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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Comprehensive coverage of all major structured finance transactions Structured Finance is a comprehensive introduction to non-recourse financing techniques and asset-based lending. It provides a detailed overview of leveraged buyouts, project finance, asset finance and securitisation. Through thirteen case studies and more than 500 examples of companies, the book offers an in-depth analysis of the topic. It also provides a historical perspective of these structures, revealing how and why they were initially created. Instruments within each type of transaction are examined in detail, including Credit Default Swaps and Credit Linked Notes. A presentation of the Basel Accords offers the necessary background to understand the regulatory context in which these financings operate. With this book, readers will be able to: * Delve into the main structured finance techniques to understand their components, mechanisms and how they compare * Understand how structured finance came to be, and why it continues to be successful in the modern markets * Learn the characteristics of financial instruments found in various structured transactions * Explore the global context of structured finance, including the regulatory framework under which it operates Structured Finance provides foundational knowledge and global perspective to facilitate a comprehensive understanding of this critical aspect of modern finance. It is a must-read for undergraduate and MBA students and finance professionals alike.
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Table of Contents
Cover
Title Page
Copyright
Dedication
Preface
STRUCTURED FINANCE (OR THE LIFE OF MY FRIEND DAVID)
A TYPICAL DAY IN THE LIFE OF MY FRIEND DAVID
STRUCTURED FINANCE IS EVERYWHERE
ABOUT THIS BOOK
Introduction
A BRIEF HISTORY OF STRUCTURED FINANCE
DEFINING STRUCTURED FINANCE
WHY WAS STRUCTURED FINANCE SET UP?
NOTES
PART I: Leveraged Buyout (LBO)
CHAPTER 1: What is an LBO?
1.1 THE MAIN FEATURES OF AN LBO
1.2 A THREE‐STEP LEVERAGE
NOTE
CHAPTER 2: The Different Stakeholders
2.1 THE TARGET COMPANY
2.2 BUYERS
2.3 LENDERS
NOTES
CHAPTER 3: The LBO Process
3.1 THE SALE PROCESS
3.2 EXIT STRATEGIES
3.3 LBO AND PRIVATE EQUITY
NOTES
PART II: Project Finance
CHAPTER 4: The ABC of Project Finance
4.1 DEFINITION
4.2 WHY CHOOSE A PROJECT FINANCE STRUCTURE
4.3 CONSTRAINTS OF THE PROJECT FINANCE STRUCTURE
4.4 HOW TO CHOOSE BETWEEN CORPORATE AND PROJECT FINANCING
NOTES
CHAPTER 5: The Main Parties to Project Financing
5.1 DIFFERENT TYPES OF PROJECTS
5.2. SPONSORS
5.3 LENDERS
5.4. THE ROLE OF PUBLIC AUTHORITIES
NOTES
CHAPTER 6: Project Finance Structuring
6.1 PRELIMINARY ANALYSIS OF THE PROJECT
6.2 PROJECT FINANCE LEGAL STRUCTURE
6.3 FINANCIAL STRUCTURE
NOTES
PART III: Asset Finance
CHAPTER 7: Definition of Asset Finance
7.1 THE SCOPE OF ASSET FINANCE
7.2 HOW TO FINANCE ASSETS
NOTES
CHAPTER 8: The Stakeholders
8.1 CLIENTS
8.2 LESSORS
8.3 LENDERS
NOTES
CHAPTER 9: Behind the Scenes
9.1 INSIDE A LEASING COMPANY
9.2 LEGAL CONSIDERATIONS
9.3 THE DYNAMICS OF LEASING MARKETS
NOTES
PART IV: Securitization
CHAPTER 10: The Securitization Process
10.1 TRANSFORMING ILLIQUID ASSETS INTO LIQUID SECURITIES
10.2 TRANCHING OF SECURITIES
NOTES
CHAPTER 11: The Different Stakeholders
11.1 BORROWERS
11.2 THE ORIGINATOR
11.3 AROUND THE SPV: THE TRANSACTION'S LIFE
11.4 THE INVESTORS
NOTES
CHAPTER 12: Structuring a Securitization
12.1 COMPOSITION OF THE COLLATERAL
12.2 MANAGED TRANSACTIONS
12.3 ADDITIONAL STRUCTURING CONSIDERATIONS
NOTES
Conclusion
STRUCTURED FINANCE: WHAT HAVE WE LEARNT?
A COMPARISON OF VARIOUS TYPES OF STRUCTURED FINANCE
WHAT IS THE FUTURE FOR STRUCTURED FINANCE?
APPENDIX A: How Banks Set Interest Rates
LIQUIDITY COST
COUNTERPARTY RISK
LIBOR SCANDAL
NOTE
APPENDIX B: Syndication and Club Deals
DEFINITION
FIRM UNDERWRITING
BEST EFFORTS SYNDICATION
CLUB DEAL
ARRANGERS' AND LENDERS' TITLES
THE POST‐LAUNCH LIFE OF A LOAN
NOTES
APPENDIX C: Credit Derivatives
CREDIT DEFAULT SWAPS (CDS)
CREDIT LINKED NOTES (CLNS)
Bibliography
BOOKS IN ENGLISH
BOOKS IN FRENCH
ARTICLES, PROFESSIONAL REPORTS, AND CASE STUDIES IN ENGLISH
EDITED TRANSCRIPT
ARTICLES IN FRENCH
Acknowledgments
Index
End User License Agreement
List of Tables
Introduction
TABLE I.1 Amount of Capital Required From a Bank to Fund a $100 million Loan ...
Chapter 2
TABLE 2.1 Ranking of the Largest Restaurant LBOs
TABLE 2.2 Transactions involving NFL franchises since Glazer's acquisition of...
Chapter 3
TABLE 3.1 Top 10 Private Equity Exits Announced in 2016
4
TABLE 3.2 Airbnb Funding Rounds, from Seed Money to Growth Capital (2009–2017...
