A Structured Lending Approach for Securities-Backed Financing

Introduction

Securities-backed lending, commonly referred to as “stock loans”, provides a strategic financing that enables shareholders of publicly traded equities to unlock liquidity without divesting their holdings. This lending mechanism allows borrowers to access liquidity without selling their securities, as they use their stocks as collateral for loans. This type of lending is particularly useful for high-net-worth individuals and business owners who wish to leverage their stock holdings for financial flexibility.

Stock loans have grown in popularity as an effective strategy for investors who want to maintain their market positions while monetizing their portfolios for additional capital. By securing a loan against their stocks, borrowers can achieve multiple financial objectives, such as business expansion, real estate investments, or simply covering short-term liquidity needs without triggering a taxable event from selling stocks.

Two Types of Stock Loans: Recourse and Non-Recourse

Stock loans come in a variety of structures, but they can generally be divided into two very distinctive groups: Loans with recourse and loans without recourse.

Loans with recourse are loans where the borrower remains personally liable for repaying the loan in case the collateral of shares does not cover the outstanding loan balance.

Non-recourse loans are loans where the lender’s only recovery option is limited to the collateral (stocks) and thus does not have any other claim against the borrower.

Loans with recourse are usually the type of securities-backed lending that banks and stockbrokers offer, while non-recourse loans are predominantly offered by a variety of lending institutions and hedge funds. As the risk to the lender is significantly higher in non-recourse loans than in recourse loans, the non-recourse lender will engage in different hedging strategies to mitigate the increased risk.

In this paper, we will take a deeper look at the non-recourse type of securities-backed loans.

Loan Structure Overview

The overall non-recourse loan structure is quite simple:

1) The borrower delivers the stocks as collateral to the lender,

2) The lender delivers the loan proceeds to the borrower,

3) At the end of the loan term (usually 3 years) the borrower repays the principal in full (bullet repayment) and the lender returns the pledged stocks to the borrower.

4) Interest is customarily serviced on a quarterly basis.

Should the borrower default, the lender retains the right to liquidate the pledged stocks to cover the principal, outstanding interests, etc., but does not have any claim toward the borrower, even if the value of the pledged shares is lower than any deficiency.

Given the complexity of the structure, the many variations, twists, borrower pitfalls, and small text, it is imperative that the borrower retains advisors validating that the loan offered is in the best interest of the borrower.

Key Loan Elements

The main elements of a non-recourse loan can be different to the recourse loan and are thus something the borrower should investigate and negotiate. The following are generally the main elements.

Loan-to-Value (LTV) Ratio: Typically ranges from 50% to 70%, depending on stock liquidity, volatility, and borrower profile. More liquid and stable stocks tend to receive higher LTV ratios, while less liquid or volatile stocks may qualify for lower ratios. Some lenders may adjust the LTV dynamically based on market fluctuations.

Liquidity Requirements: Eligible stocks must be freely tradable and not subject to restrictions that limit their transferability. The non-recourse lender will usually trade the stocks to hedge the risk and thus require title transfer of the stocks and/or the stocks to be placed in an omnibus account, which the lender has access to. Some jurisdictions find the title transfer to be a sale of the stocks (and the requirement to pay back the loan as an option), and the loan will be taxed as a sale of the stock. In these jurisdictions, a non-recourse loan with title transfer is not recommended.

Payment Against Delivery and Funding Protocols: The integrity of non-recourse loan arrangements is closely tied to the timing of disbursements. As lenders have the ability to trade the borrower’s stock, the lender can have the ability to fund the loan with the pledged stocks if there is no payment of loan proceeds against delivery of the stocks. The distinction between professional (legit) and non-professional (scammers) providers of stock loans is thus the timing of the loan proceeds. To make sure the lender has the loan proceeds, it is recommended that the lender show proof of funds no later than the time of delivery of the stocks. Further, a significant part of the loan proceeds – e.g., 50% – should be disbursed to the borrower when the stocks have been delivered and the remaining of the loan proceeds not more than one to three days thereafter.

