By Richard Sullivan and Giuliano Giovannetti, Granular Investments
Car hire, fleet finance and vehicle leasing have experienced some turbulent times in the recent past. After the banking crisis of 2007/8, the market underwent some funding trauma as the number of available lenders shrunk dramatically and the cost of funding rose significantly.
The situation has now improved, with more lenders returning to the market, but is still highly reliant on one lender in particular.
The vehicle leasing industry has gladly embraced the return of financing, although at more expensive terms than in the past, but remains concerned that the situation may deteriorate again.
In this respect, conduit securitisation financing offers an attractive alternative to bank lending for those players that have the necessary size (5-10,000 vehicles or more) and are willing to go through the non-trivial negotiations and administration requirements.
The result can be a significantly improved cost of funding, the possibility to scale up the business significantly and certainty over availability of funding at predetermined terms and conditions for several years.
What is Conduit Financing?
Conduit financing is a hybrid between traditional bank lending and securitization. Bank lending is well known to the industry, while securitization is a way to use receivables as collateral to fund in the capital markets.
Two aspects are key to a securitization: the collateral (i.e. the leasing receivables) is assigned to a bankruptcy-remote special purpose vehicle (SPV) which will protect them from other creditors if the originator was to default; also, there is a distinction between “senior” and “junior” funders - the originator usually retains (i.e. funds) the junior bonds, while third party investors (pension funds, money market funds, other banks, etc.) buy the senior bonds which enjoy greater protection.
Senior bonds are usually rated by rating agencies, who determine how “thick” the junior layer has to be in order to grant the coveted AAA rating to the senior bonds.
Conduit financing combines features from both the bank lending and the securitization model.
Like in a securitization, the leasing receivables are sold to a bankruptcy remote SPV. The SPV buys the receivables, thus receiving all future payments from the lessees, and does so by borrowing money from two sources: a small “junior”, subordinated loan from the originator (i.e. the leasing company) and a large “senior” loan from a Conduit, another independent entity loosely connected to a sponsor bank.
How much of the receivables is financed by the senior loan? This is determined so that the senior loan can be considered equivalent to a “AAA” bond if this was a securitization – the precise number depends on several factors but it usually is 80-90% of the present value of the receivables. The senior loan can also fund a portion of the residual value of the vehicle.
These loans match the duration of the leasing contracts, so likely up to three years in the case of auto leasing.
The senior loan provided by the Conduit has the most protection and a fixed rate for the duration of the facility (including the run-off of the remaining receivables at the end of the period). The junior loan does not receive a fixed interest, instead it receives “whatever is left” after paying back principal and interest to the senior loan.
In order to provide the loan to the SPV, the Conduit issues short dated notes called Commercial Paper (CP) at a very cheap rate (usually Libor flat). The conduit achieves such low cost of funding because it only offers loans of AAA-quality to SPVs which are bankruptcy remote and collateralized by high quality assets. This allows the CP issued by the conduit to be rated AAA equivalent.
It differs from securitization, which is usually for one specific asset class (auto finance, consumer credit, residential mortgages, …) and for the benefit of just one originator, in that a conduit acts for a multitude of other originators that can be from very different industries – thus achieving better diversification for the benefit of its “lenders” – the buyers of the notes.
Also, while a securitization is a very public affair, the relation between the Conduit and the leasing company is private – its existence does not need to be disclosed, nor data about the portfolio size or characteristics is revealed.
There is a gap between the duration of the leasing business, which requires 3-year funding, and the nature of the conduit, which receives short dated money. This gap is closed by the sponsor bank, which guarantees the necessary liquidity if something went wrong in the CP market.
The role of the sponsor bank is paid by the Conduit spread, the margin above Libor that the Conduit charges to the SPV.