What is Collateral Transfer?
The ‘Lease’ or ‘Leasing’ of Bank Guarantees are undertaken through Collateral Transfer facilities, sometimes called ‘Collateral Provision’.
Collateral Transfer is the provision of assets from one party (the Provider) to the other party (the Beneficiary or Recipient), often in the form of a Bank Guarantee or Standby Letter of Credit. Whereas the Provider agrees (through his issuing bank) to issue a demand guarantee (the ‘medium’) to the Beneficiary in return for a ‘rental’ or ‘return’ known as the “Contract Fee”. The parties agree to enter into a Collateral Transfer Agreement (CTA) which governs the issuance of the Collateral or Guarantee.
‘Leasing a Bank Guarantee’ or ‘SBLC’ is a common phrase associated with Collateral Transfer. Since it is not possible to physically ‘lease’ a bank guarantee, we use the term loosely as its structure resembles that of a commercial lease. However, these arrangements should be correctly referred to as ‘Collateral Transfer Facilities’ as effectively no leasing takes place. A Bank Guarantee is issued specifically for the purpose to the Beneficiary and each contract is bespoke. A Bank Guarantee cannot be transferable, purchased or sold. A Collateral Transfer facility is the Provider using his own assets to raise a specific Bank Guarantee through his issuing bank for the sole use of the specified Beneficiary, for the specified term. It is effectively a form of Securities Lending and often a derivative of re-hypothecation. There is no reference to ‘leasing’ when receiving a Bank Guarantee in this fashion.
The Guarantee is issued by the issuing bank of the Provider to the Beneficiary’s account at the Beneficiary bank and is transmitted inter-bank via the appropriate SWIFT platform (MT760 in the case of Guarantees). During the term of the Guarantee, the Beneficiary may utilise it for their own purposes which may include; security for loans, credit lines or for trading purposes. At the end of the term, the Beneficiary agrees to extinguish any encumbrance against the Guarantee and allow it to lapse (or return it) prior to expiry and indemnify the Provider against any loss incurred by default of loans secured upon it.
A Provider will often be a collateral management firm, a hedge fund or private equity company. Effectively, the Guarantee is ‘leased’ to the Beneficiary as a form of investment since the Provider receives a return on his commitment, hence the misnomer of the term ‘leasing’.
Over recent years, these facilities have become more popular since they enable the Beneficiary to have access to substantial credit facilities by using the Guarantee as loan security. Since the Guarantee is effectively imported to the account of the Beneficiary, the underwriting criteria is considerably less than that of conventional lending.
Guarantees received in this way are in no way different from any other form of demand Guarantee. The fact that there is an underlying agreement (the Collateral Transfer Agreement) has no bearing on the wording or construction of the Guarantee. This allows the Beneficiary to use the Guarantee to raise credit, to guarantee credit lines and loans or to enter trade positions or buy/sell contracts.
More competitive pricing by Collateral Providers have also made it available to a growing number of smaller sized enterprises seeking urgent capital for a wide range of reasons.
What or Who is a ‘Provider’?
A Provider is the party who enters the Collateral Transfer Contract (or the Collateral Transfer Agreement, “CTA”) with the Principal or Recipient. A Provider will typically be a private equity firm, a hedge fund or wealth manager or indeed a family office, managing funds on behalf of their clients or investors.
The Provider will place their funds (the underlying funds) with the Issuing Bank who will ultimately issue the Collateral in the appropriate medium, often a Bank Guarantee.
The Provider may use their own funds but it is more common that Providers represent their investors who will invest funds with them in order to enter Collateral Transfer commitments.
Sometimes, Providers may utilise Private Label Funds or White Label Funds in which to make their commitments. Involving up to 7 single investors at a time to create the Commitment Fund (the underlying asset) to which the commitment medium is raised against and issued to the Recipient.
Although the Recipient may see a single commitment with a Provider for up to a total amount of €100 million, behind the scenes this could represent up to 7 investors’ contributions. The Provider of course taking liability to provide a return to each investor and therefore sharing the Contract Fees between the investors
What are the benefits of the Provider investing in this way?
