We can say, finance for businesses is what food is for our bodies. Like we require food to carry out various functions, a business requires finance for almost everything. Like we are often advised for a balanced diet for proper nutrition, but we can also consume anything, and everything which is not good for health, the very same difference is when a business follows any financial strategy and when it follows a structured financing strategy for specific needs and goals.
What do we mean by structured finance?
- All the businesses do not have needs and goals, which are common, so structured financing offers large businesses, i.e. the borrowers' composite financial instruments, which provide a large amount of funding and help in transferring risk.
- When any business, especially those working on a very large scale, analyze all the financial aspects( sourcing, utilization, cost, risk and return, ownership) and adopt a strategy for finance that fulfills all the specific objectives related to these factors as well as helps in fulfilling the overall objectives of growth and profitability of the business which the conventional financial strategy cannot fulfill.
- The company here is opting for financial products that are non-conventional for their specific needs and goals.
How is it done?
- A proper evaluation is carried out by the bank in which the debt requirement, credibility, and capital availability are assessed before it grants the finance.
- An SPV is created for the purpose of risk mitigation in which investment is differentiated from the promoters/sponsors.
- Out of the two ways of collaterals -debt against a property and contractual guarantees the latter is given preference to show perpetual cash flows.
Why is it important?
- The strategy and instruments are customized as per the fundamentals of each business which makes the prospects of achieving the overall goals even better.
- The various products of structured finance involve entities that have greater credibility and expertise, such as banks, big investors, and financial institutions.
- The main idea behind them is to lower the risk with a combination of different instruments in one.
- These are non-transferable, unlike the standard loan, which can be easily shifted between various types of debt.
- The companies can use structured financing to restructure debt, make savings on repayments, and free up working capital.
Benefits of structured finance
The benefits as discussed above are:
- A large amount of inflow is available as structured financing when a company requires
- Offers avenues for growth and increases reach.
- Risk is transferred from sellers to buyers, so liquidity is improved.
Refers to how the same pool of assets is used to create different security classes with different credit ratings. Different investment classes are created through this, and cash flow is diverted from the underlying asset to various investor groups.
Credit Enhancement happens when security created from an underlying pool of assets has a higher rating than the entire pool. For example, this happens when subordinate bonds are issued, and any losses before being allocated to the senior bonds are allocated to the subordinate bonds.
This is the process by which asset pools and structured yet complex financial products are created to satisfy the needs of corporations and investors.
It is beneficial because:
- The specific funding needs are satisfied.
- Mitigation as well as the transfer of risk
- Cost-saving and better utilization of available capital
Examples of structured finance
These securities are backed against a pool of assets, also known as ABS. Examples are credit card receivables and auto loans.
These are extremely credit-worthy.
These are asset-backed securities backed by a pool of mortgage, i.e. principal and interest payment of loans.
Collateralized mortgage obligations
When mortgage-backed securities are securitized, it is known as collateralized mortgage obligations. The investors usually receive predetermined interest and principal payments on these.
Hedging is what credit derivatives do against credit risks by transferring risk between the protection buyer and seller. Collateralized debt obligations(CDOs)
- Hybrid securities
- Syndicated loans
- Collateralized bond obligations(CBOs)
- Credit Default swaps(CDSs)
- Collateralized mortgage obligations
All in all, the conclusion is, even though slightly complex, structured financing is a great way to go for a company in case of specific requirements. Apart from that, even with basic financing, a proper structure should be adopted which defines the requirements, sources, cost, risk and return from different sources, avenues for utilization, ownership structure properly. All of them are considered for the adequate amount of finance to be kept as fixed capital and working capital requirements and for special cases already know the solution, structured financing.