TABLE 3.3 Growth Capital vs. Venture Capital
TABLE 3.4 The 15 Largest LBOs in History
TABLE 3.5 Top Five Real Estate Funds Raised During the 2005–2008 Period
TABLE 3.6 Hilton Hotels LBO Capital Structure
Chapter 4
TABLE 4.1 Key Differences between Corporate Financing and Project Financing
TABLE 4.2 Sources and Uses of Funds in French Francs
Chapter 5
TABLE 5.1 Shareholding of Heathrow Airport Holdings Limited
TABLE 5.2 Publicly Listed Funds Managed by MIRA
TABLE 5.3 List of the Main Yieldcos' IPOs
TABLE 5.4 2019 Global Project Debt League Table
TABLE 5.5 Simplified Overview of a PF Financing Structure with an ECA Cover
TABLE 5.6 Initial Project Financing of the Ichthys LNG Terminal
21
Chapter 6
TABLE 6.1 Simplified Calculation of Net Operating Cash Flow in Project Financ...
TABLE 6.2 2019 Global Project Finance Advisory League Table
TABLE 6.3 Waterfall in Project Finance
Chapter 7
TABLE 7.1 Calculation of Rentals
TABLE 7.2 Calculation of the Profitability for the Tax Investor
TABLE 7.3 The Different Financing Options
Chapter 8
TABLE 8.1 Major Bankruptcies Among US Airlines Since September 2001
TABLE 8.2 Airlines that Ceased Operations in 2019
TABLE 8.3 Financing Airlines – Risks and Opportunities
TABLE 8.4 Average Number of Days Needed by Lessors to Repossess Their Aircraf...
TABLE 8.5 Top 25 Aircraft Leasing Companies (Ranked by Number of Aircraft)
TABLE 8.6 The World's 10 Largest Airlines by Fleet Size
TABLE 8.7 Calculation of The LTV of a 10‐year $80-million Loan with a $100-mi...
TABLE 8.8 Project Finance Loans vs. Mortgage Loans for a Lessor
TABLE 8.9 Unsecured Bonds Issued by Lessors in 2018
TABLE 8.10 Long‐term Rating of a Selected Number of Lessors
Chapter 9
TABLE 9.1 The Top Ten Busiest Scheduled Air Routes in the World in 2017
TABLE 9.2 Different Types of Maintenance Events
Chapter 10
TABLE 10.1 Tranching of a $700-million Securitization
TABLE 10.2 Different Names of Securities
TABLE 10.3 ABS and Covered Bonds
Chapter 11
TABLE 11.1 Key Metrics Before and After the CLO Issuance
TABLE 11.2 Tranching of CLNs for a Synthetic Regulatory Capital Trade
Chapter 12
TABLE 12.1 Example of Portfolio Profile Test
TABLE 12.2 Comparison of Static and Managed Transactions
TABLE 12.3 Tests Expected by Rating Agencies
TABLE 12.4 Tranching of a €411-million Securitization Including Fixed-rate Tr...
TABLE 12.5 Statistical Information on Securitized Pools of Sallie Mae Educati...
TABLE 12.6 Aircraft ABS Issued in 2018 (Excluding Equity Tranche)
TABLE 12.7 Types of Assets Pulled Together in Auto ABS
List of Illustrations
Introduction
FIGURE I.1 Simplified diagram of a standard structured finance transaction
Chapter 1
FIGURE 1.1 Simplified LBO Structure
Chapter 2
FIGURE 2.1 EBITDA Margin Burger King 2005–2013
FIGURE 2.2 Fund Structure in the LBO Sector
FIGURE 2.3 Value of NFL TV Rights in $m per Season (1982–2021)
FIGURE 2.4 Domestic Premier League TV Rights in £m per Period (1992–2022)...
FIGURE 2.5 Overseas Premier League TV Rights in £m per Period (1992–2022)...
FIGURE 2.6 The 10 Most Expensive Jerseys in Club Football (Amounts in £m per...
FIGURE 2.7 Manchester United Revenues in 2006 and 2019
Chapter 4
FIGURE 4.1 Simplified Diagram of a Project Finance Structure
FIGURE 4.2 Financing Structure of The Eiffel Tower
FIGURE 4.3 Shareholding Structure of The Eiffel Tower After Construction
Chapter 5
Figure 5.1 Simplified Yieldco Structure
Figure 5.2 Outstanding Amount of a Fully Amortizing Project Finance Loan wit...
Figure 5.3 Outstanding Amount of a Hard Mini‐perm with a Maturity of Constru...
Figure 5.4 Simplified Project Finance Structure with ECA Cover
FIGURE 5.5 Simplified Financing Structure of Disneyland Paris
Chapter 6
FIGURE 6.1 Interest Rate Swap in Project Finance
Chapter 7
FIGURE 7.1 Simplified Mortgage Loan Structure
FIGURE 7.2 Simplified Finance Lease Structure
FIGURE 7.3 Simplified Operating Lease Structure
FIGURE 7.4 Simplified JOLCO Structure
Chapter 8
FIGURE 8.1 Air France‐KLM's Debt Reimbursement Profile at 31 December 2019...
FIGURE 8.2 Lessor Fragmentation 2002–2018
FIGURE 8.3 Simplified Sidecar Structure
Chapter 10
FIGURE 10.1 Simplified Securitization Structure
FIGURE 10.2 Simplified Balance Sheet of an SPV Issuing Six Tranches of Notes...
FIGURE 10.3 Simplified Transaction Structure
Chapter 11
FIGURE 11.1 Overview of the Borrowers' Position in the Securitization Proces...
FIGURE 11.2 Overview of the Originator's Position in the Securitization Proc...
FIGURE 11.3 Overview of the SPV's Position in the Securitization Process
FIGURE 11.4 Overview of the Investor's Place in the Securitization Process
FIGURE 11.5 Simplified Structure Diagram of a Synthetic Capital Relief Trade...