When a private equity firm or other types of funding institutions make an investment into companies on an international platform, several laws come into play. If an equity company made an investment (or indeed a loan) into a company outside of their own jurisdiction (i.e. they physically lent funds in a different country), they may need Government permissions, licenses and other forms of financial authority registrations in that jurisdiction in order to make such investment or lending commitment. In addition and in the event of a default, they would be expected to enter that offshore jurisdiction to recover their losses. Several different laws may therefore apply. If the equity firm did not have representation in that country or had no specific location knowledge, they would find it difficult and therefore of higher risk.
In order to keep things simple, the equity firm will set-aside the funds in their own jurisdiction and retain them at their own bank. Requesting their bank to issue a collateral medium often in the form of a Letter of Guarantee (Bank Guarantee) to the borrower or recipient, using their funds as the underlying security or asset. Therefore, they use the Banks international network whereby the bank will have representation in that jurisdiction (a correspondent bank for example).
The receiving bank of the Letter of Guarantee can then extend the borrower or recipient the credit or loans required under the laws of their own jurisdiction.
By employing these techniques, the equity firm would mitigate risk as the recipient bank would also take responsibility for the recovery of losses. This means that the equity firm would not need to enter that jurisdiction to recover losses. This makes the financial model of Collateral Transfer very appealing to equity firms and lenders alike.
Why is it called ‘Leasing’?
The word ‘leasing’ in this respect is a misnomer and should be avoided.
Leasing Bank Guarantee’s (BG) or Leasing Standby Letters of Credit (SBLC’s) are common phrases associated with Collateral Transfer. However, leasing is not really the correct term to use as it is not possible to actually lease a bank guarantee in this manner.
Hence it is a misnomer. We use the term loosely as its process is almost exactly that of commercial leasing. In effect, the Provider offers temporary ownership of his assets to the Beneficiary in return for a fee and at the end of the term the assets revert back to the ownership of the Provider. The assets are used to raise specific and non-transferable bank indemnities which the Beneficiary may utilise.
It is a misnomer as in effect no leasing takes place. Through a Collateral Transfer Agreement, a Provider will agree to place his assets with a facilitating bank. The bank will charge the asset and will raise a bank indemnity against it in favour of the Beneficiary. This bank indemnity will commonly be in the form of a Bank Guarantee issued specifically for the purpose to the Beneficiary.
These Collateral Transfer (or C/T) facilities are useful for when a business needs to import or create security (collateral) to underpin credit lines or loans, otherwise referred to as monetization.
What is the collateral transfer ‘medium’?
The ‘medium’ refers to the actual instrument used to convey the commitment to the Recipient of the Collateral Transfer facility. Since the collateral is remitted bank-to-bank, it is remitted in the form of a bank commitment, often in the form of a Letter of Guarantee (Bank Guarantee,’BG’) and sometimes, although not as common, in the form a Standby Letter of Credit (SBLC).
In what form is the Collateral injected ?
Collateral Transfer facilities are wrongly referred to as ‘leasing’ as this document explains. However, the injection of capital or collateral is made by the Provider to the Recipient via the Issuing Bank and the Recipient Bank. There is never any mention of the word ‘lease’ or ‘rent’.
Bank Instruments (Letters of Guarantee-Bank Guarantees and Standby Letters of Credit-SBLC’s) sent in this way are standard bank instruments. There is no difference between an instrument remitted under a Collateral Transfer facility and an instrument issued in a more conventional manner. Any person that tells you otherwise is simply wrong.
Officially, the bank instrument (the medium) is remitted to the Recipient Bank for the benefit of the Recipient as a form of “investment” from the Provider.
This investment is evidenced by the Collateral Offering Contract and the Collateral Transfer Agreement. It should be treated in the same way as if the Provider was investing physical cash.
Bank to Bank Platform
As Collateral Transfer facilities are founded on the injection of a inter-bank financial instrument (Bank Guarantee or SBLC) from the Provider’s bank to the Recipient’s bank, the transaction relies on both banks talking to each other, i.e. The bank of the Provider issuing the facility (the Issuing Bank) and the bank of the Recipient receiving the facility (the Recipient Bank). It is therefore important to first set these communications between the banks as the stage of performance of the transaction. Without the two banks’ involvement, the transaction is not possible.
