Boring but lucrative

Asset-backed finance has had a huge impact on the buyout market in recent years. Deal Mechanic examines how it works.

Asset-backed finance is a highly efficient method of leveraging specific assets or businesses to raise debt capital at comparatively low cost. It cannot be applied to all businesses or types of asset. But as a growing number of deal sponsors have discovered, if the situation is right, it genuinely is something of a holy grail for corporate financiers, and it seems a safe bet that it is going to feature in a growing proportion of transactions going forward.

Securitisation is a financing tool that has been around for some time, having originated in the US and the mortgage-backed securities market. In essence it works by separating a specific pool of assets from a business and financing them independently. In order for this to be attractive to investors, the assets must possess certain characteristics. In a nutshell, they must be boring. In the first instance, their cash generative ability must be stable and easily predictable. The more this is the case, the less associated credit risk there is. If the risk is reduced, the credit rating attributable to the debt raised against the assets is higher and the cost of finance lower. The effect is accentuated further if the assets can be transferred to a separate company which is incorporated solely for the purpose of using them as collateral and over which the management of the original business have reduced, or very little, direct control. Finally, giving investors direct recourse to the assets in the event things go wrong, by providing security over them, tightens the package even more.

From the second half of the 1980s on, the use of securitisation techniques were pioneered primarily by mortgage and commercial banks as a way of diversifying their funding and spread rapidly across Europe. Latterly, the corporate sector has also begun to exploit its potential, and ways of securitising pools of trade receivables, property portfolios, and even whole businesses or corporate divisions have been found.

One of the earlier examples of the power of asset-backed financing tool is the acquisition of a portfolio of pubs by Nomura's by now legendary Principal Finance Group from Inntrepreneur in 1998. The portfolio was split into two, and 2,600 pubs (or sixty per cent of the estate) formed Unique Pub Company, which was set up to manage the core estate. The comparatively stable cash flows generated by Unique – pubs or bars are typically small local businesses with a loyal clientele – were securitised, raising £810m of debt equivalent to 9.5x EBITDA, with a weighted average life of around 13.5 years, at a cost significantly below that available in the leveraged finance market. This is ?efficient? by anyone's standards and attractive to all parties involved (Nomura have recently exited their investment and the business is about to be refinanced with another asset-backed deal).

A more recent and slightly larger example was the acquisition of the General Healthcare Group by BC Partners, backed by Morgan Stanley, from Cinven in September 2000. The purchase price was £1.29bn. In July 2001, an initial bridge loan was replaced by £975m of asset-backed bonds ? a so-called ?whole business? securitisation. In effect, the view was taken that the entire operations of the group, and the sector in which it operates (private acute hospitals), were sufficiently stable for the business to be financed in this way. The amount raised was equivalent to over 75 per cent of the purchase price and represented 6.4x EBITDA. The average maturity of the bonds issued exceeds 22 years and the current effective margin over LIBOR paid is around 140bps (although this does exclude the annual fee payable to the insurer supporting the rating of some of the bonds, which is likely to add at least a further 50bps). Yet another powerful example of the possibilities offered by this technique, and an illustration of how being boring can sometimes prove very lucrative indeed.