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Utilizing Contracts as Collateral in Asset-Based Lending

This article was jointly authored by Roy D'Souza, Ed Usalis and Cari Jankuski of AccuVal, and first appeared in the February 2010 issue of Financier Worldwide.

Considerations for utilizing contracts as collateral

In very general terms, contracts derive value from their capacity to generate cash flows to their owners. The value of contracts is a combination of both the expected future cash flows and the uncertainty associated with these cash flows. As a result, the basic principles of discounted cash flow valuation apply. The following are the basic steps of discounted cash flow valuation. First, estimate the cash flows from the contract for the estimation period. Second, estimate the value of the contract, if any, at the end of the estimation period — if the contracts are tied to the rental/lease/use of owned fixed assets, a consideration of the residual value of the assets at the end of the contract period. Third, estimate a discount rate that reflects the riskiness of the cash flows. Finally, calculate the present value of the cash flows to arrive at the value of the contract.

When using long–term contracts as collateral, their value should be considered as if they were under distress since that would be the most relevant value for the lender. Additionally, an exit strategy for realizing the value of the long–term contracts needs to be explicitly considered. The exit strategy should include identifying the most likely market for the asset and the time and manner in which a sale could be consummated. The use of an ‘orderly liquidation value’ premise of value should address the potential for the borrower’s distress and the lender’s exit strategy.

Applicable situations

Based on our experience there are several situations where long–term contracts represent significant value and are conducive to asset–based lending.

First, there are situations where a borrower would sell both the capital good (i.e., the razor) and a consumable good (i.e., the razor blade). In these ‘razor–razor blade’ situations, there is often a long–term contract in place for the consumable good. These long–term contracts are particularly attractive to lenders for several reasons. In these situations, the sale of the consumable good is usually very predictable. Furthermore, the borrower typically earns a very attractive margin on the sale of these consumable goods. And, in the event of liquidation, another party could easily assume the long–term supply contracts for the consumable good based on the population of deployed capital goods.

Second, in the equipment leasing business, there are often circumstances in which the cash flows associated with long–term leasing contracts exceed the value of the underlying equipment. Since this situation includes both fixed assets (i.e., equipment) and periodic contractual cash flows (i.e., the lease payments), the lender can use both as collateral. By utilizing the fixed assets and contractual cash flows, the lender is able to maximize the collateral for the loan and make a loan that would otherwise be insufficiently collateralized.

Third, there are situations in which a borrower would have long–term contracts to provide a routine product or service on a regular interval (monthly, quarterly or annually). Because these contracts involve very predictable cash flows, they are amenable to being used as collateral. However, an appraiser should give explicit consideration to the associated renewal or cancellation rates, as abnormally high or unpredictable rates would diminish the value.

Finally, many manufacturers will enter into long–term contracts for the purchase and supply of raw materials. Given the recent volatility of commodity prices, these contracts may be at very favorable prices. In this situation, a favorable price provided by the contract may represent significant collateral value. This situation is further enhanced if the contract is for a commodity product that can be liquidated in the event of default. Unfortunately, the greatest risk in these situations is the raw material price risk and lenders should pay close attention to changes in the price of the underlying raw material.

The valuation process

When analyzing a borrower’s long–term contracts for use as collateral, there are a number of questions that a lender should ask. The most important questions include: How long have the contracts and accompanying cash flows been in place? Have these cash flows been declining, consistent or growing? What is the financial health of the borrower’s customers under these contracts?

To answer these questions, an appraiser would conduct a thorough investigation as to the key drivers that underlie any contract. This investigation will generally begin with a detailed interview with key company personnel. Through these interviews, the appraiser is gaining an understanding of the characteristics of the contract. Furthermore, these interviews will allow the appraiser to identify any opportunities or risks associated with the performance of the contract.

Next, the investigation would examine the underlying economics of the subject contract. By examining its financial performance and profitability, the appraiser is assessing historical performance and making judgments concerning its expected future performance. While the appraiser may receive the borrower’s input regarding this future performance estimate, the appraiser should employ independent judgment in arriving at these estimates. Specifically, the appraiser would consider factors beyond the borrower’s control in developing any expectations for future performance.

Finally, an appraiser would attempt to assess all of the risks associated with the performance of the contract. These risks would include borrower–specific considerations as well as broader economic and industry factors. Ultimately, these risks are reflected in the discount rate selected by the appraiser. It is in the discount rate that the appraiser may adjust for the ‘orderly liquidation value’ premise. Under the orderly liquidation premise of value, the risks and costs associated with having to liquidate the contract would be considered.

By applying a discounted cash flow valuation methodology to a specific contract, an appraiser could very transparently identify its value and associated risks. For example, the appraiser could limit the expected cash flows to a term that either matches the contract period or suits the lender’s underwriting requirements. Additionally, the appraiser could modify the contractual cash flows or the selected discount rate to approximate different levels of potential borrower distress. Regardless of the lender’s needs, these assumptions and value conclusions should be thoroughly documented in the appraiser’s report in order to maintain its independence.

During this continued difficult economic period where liquidation values of fixed assets are continuing to decline in many instances, a lender may be able to satisfy the collateral base requirements in certain scenarios through the inclusion of intangible assets, such as contracts, where the client would not otherwise qualify for that loan amount when only looking at traditional collateral sources. Lenders will obtain the greatest comfort from working with appraisers that understand the intricacies and complexities of valuing long-term contracts and the rationale behind asset-based lending decisions.

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About AccuVal
AccuVal provides a broad range of valuation, advisory and asset management solutions that contribute to growth or help ensure survival. We appraise the business enterprise and shareholder equity; bonds; intangibles and intellectual property; machinery and equipment; inventory; real estate and accounts receivables in over 100 industries worldwide. Learn more at www.accuval.net.