Since the parties (the Provider and the Recipient) cannot enter into contract with each other whereby such contract commits the Issuing Bank and the Recipient Bank to undertake matters on behalf of their customers (the parties) since the two banks are not party to this contract, it is necessary for the parties to first enter into an offering contract (or pre-contract). This is generally done by the Provider issuing to the Recipient an Offering Contract, rather like a mortgage offer that a bank may offer its customers.
This Offering Contract sets the parameters of the transaction. Once this contract is entered into, the Provider will instruct their Issuing Bank to first advise the Recipient Bank by what we call a ‘pre-advice’. This is done through the inter-bank communication system called SWIFT.
The Issuing Bank will send a SWIFT message to the Recipient Bank stating that their customer (the Provider) is about to enter into contract with their customer (the Recipient) and will be sending a Letter of Guarantee (or SBLC), the ‘collateral medium’. The wording or draft of this instrument will also be enclosed. The Issuing Bank will request within this pre-advice communication the Recipient Bank’s to confirm their readiness and willingness to receive such financial instrument on their clients behalf. Only when this communication line has been established will the two parties be able to enter into contract for the remittance of the collateral and therefore the closure of the Collateral Transfer provision. At this point the Collateral Transfer Agreement is signed and the medium is remitted. The Collateral Transfer Agreement is an identical agreement (in respect to the terms) to the Offering Contract or Collateral Transfer Offering.
The remittance of such intention or ‘pre-advice’ involves the Provider committing the funds to the Issuing Bank and the funds will often be ‘locked’ by the Issuing Bank prior to sending this pre-advice communication. Therefore, the Provider may seek some form of commitment from the Recipient as to lock them in to receive the facility and prevent them from backing-out. These communications are also often irrevocable and represent a binding commitment between the parties.
How does it work?
Collateral Transfer is where a Provider agrees to utilise his assets to the benefit of a third party, namely the Beneficiary (or Principal). This is done through a Collateral Transfer Agreement and involves the ‘transfer’ of the original asset (the ‘collateral’) into a new security that the Beneficiary can utilise. Hence the term “Collateral Transfer”.
This is done by the Provider of the original or underlying asset pledging the asset to the facility bank (the Issuing Bank) in order that the Provider can instruct the remittance of a Bank Guarantee to the Beneficiary and his Recipient Bank. The Bank Guarantee that results can be used in any way by the Beneficiary. The underlying asset pledged to the Issuing Bank may be cash, bonds, stocks, gold or other assets (or often a combination of many) and is provided by the “Provider”.
The Provider will be a private equity or investment group or a collateral management company making investments on behalf of its clients. A Provider will often receive the assets through private label funds set up for the purpose, or from hedge funds, pension funds or high net worth individuals and family offices.
Provider’s are able to offer its investors good returns on non-liquid assets by offering Collateral Transfer facilities. This makes good opportunity to investors that wish to seek additional returns by placing their assets with the Provider. The Provider then in-turn seeks suitable clients (beneficiaries) to receive Collateral Transfer facilities. The Contract Fees paid to the Provider by the Beneficiary for the use of the bank guarantee are then divided amongst the investors (the owners) of the original underlying asset as a return. A portion of course retained by the Provider as their management fee. This allows investors to obtain good annual returns on assets they would otherwise not be able to invest. For example, valuable artworks, real estates, stagnant capital, etc.
The Provider will use his bank relationship to pledge these assets to the Issuing Bank and have them issue a Bank Guarantee to the Beneficiary for a given term (usually 12 months renewable terms). The Beneficiary will pay to the Provider a Contract Fee for the use of the Bank Guarantee over the term.
