Asset-based Finance – a Capital Idea

Twin Peaks

The world’s markets in financial Capital are built upon the “Twin Peaks” of “Equity” and “Debt” – often also characterised as “Investment” and “Credit”.

“Asset-based” Finance, by which I mean investment in an asset-owning legal entity, is fundamentally different from the familiar “Deficit-based” Finance, meaning Credit or “time to pay” which arises in the context of:
• a transaction between buyer and seller with delayed payment (ie “trade credit”); or
• a loan created by a “Credit Institution” such as a Bank or Building Society”.

Where credit is secured by a claim over assets such as a mortgage, I refer to it as “Deficit-based” but “asset-backed”.

At this point it is worthy of note that 97% of the money in circulation in the UK consists of such credit which has been “monetised” two thirds of which is based upon mortgage loans. ie the UK monetary system is “Deficit-based”, but for the most part “asset (property)-backed”.

Existing Asset-Based Finance

(a) Companies

The pre-eminent mechanism for asset-based finance is the “Joint Stock Limited Liability Company” where investors in shares issued by the Company have an absolute and permanent legal claim over the assets and revenues contained within its “legal wrapper”.

The flaws of this structure have been well documented and are essentially twofold. Firstly, there is the conflict of interest between the shareholders and all other “stakeholders”, often described as the “externalisation of costs”. We are all familiar with the rhetoric of “shareholder value”, “cost-cutting” and of course “Corporate Social Responsibility” that flows from this.

Secondly, there is the “Principal/ Agency” problem which is that of the relationship between the Shareholder owners and their agents the Directors and other managers who are often prone to favour their own interests at the expense of the shareholders.

(b) Trusts

We have seen in recent years the development of another type of legal “wrapper” for assets based upon the law of “Trusts”. This body of law is not based upon statute but has developed over hundreds of years through decisions by judges. Essentially a “Trustee” owns the relevant assets and revenues flowing from them on behalf of a “Beneficiary”.

Through the concept of the “Unit Trust” and the “Investment Trust” investors have been able to invest in assets – typically bundles of investments in companies.

More recently we may observe in Canada – principally due to the existence of a favourable tax regime – the emergence of “Income Trusts” or “Royalty Trusts” typically invested in oil and gas utilities and providing a stream of revenues based upon oil and gas production. These Income Trusts are hugely successful, particularly as an asset class for long-term investment by Pension funds.

We also see in the hugely successful business model of the Australian Macquarie Bank the advantages of acquiring assets using deficit-based financing and then refinancing them using asset-based financing through Investment Trusts.

Like Companies, Trusts also have flaws, being costly and complex to set up and to amend and also complex in terms of taxation. However, the principal problems are the management issues arising out of the restrictions of the Trustee/ Beneficiary relationship and the conflicts of interest inherent in the use of external managers /advisers.

“Co-ownership” – Asset-based finance through Partnership

There is in fact another possibility based upon the utilisation of a new type of legal “wrapper” based upon partnership principles.

The first example of an “Open Corporate” or “Corporate Partnership” is the new UK Limited Liability Partnership introduced on 6 April 2001. Confusingly, despite the name an LLP is not legally a partnership but is in fact – like a Company -a corporate body with a continuing legal existence independent of its Members. Also like a Limited Company an LLP has the benefit of limitation of liability, so that members cannot lose more than they invest.

In taxation terms an LLP is “tax transparent” – in other words as far as the Inland Revenue is concerned it is not taxed in its own right, but revenues pass straight through it to the Members who are then taxed individually.

Crucially, in an LLP it is possible for other stakeholders beyond the Investors to be Members. This quality of open-ness combined with infinite flexibility (since the LLP Member agreement is not prescribed and need not even be in writing) may mean that an LLP is an optimal vehicle for investment allowing the problems of existing legal vehicles to be transcended.

We may achieve this - notwithstanding Treasury-inspired restrictions upon “Investment LLP’s” generally and “Property Investment LLP’s” in particular – through a “Capital Partnership” which has three or four Members.

a “Trustee” member who owns the asset essentially as a custodian in accordance with Aims and Objectives expressed in the LLP agreement.
an “Investor” or “Capital Provider” member who invests money or money’s worth in assets into the partnership;
an “Occupier” or “Capital User” member; and
a Managing member ((optional).

The Capital User pays a “Capital Rental” to the Investor and/or Manager consisting of a share in the revenues produced by the assets in question. This Rental is not paid for a defined term but is paid for as long as the capital is used. Any rentals paid before the due date automatically become investment.

Co-ownership
The outcome of a “Capital Partnership” is “Co-ownership” between the Investor and the user of the Investment. The asset itself need never be sold again – remaining in Trust - although the Investors, Investment Users and Managers (if any) may change in accordance with the LLP agreement. This essentially comprises an entirely new property right, since the property relationship between an investor and an asset is being encapsulated in a radically simple new way without the conflicts in existing property law between the absolute rights of an “owner” and the temporary rights of a property user.

Open Capital: In terms of financial capital, we see a new “Open” form of “Capital” which is neither Equity nor Debt, as we know them, but something new and arguably optimal.

A transaction entered into in late 2002 by the Hilton Hotel Group serves as an example of a prototype “Capital Partnership”. The Hilton Hotel Group (the Occupier) invested a portfolio of ten hotels in a Capital Partnership LLP and development finance of some £350m was invested by another LLP linking three Investor Members who receive for 27 years a share of the gross revenues from these hotels. So if the Hilton Group has a good year, so do the Investors.

Proportional shares (“n’ths”) in such asset-owning LLP’s constitute an entirely new asset class not dissimilar to units in a unit trust, but simpler, tax transparent, and arguably optimal in the way that stakeholders’ interests are aligned.

Outcomes
The possibilities of “asset-based finance” as a technique are not limited to the private sector. There is no reason why public assets – such as new schools and hospitals -should not be financed by pension investors interested in a secure index-linked revenue stream using this technique.

In fact it brings in to question the “Public Sector Borrowing Requirement” since demonstrably borrowing is not involved. In addition to pension funding the asset class may also attract the huge amounts of petrodollars in the Middle East looking for Islamically sound investment opportunities.

In the housing sector we see the possibility of a new “Fifth Option” – “Co-ownership” by tenants in affordable/social housing financed by pension investment in property on land retained in trust for the community.

Chris Cook
September 2005