Chapter 12
FIGURE 12.1 Concept of a Managed Securitization
FIGURE 12.2 Example of a Ramp‐up Period of a €500-million Arbitrage CLO
FIGURE 12.3 CLO Lifecycle
FIGURE 12.4 OC and IC Tests in a CLO Structure
FIGURE 12.5 Simplified Diagram of a Credit Card ABS
FIGURE 12.6 Standard WBS Diagram
Conclusion
FIGURE C.1 The logic behind a corporate loan
FIGURE C.2 Example of financial disintermediation
FIGURE C.3 Disintermediation thanks to structured finance
Appendix C
FIGURE C.1 Credit default swap
FIGURE C.2 Credit linked note
Guide
Cover Page
Table of Contents
Begin Reading
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Structured Finance
Charles-Henri Larreur
This edition first published 2021Copyright © 2021 by Charles‐Henri Larreur.
Registered officeJohn Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom
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Library of Congress Cataloging‐in‐Publication Data is Available
ISBN: 978‐1‐119‐37110‐6 (paperback) ISBN 978‐1‐119‐37128‐1 (ePub)ISBN: 978‐1‐119‐37126‐7 (ePDF) ISBN 978‐1‐119‐38931‐6 (Obook)
Cover Design: WileyCover Image: © hunthomas/Shutterstock
To Tammy, Clémence, and Alexandre
Preface
STRUCTURED FINANCE (OR THE LIFE OF MY FRIEND DAVID)
David is my best friend. I met him a few years back in business school. We were in the same class and shared a background in history and political science as well as an interest in finance. Unlike me and many others in our class, David was not lured into banking by the prospect of a big pay check. He chose what looked like a boring option at the time, joining the management program of a major French retail company. It turned out to be a very clever move. While those of us who chose banking experienced at first hand one of the greatest economic crises of all time (2008) – and the frustrations of the regulatory clampdown that followed – David has enjoyed a brilliant career. He was sent to Italy to assist the local CEO with trade union negotiations; worked in Brazil for two years setting up a joint venture with a local partner; and lived in Singapore while helping to establish his firm in Asia. He now serves as head of corporate strategy, sitting on the company's executive committee.
David teases me when we talk about work. He tells me that his business is simple, where mine is incomprehensible. The recipe for making money in the retail business is easy: since supermarkets sell products at low prices, they have to buy products at very low prices. Margins are small but are offset by volume. Structured finance is the exact opposite: high profits but a business model that no one understands, even when they pretend they do.
What David says is partly true. Most people have a very limited understanding of my industry. Despite the profits it generates, structured finance is less well known than M&A or capital markets. And what little is known about structured finance has mostly to do with its role in bringing about the subprime crisis, leaving it associated with shady dealing, tax evasion, and accounting manipulation.
Far from being responsible for all of the planet's woes, structured finance is actually essential to the global economy. Most people benefit daily from it. There is nothing exotic about it. It is simply a set of techniques used to finance the companies and assets that are part of our everyday lives.
Take my friend David for instance. He ignores it, but structured financing is all around him.
A TYPICAL DAY IN THE LIFE OF MY FRIEND DAVID
David flies to New York regularly to meet the local management of his company's US subsidiary. He wakes up early, has breakfast and goes down to a car ordered on his smartphone. On his way to the airport, he passes the Seine River and the Eiffel Tower, making it out of the city in time to beat the morning traffic. He flies to New York on Delta, United, American, or Air France – whichever has the cheapest business‐class ticket. After landing at JFK Airport, he hails a taxi to the office. When the workday is over, he heads to his hotel, usually the Hilton Midtown, a few blocks away from Rockefeller Center. He takes a shower and spends an hour making calls and answering emails. Then he takes another taxi to a fancy restaurant and has dinner with the local CEO or some key suppliers.
Most of the next day is spent at the office in back‐to‐back meetings with the local management team. There are intense discussions about all the typical aspects of a retail business: sales, margins, finance, supply chains, and HR. David then usually meets investment bankers to have their views on the US market and the strategic options available for his firm. I know, for instance, that a couple of years ago he spent a lot of time working on a potential acquisition of Safeway, a retailer with a strong foothold in the West. David unfortunately lost that deal, and Safeway was eventually acquired by another competitor, Albertsons.
When he has a minute, David calls his wife and speaks with his kids. They talk about school and the toys they want for Christmas or their birthdays. Almost always, they ask if he will take them to Disneyland Paris when he gets back.
The following day, David picks up a rental car at Hertz and drives to New Jersey or Connecticut to check on a few stores himself. One of them, in Newark, not too far from the Port of New York and New Jersey, where large ships from all over the world can be seen loading or unloading containers, is a worry for him. The supermarket has been struggling for years and, despite recent refurbishments, there has been no real sign of improvement. Its location is not the best: David will probably have to close it.
In Connecticut, however, business is good, especially in the south where his company's upscale grocery stores appeal to the large, affluent hedge fund community. The fresh products the stores offer are in line with the expectations and means of people who pay attention to what they eat. Customers here are also more eco‐conscious than usual, an attitude reflected in the wind and solar farms that David passes on his drive.
On a day like this, David enjoys a simple lunch. If he had been with a colleague, he would have eaten in one of the cafés inside their stores. Alone, he chooses a fast food restaurant, ideally Burger King, a favorite from his childhood. In the afternoon, David goes back to Manhattan and tries, if he can, to squeeze in a drink or dinner with a friend. The next day, he checks out early from the hotel, using a Visa card or an American Express. He then goes back to the office and starts another round of meetings, this time mostly with suppliers.
A few hours later, David is back at the airport. He can finally relax. Comfortably seated on the plane, he enjoys a glass of wine, plugs his headphones into his cell phone and listens to classical music or David Bowie, his favorite singer. He checks the sports pages in the paper, paying extra attention to articles on motorsports and Formula One. Then he gets some rest and starts thinking about his weekend, wondering whether he will have enough time to take his Harley Davidson for a spin.
