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Caveat Legal

Caveat Legal

Caveat Legal

When a business decides to raise funds, it has a number of options available. The most common options would be in the form of a loan from a licensed institution (whether in the form of overdrafts, revolving credit facilities, syndicated loans or other forms) or to approach the capital markets. These loans would c be in the form of equity or debt (which includes securitisation).

Capital Markets

In today’s financial sector, capital markets are often favoured over traditional loan funding for a number of reasons. These include increased efficiency due to the documentation required being standardised, reducing the time required to issue the product to the market. This makes it more attractive to investors, particularly opportunistic ones. In addition, subsequent finance raisings are even more swift given that the programme is already established. The process can  therefore take as little as two weeks.

A key benefit to accessing capital markets is a diversification of funding sources given that the issue of a capital market instrument is open to a wider pool of investors, including both retail investors and institutional investors (including asset managers, pension funds, investment banks and insurance companies). Furthermore, one programme can comprise more than one option in terms of structure of the note issued under the programme. This could be notes with different applicable interest rates or notes specifically structured to meet the specific needs of a particular investor/type of investor. In securitisations, exposure for investors can also be limited to a specific asset base, giving investors additional security in  that they know what is backing their investment.

Cost of funding is always a critical factor in the process of determining which route to take in terms of fundraising . Capital markets as a source of funding are said to be less costly due to the fact that standardised documentation is used, reducing the legal costs required for negotiating the terms of the transaction. Pricing is also improved by competition between a large number of players  with deep pools of liquidity, compared to a finite number of lending institutions with limited access to funds. In addition, pricing is improved through the use of an auction format.

A number of investors prefer investments which can be further traded. The tradability of capital market instruments is accordingly often favoured by investors, given that the option of a secondary market allows for trading, whereas selling  participation in a loan is arguably far more difficult.

Securitisation

Securitisation is a debt capital markets instrument which involves a process of transforming non-tradeable assets into tradable securities through a structured finance process that distributes risk by aggregating liabilities and assets in a pool, and issuing new securities backed by that pool. Securitisation can be compared to secured lending. Secured lenders require borrowers to pledge specified assets as security for financing. Cash flows to the borrower, and then their assets are used as security to protect the lender in the event of default. In securitisation, the pool in the securitisation structure acts as security for the debt.

As a capital markets instrument, securitisation holds a number of advantages over the vanilla loan alternatives, including increased efficiency, diversification of funder resources, better pricing and better tradeability. It further holds the following advantages over its equity counterparts:

(i) Turning illiquid assets into liquid assets

(ii) Freeing up capital for the originator

(iii) Lowering the investment risk

(iv) Proper management and maintenance of the asset pool

(v) Diversity in an investment portfolio

(vi) Good regulation

(vii) Insolvency remoteness and originator liquidation

(viii) Minimal effect on borrowers/obligors

As with all financial instruments, there are certain potential issues which should be taken into account when selecting the instrument of securitisation, as follows:

(i) Risk of default on underlying loans

(ii) Early repayment

(iii) Lack of transparency of underlying assets

(iv) Investor assuming the role of a creditor

(v) Complexity of structure

(vi) Risks associated with the role of the arranger/originator

The economic rationale for securitisation of assets and liabilities is clearly motivated by the numerous benefits to both investors and originators. While there are potential concerns to be noted and considered in making the selection of securitisation, perhaps the biggest concern would be around defaulting borrowers, given the impact this can have (and historically has had) on financial stability, the 2008 financial crisis being the most notable example.

This risk is indeed mitigated by the strong regulatory environment in which financial markets in South Africa operate, in particular with regards to banking, advancing credit, and the stringent requirements as set out in the Securitisation Regulations.

Lisa Wake

Lisa has a BSocSci and an LLB and was admitted as an attorney in 2005. She progressed to the level of Director at Glyn Marais attorneys before moving to Eurasian Resources Group in 2010 where she worked as Deputy General Counsel: Africa. Lisa left ERG to join Caveat in 2020, specialising in corporate and commercial work.

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