What is structured finance?
In structured finance, banks pool together loans backed by assets that generate cash flow and price the different tranches by riskiness. However, what makes structured finance loans different from other generic loans?
For most companies with vanilla financing needs, structured finance is not neessary. For companies that need to manage complicated forms of risk however, structured finance helps create the protections necessary for investors to feel comfortable entering the investment. For example, structured finance may involve tacking on legal protections to an investment that alter the composition, payout order, or credit risk of the receivables backing the investment.
Structured finance is uniquely positioned to fulfill the specific capital needs not covered by traditional lending. The new financial instruments involved in structured finance have increased liquidity (especially in the short-term) and companies use this reshaped liquidity structure to finance projects more flexibly. As we covered in a previous post on asset-backed debt, structured finance can help companies access capital by making it easier for debt investors to accept the risk profile of the investment.
Securitization, a subset of structured finance, is often the core of this process, as it involves bundling illiquid assets with others of the same class to sell to investors interested in the cash flows from the investment. (Over the years, the types of cashflows that have been securitized have expanded to include a staggering variety of industries.)
What are some of the key purposes of structured finance?
Risk Management. Bundling assets spreads risk among multiple investors and reduces the impact of defaults or market fluctuations.
Customized Financing Solutions. Structured finance allows for the creation of tailored cash flow structures, risk profiles, and payment priorities, enabling borrowers to access funding that fits their specific requirements and also meets investors' risk and return expectations.
Cash Flow Optimization. Structured finance can repackage and restructure the cash flows generated by underlying assets to align them with different investment strategies and preferences. This allows for the optimization of cash flows for the various needs of investors or issuers.
Access to Funding. Because structured finance and securitization involve diverse assets like mortgages, auto loans, and corporate debt, they help expand access to funding for various industries.
Diversification. The wide array of asset classes and the risk associated with them has also allowed investors to diversify their portfolios, reduce risk, and improve portfolio performance.
What are some common use cases of structured finance?
Structured finance is an incredibly versatile tool, so you see it used to finance projects across all verticals. Below, we list a few common types of structured finance:
Project Finance. Project finance is usually utilized for long-term infrastructure and industrial projects and often includes government involvement.
Leveraged Finance. Leveraged finance makes use of the value and future cash flows of an asset. Specifically, the future cash flows of acquired assets can be used to secure debt.
Export Credit Agency Finance. An export credit agency (ECA) acts as an intermediary between governments and exporters. It often helps provide credit insurance or financial guarantees as a part of a financing and aims to boost exports by domestic companies.
Structured Trade Finance. Structured trade finance is a specialized form of financing against commodity trade flows and is structured around the supply chain. It is usually used for commodity trading of products of large quantities or high values.
Real Estate Finance. Real estate finance utilizes the income generated from real estate properties and the value of the properties to act as collateral to secure a loan. A special-purpose company then uses that loan to purchase those properties. In general, real estate finance can help property owners optimize their balance sheets and facilitate real estate investment trusts (REITs) in acquiring properties.
Securitization. Securitization includes bundling a group of illiquid assets to turn them into an instrument that can be invested in. Securitization allows for diversification of funding sources and improvement of cash flows, with the most common forms of securitization including asset-backed securities (ABS) and mortgage-backed securities (MBS).
Ship Finance. In ship financing, collateral is structured around shipbuilding and charter agreements, and vessel charter fees act as the primary source of repayment.
Want to learn more about debt capital and structured finance software?
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