Size of loan: The total size of the loan is subject to the value of the pledged stocks and the LTV ratio. But there are usually more restrictions on the size. First of all, the financial ability of the lender. Secondly, the fundamentals of the pledged stocks, especially the daily traded volume of the stock. This will usually dictate whether the loan proceeds can be distributed in one lump sum or in loan tranches. With the lender engaging in hedging activities, there is a limit to the individual loans/distributions, with a maximum usually the value of 5-10x the average traded volume. Hence, if the loan is USD 10M and the average value of the traded volume is USD 1M, the entire loan may be executed in one go or divided into two separate (payment against delivery) loans of USD 5 M.

Margin Calls: If the stock price declines significantly, the lender may require additional collateral or loan repayment. The higher the LTV, the lower the threshold of the margin call usually is. Borrowers should have contingency plans to meet such margin calls to avoid the liquidation of their securities and/or defaulting on the loan.

Costs and Interest Rates: Interest rates range from 3% to 10%+ annually. In addition, fees such as origination fees, administrative fees, and legal fees apply. The fees and usually the first quarterly interest payments will be deducted from the loan payments, as is usually the case with standard (bank) loans.

Benefits and Risks

The are benefits and risks, the main benefit being that the shareholders can liquidate their stock assets without having to sell their stock holdings, and the main risk being loss of control.

Benefits

• Liquidity Access: Borrowers can unlock cash without selling their stock holdings, making stock loans an effective tool for financial needs or investment opportunities.
• Tax Efficiency: Unlike selling shares, stock loans may defer capital gains taxes, allowing borrowers to optimize their tax liabilities while maintaining asset appreciation potential. This can be particularly beneficial for long-term investors who want to avoid triggering a taxable event.
• Portfolio Retention: Investors can maintain their equity potential future appreciation, avoiding the downside of missing out on future stock gains. This can be crucial in bullish market conditions where stock prices are expected to rise.
• Diversification Strategy: Investors can use stock loan proceeds to diversify their portfolios by investing in other asset classes, such as real estate, bonds, or private equity, reducing overall investment risk.

Risks

• Margin Calls: A decline in stock value may trigger a demand for additional collateral, requiring borrowers to provide extra assets or repay part of the loan. If the borrower is unable to meet the margin call, the lender may liquidate the pledged securities.
• Interest Costs and fees: Higher rates and fees compared to traditional secured loans can increase the cost of borrowing over time, impacting net returns. Borrowers should ensure that the benefits of stock loans outweigh the associated interest expenses.
• Stock Control and Loan Default: The Lender can trade the pledged stocks, and the loans may result in the loss of pledged shares if the borrower defaults, which could lead to unintended capital losses. Borrowers should work with reputable lenders to ensure fair terms and protection.
• Regulatory Risks: Securities-backed lending is subject to financial regulations that may vary by jurisdiction. Borrowers should ensure compliance with all applicable regulations to avoid legal and tax complications.

Conclusion

Stock loans provide an attractive alternative to selling shares by offering liquidity while retaining appreciation potential. Borrowers can use this financing tool for diverse financial goals, from expanding businesses to optimizing tax strategies. However, they must carefully assess LTV ratios, payment timing, interest rates, and margin call risks before entering into such agreements. Understanding the terms and conditions is crucial to maximizing the benefits while mitigating potential downsides.

Additionally, borrowers should select reputable lenders and advisors to ensure their interests are protected and that the loan structure aligns with their financial objectives. As financial markets evolve, stock loans remain a valuable tool for investors looking to maintain market exposure while accessing needed capital. Careful planning and due diligence can help borrowers leverage this financing method effectively while managing associated risks.

Kapital Partner

Denmark-based Kapital Partner has for decades assisted shareholders by unlocking the value of their portfolio by applying a variety of financial structures, including non-recourse stock loans. Kapital Partner acts both as a placement agent and purely as investors’ financial advisors, providing valuable insights and experience in global financial markets to our clients.

For more information, please visit: www.kapitalpartner.dk