securitization." This allows companies to raise capital without having too much impact on their own balance sheet, gives them the ability to isolate the risks and also get in touch with capital providers that are outside of the normal sphere of banks.
These are just a few of the benefits of structured finance for the sponsors but there are myriad of other reasons why sponsors would or should choose the structured finance approach rather than the corporate route. With somewhat understanding of the sponsors side, I think we are in a better position to now look at the other side of the coin: Lenders.
Not too dissimilar to the sponsors, lenders also engage in structured finance transactions for a multitude of reasons. Structured finance permits lenders, financial and institutional, to participate in transactions that they typically wouldn't be able to, i.e., engaging in private equity deals, funding the acquisition of assets such as planes, trains and containers, partake in project finance and infrastructure transactions, and last but not least, structured finance allows lenders to initiate "Securitization" transactions. Some of the reasons why lender might be interested in structured finance are as follows:
- Diversification:
- Structured finance provides capital providers with an ample amount of avenues to efficiently and effectively allocate their capital. Typical lending transaction is when a firm or an enterprise is looking to raise capital at the corporate level; this debt at the corporate level is impacted by various factors such as the company's current rating (investment or non-investment), current level of debt, current asset utilization and ability to generate cash flows, current macro conditions and lastly the investor sentiments to name a few. These factors, one way or another, limit the number of transactions that banking or institutional investors can engage in; this is where structured finance enters the picture. It allows lenders to lend capital to a diversified set of clients rather than just corporations, i.e., they can choose to lend to a certain renewable energy or an infrastructure project, they can select a transaction where they make loans in the asset finance category or they can take part in a securitization transaction and buy securities that are backed by an amalgam of assets such as MBS, CMBS, ABS, CDOs, and CLOs.
- Ability to pick and choose assets:
- Structured finance allows creditors the ability to pick and choose the assets that they would like to invest in. For instance, in a typical corporate transaction, when lenders, financial institutions or other institutional investors, invest in a company, they do not get to pick and choose how the management utilizes the capital, they are more or less the limited partners, but in a structured finance transaction, lenders can quite literally pick the assets that they would like to lend to. For instance, lenders might not be interested in investing in an IPP (independent power producer) but they will more than likely invest in a solar or wind project initiated by the same IPP that is backed by a long-term power purchase agreement.
- Risk management:
- Since structured finance transactions are not only backed by the cash flows of the underlying assets but also mortgages and liens that they can use in case the sponsors can't meet their necessary obligations this allows lending institutions to utilize a lower amount of their capital which improves their risk weighted assets (RWA).
Again, these are just a few of the benefits to the lenders, but there are plenty of others. Now to drive the point home, lets look at how this take-private transaction of EA sports is a structured finance transaction. One of the first steps that the sponsors most likely took was to set up a hold Co., and use this holding company to raise the $20BB that they got from JP Morgan. The loan that they got was more than likely backed by EA's ability to generate steady and healthy cash flows in order for sponsors and the hold co. to meet their obligations, and in case they can't, JP Morgan has no recourse to the sponsors (ring-fenced), and the most sponsors can loose is their equity contribution. JP Morgan has also, without a doubt, taken guarantees in the form of mortgages and liens belonging to EA Sports.
In conclusion, Structured finance is one of the most riveting inventions in finance, and it will only increase in its usage and deployment as time goes on. It allows certain securities and assurances to all parties involved, and this makes it an enticing avenue for both lenders and sponsors. I believe structured finance doesn't only connect lenders with capital seekers, but it also increases liquidity in the overall market, and with time, will only increase the on-going disintermediation in the financial markets.
