Should You Raise Capital by Leveraging Real Estate, Securities, and Luxury Assets?

Raising capital for a business venture is not always as straightforward as heading to a bank for a lump-sum loan or line of credit. Instead, many entrepreneurs explore alternative financing to raise funds in ways that are less common but sometimes just as effective. Alternative financing is a term that describes an array of non-traditional methods and approaches to obtaining capital.

Two such instruments — collateral loans and securities-based loans — often serve as focal points for clients needing liquidity. While both hinge on leveraging assets, they exhibit distinct characteristics. Before deciding if you might want to use securities or assets for loan collateral, it's important to understand those characteristics, common uses for this type of funding, and the advantages and risks of each. 

A collateral loan, allows an individual or entity to borrow money against the value of an asset or multiple assets, which then serve as collateral. Common assets used for collateral loans include real estate, machinery, luxury vehicles, yachts, aircraft, jewelry, precious metals, or fine art.

On the other hand, a securities-based loan is more specialized, enabling borrowers to leverage the value of their investment portfolio — stocks, bonds, or other securities — as collateral. Securities-based loans are often favored for immediate liquidity needs, diversification strategies, or short-term financing without liquidating an investment portfolio.

However, using securities to secure a loan is not advisable during volatile market conditions. If market values decline and the loan value exceeds a specified percentage of the securities' value, borrowers might have to deposit additional funds or securities. Similarly, with collateral loans, if a borrower defaults, the lender can seize the asset. In a real estate scenario, this would mean foreclosure.

If you're seriously considering using either collateral or securities-based loans, it's important to understand the specific advantages and risks of each. Let's first look at the process of securing alternative financing. Then, we will examine why a borrower might have an advantage with alternative loan financing and what can happen to borrowers if they default on repayment. 

Applying for Alternative Financing

Pre-Application:

The first step to obtaining either a collateral or securities-based loan involves organizing and evaluating the value of the items you intend to use to secure the loan. 

Collateral loan: Using tangible collateral will likely necessitate a professional appraisal. The lender will conduct their valuation of the asset and quote the funds they are willing to loan against that collateral. This is usually expressed as a percentage of the secondary market value of the collateral, or a loan-to-value ratio (LTV).

Before applying for a collateral loan, you will also want to get professional appraisals for high-value items and secure proof of ownership and asset-related documents. Doing so will be in addition to all the documents an approved lending institution will require prior to making any loan. 

Securities-based loan: If you're going for a securities-based loan, the lending institution will review your investment portfolio by examining the types and quantities of securities held, current market prices, historical price fluctuations, recent market trends, and any anticipated market events that could affect the securities' value (this is called volatility). They pay particular attention to the liquidity and trading volumes of the securities to determine ease of sale in case of default. Additionally, they assess the portfolio's diversification, favoring a mix of assets to mitigate risk. 

Before applying for a securities-based loan, you will want to 

• Compile recent statements of all investment accounts
• Understand the liquidity and volatility of securities in your portfolio
• Gather any relevant tax documents related to the investment portfolio 
• Be aware of any restrictions or conditions associated with selling or pledging specific securities.

Application: 

When applying for either loan, borrowers will be asked to complete a detailed application, providing personal, financial, and/or asset-related information. Typically, lenders thoroughly review the borrower's credit history and current financial standing. Even when an asset backs a loan, and it is often easier to obtain secured loans with poor credit compared to unsecured loans, most lenders will still perform a credit check for several reasons.

First, a credit check provides a comprehensive view of the borrower's financial history and gives lenders insight into their likelihood of defaulting. True, securing a loan with assets ensures the lender can recoup the loan amount if the borrower defaults. But still, it doesn't guarantee the borrower's current capacity to make regular loan payments. 

Second, lenders will often use credit scores to set interest rates. Borrowers with higher credit scores usually receive lower interest rates. In comparison, those with lower scores are often charged higher rates due to the perceived increased risk, even if there's collateral involved.

