Insights / Structures
Hypothecation or asset sale: what the choice does to your balance sheet
· Capital Sources, LLC
An operator that finances its own customers ends up holding a book of receivables. At some point that book is either the most valuable thing the business owns or the thing that is strangling its cash, and often it is both at once. There are two ways to turn it into money without stopping the program: borrow against it, or sell it.
Hypothecation means the receivables stay on your books and a lender advances funds against them. The lender takes a security interest in the pool, advances a percentage of the eligible balance, and you continue to service the accounts and collect the payments. The customer never knows a lender is involved. You keep the interest income above the lender's cost, you keep the relationship, and you keep the credit risk. If the pool underperforms, the advance rate drops or the lender asks for more collateral.
An asset sale means the receivables leave your books. A buyer pays a price for the pool, usually expressed as a percentage of principal, and takes the risk and the reward from that day forward. Servicing may stay with you for a fee or may transfer to the buyer. You get cash now, your balance sheet shrinks, and you give up the future interest. A forward flow arrangement is the same transaction repeated: the buyer agrees in advance to purchase what you originate, at agreed terms, for an agreed period.
Which one is right depends on what you need the money for and how your book performs.
If your paper performs well and your margin above the lender's rate is meaningful, hypothecation usually makes more money over the life of the pool. You are renting capital rather than selling the asset that earns it. The cost is covenant discipline: eligibility rules, concentration limits, reporting every month, and a lender who will want to see your servicing up close.
If your paper is harder to underwrite, or your business needs its capital in the business rather than in a loan book, selling can be the better choice even at a discount. A dealer whose real business is selling equipment does not always want to be a finance company. A membership operator growing quickly may prefer to convert each month's originations to cash and let someone else carry the risk. The discount is the price of getting out of the lending business while still offering financing to customers.
Lenders and buyers price both structures off the same facts: the credit quality of the customers, the age and seasoning of the pool, delinquency and charge-off history, the average ticket and term, what the customer bought and whether it was delivered, and how well the accounts are serviced. A clean, well-documented book commands a higher advance rate or a higher purchase price. A book with thin documentation and inconsistent servicing commands a haircut, or no offer at all.
The decision is rarely permanent. Many operators borrow against the book while it is young and sell seasoned pools later, or sell current originations under forward flow while holding the older paper. The right structure is the one that fits what the business needs the capital to do this year.
Capital Sources places both structures with lenders and buyers who specialize in them. Tell us what you hold, roughly how much, and how it performs, and we will tell you plainly which structures are realistic and who is likely to look at it.