Asset Financing for Competitive Advantage

by Patrick Sherrington, Director for Corporate Asset Finance, Lloyds TSB Corporate Markets

Read through the financial pages of any newspaper and you will be hard pushed to find much in the way of good news. In the UK, one of the countries hit hardest by the economic downturn, the economy contracted by 1.5% during the last quarter of 2008, following a slide of 0.6% during the previous quarter. Many companies are struggling to maintain liquidity in an environment where credit may be harder to obtain and certainly more expensive, while revenues may be less predictable than in recent years. The immediate temptation by a business may be to freeze their budgets and cut costs, but those best placed to survive the recession and possibly emerge more competitive are those that take a longer-term approach to their investment programmes.

...those best placed to survive the recession and possibly emerge more competitive are those that take a longer-term approach to their investment programmes.

Investment in Competitiveness

While managing the cost structure is, of course, vital for any business, successful companies will be those who recognise where cost savings can be made without inhibiting the business, and understand the need to invest in the short term to create efficiencies in the longer term. In particular, abandoning or postponing capital investment projects in favour of creating short term cash reserves is likely to be detrimental to the company’s long term future where such projects have the potential to reduce production costs, improve productivity, increase quality at lower cost or create other competitive advantages. Over the past few years, there has been enough business to go around, but firms are now fighting for fewer consumer dollars. Ensuring the company is as competitive as possible is not about cutting short term costs but positioning the company so that it has a stable cost base in the long term and can take advantage of commercial opportunities as they arise. While the current economic crisis is global in its scope, this does not necessarily mean recession for countries in Asia and South America, for example. Rather, these regions are seeing the meteoric growth that they have experienced in recent years slowing. Consequently, unless companies in other parts of the world position themselves now, they will no longer be competitive once economic fortunes turn compared to firms in these regions.

It is understandable, however, that in a climate where funding is difficult to obtain and expensive, it would appear foolhardy to consider large-scale capital investment projects which utilise surplus cash and require funding. However, treasurers recognise the need to invest in the company’s future, and will consider alternative funding mechanisms to traditional financing such as bond issuance or drawdowns under revolving credit facilities. Some cash can be unlocked from the working capital cycle by improving the efficiency of the financial supply chain. However, while this approach is very helpful in creating day-to-day liquidity and reducing the need for short term financing, it is usually insufficient to release the large amounts of cash required for financing even modest capital projects.

Benefits of Alternative Financing

Alternative financing, such as asset-based financing and leasing, has been less attractive to larger companies (particularly highly rated firms) than other means of financing over the past few years. There are a variety of reasons for this. For example, leasing has historically been driven by tax considerations and often involved complex and time-consuming documentation. In contrast, bond issuance or facility drawdowns have been relatively easy and convenient, with the ability to secure long maturities. This is no longer the case, and large bullet repayment risks may not be desirable, leading treasurers to rethink their various sources of funds. [[[PAGE]]]

With tax legislation in the UK having changed, long funding leases have become increasingly attractive as a funding product for capital projects and capital expenditure. Leasing structures are now far more transparent and the documentation is often as simple as more traditional forms of financing. Furthermore, leasing or asset-based financing brings specific advantages for financing capital projects. Firstly, these structures are designed for this purpose, and as they have a specific tangible asset as collateral, they are less likely to impact existing covenants limits. Different types of lease or asset-based financing can be structured very specifically according to the project. For example, while the treasurer may have relied upon their ability to draw down periodically under a credit facility to finance different stages of a project, there is now a greater risk that such financing may be available only at a prohibitive cost or the facility may be required for short term liquidity purposes. Instead, using an asset-based approach, cash can be accessed and matched with project payments at the relevant points in the project in parallel with the asset gaining in value. For some types of asset, residual value-based leasing may be appropriate. This approach reduces the amount of financing required, as the residual value is taken into account in the lease profile. At maturity, there is the option to pass the asset back to the lessor, reducing the overall risk of the transaction.

Appropriate Projects

A wide range of assets could be appropriate as funding collateral, making asset-based financing an attractive opportunity for many industries. Manufacturing is an obvious one, but others could include any industry with a production line, such as vehicles or food, transport, and companies with large-scale distribution or packaging requirements, such as retailers. Many of the projects which are suitable for asset financing have the potential to cut long-term costs and raise the company’s profile, which is positive for both customers and shareholders, as the boxed example on the previous page illustrates.

It is also in a bank’s interests to support this type of project. It actively contributes to the company’s competitive position and reduces the cost base in the long term without compromising the firm’s production capability.

Banks such as Lloyds TSB are also keen to support projects which deliver social and environmental as well as commercial benefits. In our view, such projects will become increasingly important in the next few years as companies embed both environmental and financial concerns into their strategic decision-making.

Banking Relationships

To successfully finance capital projects using asset financing or leasing requires a close relationship between corporate and bank. “Relationship banking” has been used as a term for many years but it has rarely meant more than “banking”. Very often, the relationship is on a purely transactional footing, in which corporates simply purchase services from the bank. In an asset financing model, bank and corporate are close business partners and need to work closely together from the project’s inception. Both sides can then ensure that the project achieves its objectives and that it is financed in the most appropriate way possible.

Conclusion

Asset financing can be an important complement to a corporate’s relationship with a bank, supplementing other forms of financing such as credit facilities. By using alternative forms of financing, existing covenants are less likely to be affected and greater facility headroom is created, which can then be used for short term liquidity as necessary. Capital projects which create long term cost savings and efficiencies, particularly those which have additional social or environmental benefits, are well-suited to asset financing. For these projects to be successful, companies need to work closely with a trusted bank in a long term, mutually beneficial relationship.