STRUCTURED FINANCE IS EVERYWHERE
To David, structured finance seems entirely remote from his daily routine, an obscure corner of the banking world that he associates mainly with economic disaster. He does not realize that structured finance is literally all around him. During his three‐day stay in the United States, David unwittingly came across no fewer than 20 structured finance deals – highly complex transactions designed to optimize the financing of companies, specific projects, and services.
Securitization, certainly, has been misused to sell bad loans to gullible investors, but Visa and American Express (whose credit cards David travels with) use this technique to finance cash advances to their clients. It is also a perfect tool for funding intangible assets. David Bowie's intellectual property rights and the broadcast rights to Formula One were both financed through this instrument.
Securitization is not the only structured finance product that David came across. Companies that invest in expensive movable assets rely extensively on other types of structured solutions. All the airlines that David flies with (Air France, Delta Airlines, American Airlines, and United Airlines) finance the acquisition of their aircraft through structured transactions. The shipping companies that he passes at the Port of New York and New Jersey also use these methods to finance their vessels.
Infrastructure is also an important sector for structured finance. Many large assets like roads, airports, wind farms, and photovoltaic farms are funded through structured solutions. Even the telecom infrastructures that David relies on when he uses his phone are often funded this way. Structured finance has also brought to life more unconventional projects, like the Eiffel Tower and Disneyland Paris.
Finally, we cannot talk about structured finance without mentioning leveraged buyouts (LBOs). Since the 1970s, the number of private equity firms formed to execute LBOs has exploded, and some of the world's most recognizable brands have been reshaped by the LBO industry. They include Hilton Hotels, which puts David up on his trips to New York, Hertz where he picks up his rental car, Burger King where he eats lunch, and Harley‐Davidson, which sold him his motorcycle.
Structured finance, then, is the great paradox of modern banking. Much maligned – with good reason – for its misuse before the crisis of 2008, it is also the beating heart of the global economy. It is everywhere. It has given us the Eiffel Tower, American Express, and many large infrastructure assets a point too often forgotten by business school professors, the financial press, and my friend David.
ABOUT THIS BOOK
Why a new book on structured finance? This is a question I have been asked quite often. To this question, my answer is simple: there are in fact not many books on the topic. The ones that I know are either too theoretical (to my taste at least) or too specialized. They generally deal with one sub‐product of structured finance only and too rarely with the concept as the whole.
The ambition of this book is to offer readers a tour of the structured finance world. It is to present in a simple manner and with the help of case studies the four major structured finance techniques: (i) leveraged buyouts, (ii) project finance, (iii) asset finance, and (iv) securitization. The book will be divided into four parts and each of them will analyze in detail one of these instruments.
This book will not only describe each of these four techniques it will also highlight their commonalities and the reasons why we think they belong to the same family of products. Through 13 case studies and more than 500 examples of companies, the book will also offer a historical journey through the structured finance landscape. Our objective is not only to show how these techniques work but also to explain why financiers have come up with them and the reasons they have become so successful.
Introduction
A BRIEF HISTORY OF STRUCTURED FINANCE
The emergence of structured finance in the 1970s was a true revolution in the financial sector. It was probably the greatest shakeup in the money industry since the creation of organized and fluid stock exchanges in the seventeenth century.1 If there is one day a Hall of Fame for financial innovations, structured finance will take its place among gold coins, hedge funds, central banks, and banknotes.
With the rise of structured finance, the banking industry has changed more drastically (for good and ill) during the past four decades than during the previous 300 years. In barely four decades, it has reshaped the world's largest banks and greatly increased the liquidity of financial markets. It has transformed banks from dull deposit‐to‐lend conduits with a staid management culture to money‐making factories led by brash and colorful figures.
Investment banks now have large teams dedicated to structuring a wide array of deals for their clients. Most of them have entire departments focused on each of the four types of transactions analyzed in this book. These teams are sometimes even sub‐divided by industry sector (telecommunications, energy, infrastructure, etc.). This gives them a deeper level of expertise to offer clients as well as the know‐how to manage their own risks.
Large investment banks are today active at each stage of the structured finance process: identification of potential deals, arrangement, structuring, underwriting, syndication, and sometimes – at a later stage – refinancing.
Some corporations outside the finance industry, especially utility companies or players in the infrastructure market, have also developed a strong expertise in structured solutions. Some of them have specialized teams, and their level of sophistication is comparable, if not superior, to those of the shrewdest bankers. Companies involved in the development, construction and operation of renewable energy plants (the kind that built the windfarms David sees in Connecticut) are frequent users of structured financing. For them, structured finance is the norm, while traditional bonds and bank loans are the exception.
But why the sudden boom in structured transactions? Structured finance indeed spread quite rapidly, becoming the “the new big thing” in global finance in less than a decade. In just a few years, financiers had created a wide array of new products and established entire lines of business within banks. They had closed the first securitization deals and the first leveraged buyouts or LBOs (Revlon, Beatrice Foods, RJR Nabisco), invented project finance, and structured leasing transactions to finance entire aircraft fleets.
A complex mix of long‐run trends in the banking sector and a shift in the broader context accounts for the speedy evolution of these new financing forms. The drivers of change are plenty but can be captured under three headings: (i) the rise of a new generation of uninhibited bankers, (ii) political and technological shifts, and (iii) rising demand for leverage from US and European companies.2
The Men
Although history books give credit to charismatic figures who alter the course of events, finance textbooks rarely do. In imparting their lessons about the optimal use of capital or the time value of money, they do not usually pause to mention the innovators behind these theories. And when they do, they focus on the academics who formalized them instead of the practitioners who used them in the real world – often well before they were ever expressed in a classroom.