The facility is governed by a Collateral Transfer Agreement (commonly referred to as a CTA). Each CTA is bespoke to the specific transaction. This Agreement binds the Provider to issue the Guarantee to the Beneficiary for the given term and binds the Beneficiary to accept the Guarantee and to pay the Contract Fee to the Provider for its use. It is of course known to all parties that the Beneficiary will use the Bank Guarantee to raise credit and will therefore encumber the Bank Guarantee (i.e the lending bank will lien it as security). This is referred to as ‘monetisation’ of the Guarantee. Whist this is of course acceptable to the Provider, the Beneficiary will need to make a declaration that they adhere to remove any encumbrance over the Guarantee 5 days prior to the Bank Guarantee expiry date. Therefore the Beneficiary must make his own arrangements with his bank (or the bank lending the credit against the bank guarantee) to repay any loans secured on it. Otherwise the Beneficiary will be in breach of the CTA. This is referred to as the ‘exit strategy’, i.e. how the Beneficiary will exit the contract and repay the debt secured on the Guarantee.
Commonly, the Beneficiary will refinance with the lending bank to remove any encumbrance over the guarantee at expiry, or choose to renew the CTA for a further 12 month period. If the Beneficiary fails to repay any loans secured on the Guarantee at expiry, the lending bank will call it and the Provider will lose his pledged assets. In these cases, the Provider will take recourse of debt recovery against the Beneficiary. It is therefore required that the Beneficiary is reputable and financially sound and that is why there is the initial due diligence and acceptance period before we are able to offer Terms. Only when the Beneficiary is accepted are Terms offered.
Therefore, to exit the contract successfully, the Beneficiary will utilise loan funds raised on the Guarantee for commercial purposes. Rather like a bridge loan, the Beneficiary will need to receive his investment or liquidate his project prior to the expiry of the Guarantee, allowing him to clear and remove any encumbrance over it.
It is common to find that a Beneficiary will use Collateral Transfer facilities to either participate in trade positions where his returns are received prior to expiry of the bank guarantee, or for property development projects where liquidation or refinance of the bricks and mortar once construction is complete will serve as his exit strategy. This fairs well with these types of facilities and are preferred by Providers.
Raising Credit Lines and Loans Against ‘leased’ collaterals
9 times out of 10 clients that apply to receive a Bank Guarantee or Standby Letter of Credit through Collateral Transfer are doing so with the intention of raising credit or loans. It may be the case that they do not have sufficient existing security to allow them to borrow funds from their own bank or it may be that they have simply extended their credit too far.
As the collateral injected under Collateral Transfer facilities is worded to support credit facilities, it is possible to use it to secure credit lines and loans, either directly from the Recipient Bank holding the collateral or another third-party lender.
It has been known that some Recipient banks may refrain from extending credit to their customer regardless of the strength of the security that this collateral represents. This is often due to the borrower being newly formed with little or no credit record. It should not be assumed that just because the borrower is the proud owner of a bank guarantee that his bankers will extend credit against it. To the contrary, lending banks will still impose their rigid lending criteria.
In these events, IntaCapital are happy to offer credit line facilities which we can arrange for our clients. Please enquire with us and we will be happy to provide full details.
A word about exit strategy?
Collateral Transfer facilities provide an excellent model for short to mid-term financing and capital raising solutions. However, they are not the be-all and end-all solution to longer term business or project finance.
Collateral Transfer facilities are not suitable for long-term financing needs, i.e. 7 years or more.
It is important that the business principal match-funds his enterprise. That means that you match short-term assets with short-term finance and long-term assets with long-term finance or mortgage. If the principal is seeking to utilise Collateral Transfer facilities to import into his enterprise to enable them to raise fast and efficient project capital, example; A real estate development or to finance a long-term or permanent company project, it is important to plan ahead and focus on the exit strategy. By this we mean the migration from using the funds raised short or mid-term (up to 7 years) under the Collateral Transfer facility, to funds borrowed for the longer term. Unless of course the plan is to sell off the project once completed as this would of course provide the means to repay any credit secured on the Collateral, allowing the Collateral Transfer facility to expire well within term.
Therefore, attention should be paid to exit strategy from the very beginning. It is important that when applying for these facilities that any collateral (Bank Guarantee or SBLC) is unencumbered prior to expiry. For this, you will need to demonstrate that you have the ability to repay any liens or loans secured against the collateral prior to the collateral expiration. Of course Collateral Transfer facilities can be renewed year on year but many providers will not extend beyond 5 or 7 times, meaning a maximum of 7 year terms are available.
