(The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.)
In contrast to the secured loan structure, the notes are directly backed by the inventory. Although the inventory is the property of the SPV, the latter will place the inventory on consignment with the originator. Once the originator has found a buyer it will purchase the inventory back from the SPV before selling it to the buyer (Heberlein, 2001:4). The SPV first uses the proceeds from the sale of
Inventory
Originator Liquidity facility
provider SPV Investors Secured loan Pledge of inventory Funding Security trustee Pledge of assets Inventory
Originator Liquidity facility
provider SPV Investors Purchase of inventory Transfer of inventory Funding Security trustee Pledge of inventory Guarantee Guarantee
inventory to settle its expenses and refinance its costs, and the remainder is applied to again purchase inventory from the originator so as to maintain an ongoing revolving inventory. Since the inventory itself does not generate interest, the transaction must be structured in such a way as to provide a source of cash flow to pay interest on the notes issued (Yomtov, 2002:6). This is achieved by the SPV purchasing the inventory at a discount sized to cover the cost of funding the notes. In cases where a credit rating agency is asked to rate the SPV’s ability to pay interest in a timely manner, a cash reserve or liquidity facility is required to cover the time needed to liquidate the inventory. The inventory is pledged to a security trustee who provides security to investors. Redemption of the notes at maturity is achieved by stopping the revolving purchase of inventory, and using the proceeds from the sale of inventory to redeem the notes.
In an inventory securitisation, irrespective of whether a secured loan or true sale structure is used, the funding through the issuance of notes is directly linked to the volume and composition of the inventory by a borrowing base formula. According to Yomtov (2002:1to 6), the borrowing base can be calculated as a fixed amount per unit of inventory, or a percentage of the current value of a unit of inventory. For example, if a single unit of inventory is priced at R100, then, under a fixed amount calculation, R70 of notes could be issued per inventory unit, whereas, under the fixed percentage method, the note issuance would be 70 percent of the price of an inventory unit. This borrowing base mechanism provides the overcollateralisation between the value of the inventory and the note amount issued, thereby providing the credit enhancement required by investors. There are two types of borrowing base calculations discussed below.
− Fixed Amount Borrowing Base: In terms of the fixed-amount borrowing base, the overcollateralisation is variable since the value of the inventory may vary over time, whereas the value of notes in issuance remains constant. Investors are thus exposed to a sharp decline in inventory prices. This risk can be mitigated by including performance triggers to track inventory price declines, which if breached, would lead to an adjustment of the borrowing base or an early amortisation event.
− Fixed Percentage Borrowing Base: In the case of the fixed-percentage borrowing base, the overcollateralisation remains constant, since the amount of notes in issuance is adjusted to the inventory price variation. In the case of an increase in inventory value, new notes will be issued that will rank pari passu with the existing notes. In the case of a decline in inventory values, notes will be partially repaid so as to keep the value of notes as a percentage of inventory value constant. The partial repayment of notes in such an instance will be made by the originator. Investors’ risk exposure after an early amortisation event is therefore limited to the liquidation period, which is
the time it takes to sell the inventory and repay investors. The borrowing base should take into account the potential decrease in inventory value and the amount of interest on the notes that would have to be paid over the liquidation period.
Variations in the borrowing base formula that combine both the fixed amount and fixed percentage calculations are possible. The borrowing base may be set as a fixed amount per unit of inventory at the inception of the transaction, but may be changed to a percentage of a unit of inventory if the price drops below a set floor. Alternatively, at inception the borrowing base may be a percentage of the inventory value, but capped at a fixed amount when an upper price limit is breached.
An inventory securitisation structure usually includes early amortisation events, which will be triggered by a breach of the borrowing base, a trigger indicating a decrease in the value of the inventory, or default events related to the originator (Yomtov, 2002:4). An early amortisation event stops the revolving purchase of inventory in a true sale structure, and causes the repayment of the secured loan in the secured loan structure, resulting in the liquidation of the transaction and repayment of the notes. In an early amortisation event, investors rank first in the allocation of cash flows generated by the sale of the inventory or a refinancing by the originator. During the liquidation period, which can take up to 18 months, the liquidity facility that has been made available for a specified amount and period will be used to fund the payment of interest on the notes. An early amortisation event may be cured by the originator providing a subordinated advance to the SPV (Heberlein, 2001:5).
7.10 Whole Business Securitisation
Whole business securitisation emerged in the mid-1990s in the United Kingdom with the securitisation of cash flows generated by a nursing homes company. Several transactions followed, involving assets as diverse as hotels, pubs, theme parks and airports (Pfister, 2000:1). While a standard securitisation structure isolates certain specific assets, e.g. mortgage loans, from an originator and uses the pre-contracted cash flows derived from those assets to service the debt, a whole business securitisation relies on future, and less predictable, cash flows derived from the entire business of an operating company. According to Pfister (2000:1), whole business securitisations are, from a structural perspective, midway between standard securitisations and corporate debt. Similar to secured corporate debt, the debt issued in a whole business securitisation is a direct liability of the operating company. Ownership of the assets remains with the operating company, and bondholders are only granted a charge over those assets. As with a typical bond, bondholders are exposed to the
risks consistent with the credit rating of that company. However, as in the case of a securitisation, the assets that secure the debt are isolated from the insolvency of the operating company. This is achieved by creditors’ ability in the United Kingdom, specifically, to replace the insolvent operating company by a third party who will then manage the assets solely for the benefit of the creditors.