The structured finance revolution cannot be understood without exploring the generational change playing out on Wall Street at that time. The men taking charge of banking in the 1970s were the first to carry with them no memory of the Great Depression. Born in the 1940s and just entering their 30s, they were for this reason probably more daring (or less prudent) than their seniors. In any case, they were more prone to financial audacity and less afraid of debt.
Among this group of young and ambitious financiers, some had enormous influence on the financial innovations of that period. At Bear Stearns, the two cousins Henry Kravis (b. 1944) and George Roberts (b. 1944), and their mentor Jerome Kohlberg,3 structured the very first LBOs. At Drexel Burnham, Michael Milken (b. 1946) created the high yield market and, at Salomon Brothers, Lewis Ranieri (b. 1947) invented the concept of securitization. Far from Wall Street, in Los Angeles, Steven Hazy (b. 1946) founded in 1973 International Lease Finance Corporation, the first aircraft leasing company.
The Context
This wave of financial innovation was also partly conditioned by the evolution of the US banking regulation. The loosening of rules governing financial markets in the 1970s in many US states, and later at the federal level under Reagan, allowed easier structuring of certain debt products. It also gave banks the right to sell a wider range of financial instruments to insurance companies and pension funds, two types of investors which were, until that time, only buying stocks or corporate bonds.
Deregulation per se, was not the direct cause of these financial innovations. While most appeared around the mid‐1970s, the liberalization of financial markets was more a child of the 1980s. Reaganomics only really took hold in 1982, when Ronald Reagan signed the Garn‐St Germain Depository Institutions Act,4 and the British “Big Bang” prepared by Margaret Thatcher only came into force in October 1986. Deregulation did not create structured finance but acted as a fertilizer, stimulating competition among banks and the development of new types of financial products.
The 1980s was also a period of profound changes in the IT sector. Companies began to give personal computers to their employees. Bankers gained powerful software tools previously unavailable. The spreadsheet program Lotus 1‐2‐3 appeared in 1983 and Microsoft Excel in 1987, allowing bankers to easily design the complex financial models which are at the very heart of structured finance. In 1983, Bloomberg LP launched its famous terminal, giving its users access to an unprecedented range of financial information. The generalization of this system would greatly favour the development of structured finance, allowing investment banks to better calibrate their products.
The Demand
No demand, no offer. Behind this truism lies one of the main factors of the rise of structured financing: banks, beginning in the 1970s, realized that demand was growing among their corporate clients for structured products.
Just as a new generation of bankers took power on Wall Street, a new wave of managers rose to positions of power in corporate America. And just like their counterparts in the banking sector, they were born after the Depression of the 1930s. And just like them, they proved less reluctant to use debt.
More importantly, structured finance offered solutions that met the particular corporate needs of the era. Because of the oil shock, for instance, and the attendant rise in energy prices, oil companies started digging in the North Sea, hoping to reduce their dependence on the Organization of the Petroleum Exporting Countries (OPEC). This involved massive and unprecedented investments for which they drew upon the financial engineering capabilities of banks.
Similar challenges spurred structured financing in other sectors. The sustained growth of demand for air transport from the 1970s forced banks and airlines to come up with the means to finance whole fleets of aircraft. Here again, structured finance was the only way to accommodate the need for large and recurring capital expenditures.
Similarly, from the 1990s onwards, thanks to deregulation and the withdrawal of governments from the direct funding of some public infrastructure, companies got involved more directly in the financing of new highways, airports, fiber‐optic networks, etc. Once again, banks offered the structured solutions necessary to implement all this.
DEFINING STRUCTURED FINANCE
After this long introduction, it is probably time for a first definition of structured finance. Providing one is surprisingly difficult. There are indeed several definitions of the concept, none of which has achieved a consensus among bankers, scholars, or investment professionals.
To come up with a useful definition for this book, we will take things step by step. We will analyze the three main variants of the structured finance concept and finally settle on the definition we prefer.
First version. Structured finance refers to all loans that are not “vanilla loans”, i.e. plain and simple loans made by banks to their clients. These “vanilla loans” can be bullet (with the principal repaid at maturity) or amortizing (when principal is paid down over the life of the loan), but do not involve any twist and do not require any specific legal or financial engineering. The risk borne by the bank is solely and simply the credit risk of the company it has lent money to. According to this definition, structured finance comprises all the forms of funding that do not match the criteria of these vanilla loans.
This first definition underlines the complexity of structured finance and undoubtedly represents a solid first approach to the subject. It is unfortunately a little too vague and includes a wide array of financing types that do not have much in common. It is also a by‐default definition, which is not likely to satisfy an audience as demanding as one that would take an interest in this book.
Second version. Structured finance is a synonym of structured credit. It refers to the pooling and financing of financial assets through a dedicated company.
This definition, very popular among US scholars, strikes us as incomplete. Structured credit refers to a large sub‐segment of structured finance (also called securitization) but does not capture the whole. Adopting this definition would mean neglecting the fact that structured credit transactions have a lot in common with other types of financing. So while the first definition of structured finance may be too broad, we believe that this second one is too narrow. Structured credit remains an important part of structured finance but the two concepts are not identical.5
Third version. Structured finance describes transactions in which funding is brought by lenders to a dedicated company (also known as a special purpose vehicle or SPV) created for the sole purpose of financing the acquisition of an asset or a group of assets (financial or physical assets). The repayment of the loan is linked only to the performance of the underlying assets, meaning that it depends on the income generated by the SPV. The lenders take a risk on these assets and have no recourse on the equity holders in the SPV.
This definition zeroes in on the fact that structured transactions are not set up to directly finance a company but rather a specific asset or a portfolio of clearly identified assets. This third definition is more precise than the first one but broader than the second. It excludes from the structured finance concept some similar arrangements that do not require the creation of a special purpose company (trade finance, for instance). Yet it encompasses structured credit (our second definition) and goes further by noting that structured finance can be used to finance a portfolio of financial assets, as well as real assets such as companies, equipment, or infrastructure projects.