In the case of real estate development for example; The Principal may choose to utilise Collateral Transfer and credit secured thereon as a means to raise the capital to commence the project. Then, when the project is complete, to re-finance with conventional longer-term finance solutions such as mortgages or conventional asset loans if the asset is to be retained. Alternatively, sell the development. This too provides suitable exit strategy.
It is our advice never to enter into a Collateral Transfer facility without first planning ahead with your exit strategy. Collateral Transfer does not purport to be cheap. However, it is an ideal tool to utilise in seed or start-up projects if a long-term solution is implemented at the back-end.
What about the rates/costs?
Collateral Transfer facilities provide an ideal solution to many circumstances. However, it is important to note that these facilities are not cheap and may not suit the smaller budget.
These facilities can be provided at rates (Contract Fees) of around 6% to 8% per annum. Sometimes rising to 12% or 14% by some Providers.
It should also be noted that if the Principal intends to use the collateral to raise credit lines or loans, that they will also incur credit line interest on the monies borrowed against this collateral. This can vary, depending on the jurisdiction, the bank or the credit record of the borrower. However, typically IntaCapital can arrange credit for around 4.50% per annum, fixed for the term of 12 months.
This means that total costs can often exceed 11% per annum. Before applying for these facilities, it is important that you ascertain that your project can indeed sustain and support these costs.
Leveraging Raised Funds
Of course, once the Principal has successfully received their collateral and have negotiated a credit line against it, they are now in possession of short to mid-term business capital. Some would say mission accomplished. However, at this juncture it is also important to plan ahead and ensure that the exit strategies chosen by the Principal are always kept in-mind and worked towards.
A good tip is to start to implement and assist the exit strategy from the very beginning and from the point of when the Principal actually receives the credit or loan.
If the Principal intends to refinance their project as the exit strategy, they may consider leveraging the credit funds raised against the collateral. For example; If the Principal is purchasing real estate for development, they may choose to use a portion of the raised funds to place as a deposit. Then, utilise conventional finance (i.e. secured loans or mortgages) to raise the balance. As there will be no encumbrances taken by either the Provider or the Lender over the assets that you purchase – The only security for raising the funds will be the collateral itself – it is possible to use pledge the purchased assets and therefore leverage considerably.
How does renewal work and what are the renewal rates / costs?
Collateral Transfer facilities are issued for 12 month periods and multiples thereof. However, most facilities are offered initially as 12 month contracts with an option to renew for a further 12 months (year on year), up to a maximum of 60 or 72 months.
The initial contract will be issued with a fixed Contract Fee, typically between 6% to 8%. At renewal, the collateral (Bank Guarantee or SBLC) will expire in the usual way and a new annual collateral will be issued for the re-calculated Contract Fee which is payable yearly in advance, i.e. immediately upon receipt of the new collateral. The calculation equation will be stated in the initial contract so there are no surprises. Typically, the Contract Fee for the second and subsequent years will be calculated as a percentage (typically between 5.50% and 7.50%) above 12 month LIBOR or EURIBOR.
This means that as LIBOR and EURIBOR (12 month rates) do fluctuate a little, so the Contract Fee can of course change year on year. However, both of these rates have been extremely stable for the last several years but ultimately the risk of increasing rates will be burdened by the Recipient and not the Provider.
As both 12 month EURIBOR and LIBOR rates are very low at this time, Collateral Transfer facilities have been in great demand. We would expect that the demand for such facilities may fall off a little if these rates were to increase, due to the sheer fact that these facilities are not a cheap alternative to conventional finance, but moreover an accessible, convenient and fast solution.
Why are the terms set annually?
Collateral Transfer facilities you will often find are offered in terms of 12 to 72 months, working on a renewable 12 month contract.
Due to the providers contracts with their investors being annual contracts producing an annual return, they are set as annual contracts often linked to 12month LIBOR or EURIBOR rates.
As the Provider will enter into contract with several senior level investors for a fixed annual return, the Collateral Transfer (Contract Fee) will be set accordingly. Depicted as a fixed fee in the first year, often between 6% and 14% (depending on the provider). In the second year or upon renewal, it will be linked to either LIBOR or EURIBOR depending on the currency.
For this reason, one may find it difficult to receive a Collateral Transfer facility for other fixed periods of time, i.e. 18 months.