9 August 2010, Financial Advisor

Before becoming a hedge fund manager, Roni Dersovitz was a lawyer who knew first-hand the cash flow challenges confronting attorneys who work on contingency. With legal settlements being fairly iron clad, he decided to jump occupational aisles and set up shop providing short-term loans to lawyers against fees assured through settlements.

Since establishing his specialised asset-based lending fund – RD Legal Capital – in October 2007, he has never had a down month. Investors, who receive cumulative preferred notes, earn a fixed 13.5 per cent a year. As the fund’s sole principal, Mr Dersovitz is left with annualised profits of 1.5 per cent of the total assets – $77m (£48.5m, €58.5m) at the end of May.

Mr Dersovitz’s fund characterises the appeal of asset-based lending. While ABL managers are concerned how a business makes money, its risks, past performance and prospects, they are more focused on the value of a particular asset against which they are lending. By doing this, the odds of getting repaid if a business fails increase.

ABLs lend against a wide variety of assets: real estate, accounts receivables, inventory, film distribution rights, and life assurance policies – about 30 different such categories in all.

While the practice of lending against assets is as old as the hills, as a hedge fund strategy, it dates back only 20 years. It took off after the 2000-2002 market meltdown as institutional managers scurried for investments that were simple to understand, transparent, and a more effective cap on downside risk. ABLs were not going to make anyone rich. But the idea of consistent returns of 8-12 per cent a year sounded very appealing after portfolios crashed in the tech wreck.

According to data tracker HedgeFund.net, ABL funds returned 12.7 per cent in 2007 (before the recent crisis). Performance dropped off the following year to 5.3 per cent before picking up in 2009 to 6.2 per cent. But this was significantly affected by survivor bias, which bolstered returns and belied the story that was evolving.

The shutdown of the credit market made it difficult for borrowers to refinance after their loans matured. The cushion of high asset-to-loan ratios collapsed, hitting ABL balance sheets. And unprecedented levels of investor withdrawals forced many funds to gate or suspend their funds to avoid fireselling assets.

While it does not track the entire ABL universe, HFN reported 92 funds in its index at the end of 2008, three shy of the peak reached two quarters earlier. Yet, by the end of 2009, the number was almost cut in half, with only 51 funds reporting as funds closed or simply chose to stop reporting because of poor performance.

Jonathan Kanterman, managing director at New York-based Stillwater, which had run as much as $1bn in several ABL funds and funds of funds, observed that “more than 150 asset-backed lending funds that had three-year track records or more, with at least $100m, are winding down or reorganising into new funds”.

His firm’s flagship Stillwater Asset-Backed Offshore Fund, which had more than $300m, had enjoyed five-year annualised returns of approximately 7 per cent until the end of August 2009. Like many ABL funds, Stillwater’s strategy comprised loans, of less than 12 months, to importers, exporters and energy remarketers looking for temporary loans against receivables; and mediumterm loans of between 12-36 months to law, real estate, and life assurance groups against pending settlements, property, and policies, respectively.

Paradoxically, it was not realised losses that disrupted Stillwater and many other ABL funds, but rather when banks suddenly pulled their leverage facilities from funds of funds that had been investing in Stillwater. While this improved bank liquidity at the likes of Belgium KBC and French BNP Paribas, it had a disastrous effect on the ABL industry. It revealed liquidity risks when assets and liabilities are mismatched.

Funds of funds were suddenly forced to redeem from underlying funds, and there was not enough liquidity or new money coming in to offset unprecedented outflows. Investments from funds of funds sharply declined. In October 2008, 25 ABL FoFs with more than $4.3bn in assets were reporting to HFN; as of the first quarter 2010, the number fell to five with less than $92m in assets.

To meet redemptions, ABL funds initially sold off the most liquid, desirable assets. But that failed to raise enough capital. So to protect investor equity and asset values, most ABL funds gated or suspended redemptions. “ABL funds are structured along loans of various maturities that even in a stable economic environment can’t be quickly unwound, especially when involving longer- term assets such as real estate,” says Mr Kanterman.

For many ABL managers, the financial crisis and the subsequent fall in asset valuations prompted a shift in strategy away from pure lending toward greater ownership of assets.

David Shiff, manager of Perella Weinberg’s $362m Asset-Based Value Fund, realised early on that with valuations falling drastically, the fund could be better off owning assets. Assets in his portfolio include aircraft, railroad cars, and barges; trucks and containers; and office and restaurant equipment.

As the financial crisis deepened, Mr Schiff found greater opportunity in buying secondary loans at deep discounts from distressed owners, such as from banks in receivership, instead of originating new loans. The fund was up by more than 50 per cent in 2009 and 5.2 per cent through the first five months of 2010.
But some small, wellfocused ABLs have not needed to morph into equity owners.

Since starting up in the autumn of 2003 as a shortterm lender of first mortgage bridge loans for commercial and multi-residential properties, the W Financial Fund has produced annualised returns of 10.4 per cent to June. The $43m fund has never foreclosed on any loans and has not suffered a single down month. According to principal Gregg Winter, the fund’s success is based on lending against assets of improving value supported by quality of location, sponsorship, and low acquisition costs.

The $33m Savile Opportunity Fund has also continued to find lending opportunities. It provides shortterm trade financing to Latin American companies with annual sales of no more than $50m, lending against accounts receivable where there is no other secured lender at annualised rates of 14-18 per cent. Manager Pablo Marino hedges foreign exchange risk and his spread is about 900 basis points over his own financing costs.
More recently, Mr Marino has looked closer to home. “Though we originally sought to support international trade, we now see even greater opportunity in lending to solid small business here in the states, as local banks fail to boost lending.” Two-thirds of his loans are now strictly domestic.

Since inception in October 2006, the fund’s net annualised return has been 11.8 per cent through June, with only four losing months. So successful is Savile that Mr Marino says he could easily raise twice the capital.
But like many niche asset-based lenders, Mr Marino says greater size is not necessarily better. He limits asset growth knowing that when financials start to lend and invest again, his margins and capacity to find suitable borrowers may become more challenged.