As readers will probably have guessed, this book will focus on this third definition. We will explain in detail various types of financing. They will differ in their particulars, but each of them implies (i) the establishment of a SPV and (ii) a loan to this SPV without legal or financial recourse to the investors in the SPV.6
The four main financial techniques analyzed in this book are:
Leverage buyout
(also known as LBO): one of the techniques commonly used to finance the acquisition of companies, especially when the buyer is an investment firm or an individual.
Project finance
: a tool used to finance large infrastructure or energy projects.
Asset finance
: the financing of investments in movable assets like aircraft or ships.
Securitization
: the financing of portfolios of financial assets.
Each of these four techniques is – to some extent – a variation on the same structure. The details and subtleties may obviously vary from one deal to another but in each case an SPV is set up and financed by a mix of debt and equity with the sole purpose of acquiring an asset. The assets to be financed may differ (a company, an infrastructure, an aircraft, or a portfolio of securities) but all in all these four techniques are quite similar and could all be represented under the form of Figure I.1.
FIGURE I.1 Simplified diagram of a standard structured finance transaction
For the sake of clarity, we will in each chapter of this book refer back to this simplified structure. The idea is to underline the connections between these financing techniques and to show that they all belong to the same large family of products. This should also provide the opportunity to gradually highlight the similarities and differences between them.
Even if we perfectly understand that a reader may choose a targeted approach to this book and start from any given chapter (or simply focus on one part of the book only), we suggest – if possible – reading it from the start in the way in which it is presented here. This should enhance the reader's experience, since each chapter is not only an isolated description of one particular financial technique but also refers to concepts or elements mentioned elsewhere in the book.
WHY WAS STRUCTURED FINANCE SET UP?
There are many reasons why banks started to promote structured finance solutions to their clients. The first is obviously that structured finance products are lucrative per se. If a bank is able to capture the whole value chain for a single structured finance deal, there are not many areas of finance that can offer the same returns. The example of Michael Milken in the 1980s is striking. At one point, his single structured debt department at Drexel Burnham was earning more profits than any other US investment bank as a whole. (At the time, the other banks were generally not very active in this segment; needless to say, things changed rapidly after they saw the returns generated by Milken.)
The second reason is that structured finance can have a specific appeal to clients willing to optimize their capital structure. Structured finance is a set of techniques designed to put additional debt behind an asset. As such, it improves returns for equity holders. In an environment where companies are under pressure from shareholders to provide better returns, structured finance gives them tools to optimize their level of indebtedness.
The other reasons behind the success of structured finance are more technical and relate either to financial or regulatory specifics. If they seem a little abstract at this stage to readers without a strong background in finance, they should become less so over the course of this book. We will come back to these causes (five of them financial, one linked to regulation) in our conclusion and see how they apply to each specific type of structured finance deal.
Five Financial Reasons
From an equity investor perspective, setting up an SPV to acquire an asset (whatever this asset is) is a way to isolate risk. Debt is raised at the SPV level, and lenders have no recourse to the investor if the asset fails to perform. Other assets owned and controlled by the investor cannot be seized by lenders to repay the debt. It brings additional safety to investors, who can separate various investments into silos. Assets that are isolated this way are said to be “ring‐fenced” (Reason 1).
By sizing the debt based on the cash flows generated by the SPV, lenders can offer a higher degree of leverage to their clients than if the same asset was mixed with lower performing assets. If the asset to be financed generates steady cash flows, it is preferable to isolate it in an SPV and take advantage of its credit quality by maximizing leverage (Reason 2).
Structured finance offers lenders direct exposure to risks they are comfortable with. Instead of funding a large corporation carrying out various businesses, including some they might find less attractive, lenders can simply finance an SPV which holds one specific asset. If they are comfortable with the credit quality of this asset, lenders would rather fund this asset than a mix of businesses (Reason 3).
Structured finance has also created entirely new investment opportunities for lenders and investors. They have access today to a range of products that did not exist before. In other words, structured finance attracts liquidity because it offers opportunities that cannot be found anywhere else (Reason 4).
These new products offer the whole spectrum of return/risk combinations. All types of debt and equity investors can find their niche. Depending on their risk appetite, investors can select the product that fits their needs most: senior debt, mezzanine, or equity (Reason 5).
One Regulatory Reason
The growing success of structured transactions over the last 40 years is not only due to financial reasons. The other main driver of their popularity is that they allow banks to optimize their balance sheets from a regulatory perspective.7
The concept of banking regulation originates in the Basel Accords, first signed in 1988, between the central banks of various countries and subsequently revised multiple times.8 The Basel Accords aim to provide national regulatory bodies with tools to better control banks active in their countries. They are a set of non‐binding recommendations that have been widely adopted by governments since the 2008 crisis.
Among the issues addressed by the Basel Accords is the desire to limit the risks taken by banks. After all, banks are institutions that – to a degree more than any other business – finance their activities with high levels of debt. Their borrowings are, for the most part, the cash sitting in the bank accounts of their customers.
A Primer on Banking Regulation
Given the large amount of money they receive from depositors, most banks are highly leveraged. Unlike traditional businesses, this borrowing capacity is almost unlimited. While the financial statements of any prospective borrower are closely scrutinized by the banker in charge of analyzing the loan request, very few depositors ever analyze the balance sheet of the institution where they deposit their savings. A bank can therefore in theory have an infinite debt‐to‐equity ratio. This would obviously pose a danger to clients, since any major loss suffered by a bank would directly impact the customers' deposits.
The Basel Accords aim to limit the capacity of banks to borrow money to prevent such a scenario from occurring. In simple terms, we could say that the Basel Accords require that for each loan granted to a client, a minimum portion of it should be financed by the bank's equity, i.e. with shareholders' contributions. As a reminder, these contributions are either direct (share capital) or indirect (retained earnings). Retained earnings are simply undistributed profits or, in other words, dividends surrendered by shareholders.
The main principle of the Basel Accords is to ensure that banks cannot fund the loans granted to their clients with customers' deposits only. Banks must maintain in their books a certain amount of capital so that any loss they might suffer could be absorbed by the shareholders without impacting lenders (i.e. the depositors). This minimum amount of capital is therefore often referred to as capital buffer.
A Weighted Approach to Risk
A dilemma lies behind this commendable principle nonetheless. When two banks (Bank 1 and Bank 2) each lend out $100 million to a client, they do not necessarily take the same level of risk. Bank 1 may, for instance, lend to Alphabet,9 a company rated AA+ by Standard & Poor's (S&P), while Bank 2 lends to a start‐up launched by two teenagers. Even if the project of the two young entrepreneurs is very promising, the bank funding the start‐up takes a much higher risk than the one lending to Alphabet. The amounts at stake are the same ($100 million) but Alphabet's likelihood of default is much lower than the start‐up's. It would be nonsense if regulators were to require Bank 1 and Bank 2 to use the same amount of capital to fund their loans.
If banks had to finance every loan, whatever the underlying risk, with the same percentage of capital, they could be tempted to multiply dodgy loans. With the interest rates applicable to risky counterparties being significantly higher than the ones paid by investment‐grade companies,10 banks could prioritize loans with higher margins (hence risky) over safer prospects. For a given amount of capital, risky loans would indeed produce more revenues. This would lead to the exact opposite of what the Basel Accords aim for. Instead of creating safer banks, regulation would incentivize the opposite.
To avoid this pitfall, the Basel Accords stipulate that banks must for regulatory proposes convert each of their assets (i.e. loans, investments, guarantees, capital market instruments, etc.) into a Risk Weighted Asset or RWA, i.e. an asset whose nominal value is weighted according to its risk. The amount of capital set by the regulator to fund each asset is fixed as a percentage of the corresponding RWA. In other words, the amount of capital required from banks is not based on the nominal value of each asset but on the value of each asset weighted according to its intrinsic risk.
Let us take a numerical example. The Basel Accords indicate that the equivalent in RWA of a loan granted to a AA+ corporation like Alphabet is equal to 20% of the notional amount of the loan. If the loan is made to a non‐rated company, this amount is equal to 100%. In short, for two loans, both equaling $100 million, regulators would assign a corresponding RWA of $20 million for a loan to Alphabet and the full $100 million for a loan to a start‐up. Assuming that the required percentage of capital set by the regulator is 8%, a bank must mobilize at least $1.6 million of capital (8% x 20) when it lends $100 million to Alphabet. If it wants to lend the same amount to a start‐up, it must use $8 million of capital (8% x $100 million), or five times more.
With this weighted approach to risk, regulators avoid the paradoxical situation mentioned earlier. In a system without RWA, in which the required capital amount to finance a loan would be calculated on a nominal basis, loans to start‐ups would generate a profitability significantly higher than loans to investment‐grade companies (because margins would be much higher). Thanks to the Basel framework, the profitability of the two loans is rebalanced. It is unfortunate for the two teenagers but all the better for the stability of the financial system.
Contribution of Structured Finance
An attentive reader might at this stage be wondering what the link is between banking regulation and structured finance. To keep things simple, we have for the moment assumed that RWAs are only a function of the borrowers' credit risk. Basel's regulatory framework is in reality more complex. The amount of RWAs also depends on other factors such as potential additional guarantees. Specifically, if a bank lending to Alphabet obtains as part of the transaction a mortgage on the head office of the company, the amount of RWAs (which was $20 million) will be further reduced. The mortgage lowers the risk taken by the bank and decreases its potential loss. In case of bankruptcy of Alphabet, the bank can exercise its rights under the mortgage deed and recoup some of its losses through a sale of the building.
Even if we will see later that calculating the impact of a mortgage is not straightforward, we can assume at this stage that the amount of RWAs corresponding to a loan with a mortgage is equal to 20% of the same loan with no mortgage. In other words, the amount of RWAs corresponding to a $100m loan to Alphabet is reduced from $20 million to $4 million (20 x 20%). The bank needs as little as $320,000 (8% x $4 million) of its own equity to fund this loan, rather than $1.6 million.
TABLE I.1 Amount of Capital Required From a Bank to Fund a $100 million Loan (in $m)
Type of Loan
Loan Amount
Corresponding Risk Weighted Assets (RWA)
Capital (8% x RWA)
Loan to a non‐rated company
100
100
8
Loan to Alphabet (rated AA+ by S&P and Aa2 by Moody's)
100
20
1.6
Mortgage loan to Alphabet
100
4
0.32
Table I.1 summarizes the impact in terms of RWAs and capital needs under the three scenarios discussed so far: a $100 million loan (i) to a non‐rated company, (ii) to Alphabet, and (ii) to Alphabet with the benefit of a mortgage. The safer the loan, the less capital the bank has to use. This is in line with the objectives of the regulators. After all, the purpose of setting a minimum amount of capital to fund each loan is to create safer banks. It is not to discourage banks from doing business. If the risk of loss is minimal, then the bank should not be required to mobilize a lot of capital. There is obviously a thin line for the regulators to walk. They have to protect banks and depositors, but if they require too much capital, there is a risk that, all things being equal, margins will go up significantly. Banks' shareholders still need to receive a decent return for their investment and if a lot of equity is needed for each loan, they will ask for higher margins on these loans. That may slow down the development of small businesses.
Obtaining a mortgage when lending to a AA+ rated company may seem like a detail at first glance from a risk perspective. It is, however, essential from a regulatory perspective. It allows the bank to reduce the amount of capital allocated to the transaction. In our example, the bank saves $1.28 million (1.6 – 0.32) of capital by receiving the extra security. This capital can be allocated to other transactions, which will generate additional returns. In other words, thanks to a simple mortgage, the bank can dramatically improve its return on equity.
Structured finance transactions have in effect the same impact as this mortgage. They generally involve more leverage than plain vanilla loans but come most of the time with a package of additional securities or guarantees (called a security package). Depending on the transaction, this package can include pledges of shares, mortgages on properties, early repayment options, prepayment guarantees, etc. All things being equal, these elements reduce the amount of RWAs (and consequently capital) allocated to a deal. To put it simply, structured finance transactions allow banks to optimize their use of RWAs. This is one of the reasons for their growing success (Reason 6).11
Going into More Detail
As briefly mentioned earlier, the impact of a security package on the reduction in RWAs is not always easy to estimate. Without getting into the complexities of Basel II and III, the regulatory framework is such that banks are given some flexibility to assess the effect that a given security package can have in terms of risk (and therefore in terms of capital consumption).
The Basel Accords establish clearly the minimum impact that various securities like mortgages or guarantees can have on RWAs. Banks are by default bound to use this methodology, called the standard approach. However, if a bank can demonstrate based on its own historical data that the benefit of certain securities is greater than established in the Basel Accords, it can use its own data to calculate RWAs. The use of this method, called the advanced approach, is nonetheless subject to the approval of the local regulator.
Let us take an example:
Under the standard approach, a mortgage cuts RWAs by 80%, reducing by five times the amount of capital that a bank has to mobilize for a loan (from $1.6 million to $320,000 in the Alphabet example). From a conceptual point of view, this means regulators calculate that the risk of a loss for the bank is reduced by the same degree, five times.
Using extensive data culled from past transactions, a bank might argue that obtaining a mortgage has an even greater effect. It could, for instance, demonstrate to its local regulator that the risk of losses is reduced by six times rather than five. If the data is convincing, the regulator may grant to this bank the benefit of the advanced approach, in which case its RWAs and capital requirements would be reduced accordingly. All things being equal, it means that a mortgage loan is more beneficial for this bank than for banks using the standard approach.12
This flexibility on the part of regulators may seem surprising at first, but the point is the same: to reduce risk. By dangling the possibility of lower capital requirements, regulators hope to prod banks into investing more in the right people and IT systems for monitoring their exposure. Banks may indeed be more willing to store and produce data on their business if this data can be used to optimize their use of capital. Through the advanced approach, the objective of the Basel Accords remains to create safer banks and more financial stability.
NOTES
1
There is little consensus amongst scholars as to when stocks were publicly traded for the first time. French historian Fernand Braudel has notably shown that the equivalent of what we would today call government bonds were already traded in Venice, Florence, and Genoa at the beginning of the fourteenth century. It is, however, safe to say that even though there may have been some organized and regulated trading activity before, the Amsterdam Stock Exchange – created in 1602 originally for dealing with the printed bonds and stocks of the Dutch East India Company – is widely seen as the first organized market place to offer a high level of liquidity for traders of bonds and securities.
2
As a reminder, leverage is the debt‐to‐equity ratio used to finance an asset, whether this asset is a company, an immovable property, or a financial asset. The higher it is, the greater the level of debt.
3
The oldest banker in this list, Jerome Kohlberg, was born in 1925. He was only 30 years old when he joined Bear Stearns in 1955. He acted in a way as spiritual father to Henry Kravis and George Roberts with whom he founded KKR. He resigned in 1987 to found a new private equity firm, Kohlberg & Company. He passed away in 2008. His estimated net worth was $1.5 billion.
4
“This bill is the most important legislation for financial institutions in the last 50 years. […] Now, this bill also represents the first step in our administration's comprehensive program of financial deregulation.” Ronald Reagan on 15 October 1982 while signing the Garn‐St Germain Depository Institutions Act.
5
Part IV
of the book is dedicated to the analysis of structured credit.
6
Note: the notions of special purpose vehicle (SPV), special purpose company (SPC), or special purpose entity (SPE) are all identical.
7
We warn the readers in advance that the explanations they will be reading are complex. They are, however, essential to understanding the relevance of structured finance. We thank the readers in advance for their patience.
8
Basel II was signed in 2004 and Basel III in 2010. New modifications to Basel III were introduced in 2016 and are sometimes referred to as Basel IV.
9
Google parent company.
10
As a reminder, the debt securities considered investment grade are securities with a rating of at least BBB‐ (S&P) or Baa3 (Moody's).
11
Good news for readers: you have finished what is probably the most difficult part of the book. You deserve a medal if you have understood everything. In case of doubt, one just needs to understand that regulators require that banks fund each of their loans with a minimal portion of capital. Structured transactions often allow, one way or another, a reduction of this minimal portion. It consequently increases the profitability of the bank (as less capital is needed to finance a loan).
12
Note to readers: obtaining the benefit of the advanced approach from a regulator is a very complex process.
PART ILeveraged Buyout (LBO)
An LBO or leveraged buyout refers to the acquisition of a company with a combination of equity and debt. It is a financial technique that slowly emerged at the beginning of the twentieth century. LBOs, however, have only really taken off since the early 1980s, around the same time as project finance, asset finance, and securitization.
Readers with a background in finance are generally more familiar with LBOs than with the other financing techniques analyzed in this book. LBOs are a topic that might have been encountered in previous reading or studied in a course related to business valuation or corporate finance.
Without ignoring the link between corporate finance and LBOs, we think of the LBO as primarily a financing technique. Debt is indeed used to finance the acquisition – via an SPV – of an asset that generates cash flow. LBOs are in this respect similar to the other structures that we will discuss in this book. The main difference is the nature of the asset that is financed. It is a company in the case of an LBO, rather than an infrastructure asset, as in project finance (Part II), a moveable asset, as in asset finance (Part III) or a portfolio of receivables, as in securitization (Part IV).