Third, a credit check can also influence Loan Amount Determination alongside the value of any collateral or security. For example, someone with poor credit might receive capital at a lower LTV ratio, whereas someone with excellent credit might receive capital at a higher LTV ratio.

Finally, lenders must abide by internal policies or external regulations that stipulate the requirement of performing credit checks on all loan applications to ensure consistent lending practices.

Loan Approval: 

Once all checks and appraisals are satisfactory, the loan is approved, you will agree upon terms, the lending institution formally accepts the asset as collateral until full repayment, and funds are released.

For collateral loans, the asset is deposited or held by the lender in a secure location (or, in some cases, just the title is held, and the lender becomes a lienholder), pending repayment of the loan. 

For example, in the case of fine art, here's the process used by Artnet and Luxury Asset Capital (LAC), who recently introduced an art secured lending partnership: Clients initiate the loan process through an inquiry on Artnet's website. LAC underwriters use pertinent valuation information from Artnet's database to quote an initial loan amount. If the client accepts the initial quote, there will be physical inspection of the art, supporting documentation creation, and final loan quote preparation. The art is fully insured and held at a secure LAC facility, and loan funds are wired.  The client redeems their collateral once they repay the loan.

The full application process for collateral loans can span anywhere from a few days to several weeks, depending on the asset's type and the required due diligence. 

Upon approval of a securities-based loan, the lending institution places the borrower's securities in a separate pledged account. The pledged securities remain in this account throughout the loan duration, but the lender does not sell them. However, the lending agency has the right to lend these securities to other parties, generating additional income while awaiting repayment.

Given their more standardized nature, securities-based loans can be processed in a time frame ranging from a day to a couple of weeks, contingent on the institution and the complexity of the portfolio.

In both cases, prospective borrowers should consult with financial professionals, ensuring they are well-versed in the intricacies and obligations of their chosen lending instrument.

Advantages and Risks

Advantages of Both Collateral and Securities-Based Loans

In general, for any type of secured loan, the tangible security of collateral reduces the lender's risk and can result in advantages such as: 

Risk Offset: Borrowers with less than perfect credit scores may still qualify due to the security provided by the asset(s).

Flexibility and Negotiation: Offering any type of collateral provides a basis for borrowers to negotiate better terms or larger loan amounts. 

Quick Liquidity: Borrowers can access funds without first selling their investments.

Maintained Investment Position: Borrowers retain ownership of their assets or portfolios and can reap any benefits, such as appreciation and dividends.  

Risks of Loan Defaults and Market Fluctuations

One of the most important aspects to understand regarding any type of secured loan is what happens if there is a failure to repay the loan. No one intends to default on a loan, but before securing any loan, borrowers must responsibly educate themselves on "worst-case scenarios." Further, borrowers must understand what happens when their assets decline in value or markets fluctuate, and how their liability could end up exceeding their asset value.

Collateral Loan 

The consequences of a worst-case scenario with a collateral loan can be profound. Upon default, lenders have the contractual right to seize listed assets to recover the outstanding loan amount. However, the process isn't instantaneous. Prior to asset seizure, lenders typically provide a notice to the borrower. This notice informs the borrower of the default and provides a grace period, during which the borrower can rectify the situation by clearing the overdue amounts or negotiating revised terms. 

Should the borrower be unable to address the default within this grace period, the lender can proceed with the seizure and sale of the collateral using the proceeds to offset the outstanding loan balance. It's crucial to note that if the sale of the collateral doesn't cover the entire outstanding balance, the borrower remains liable for the deficit.

One often overlooked aspect of defaulting on a collateral loan is the resultant impact on the borrower's credit history. A default is a significant negative mark and can considerably lower one's credit score, making future borrowings more challenging and potentially more expensive.

Securities-based Loan Default and Margin Calls

In a securities-based loan arrangement, when you pledge your securities as collateral, you enter into an agreement granting the lending institution the right to sell the pledged securities to recover the outstanding loan amount. The sale process is initiated without the borrower's consent, potentially leading to the liquidation of assets at unfavorable market conditions. This sale can trigger tax implications for the borrower, depending on the capital gains or losses realized.

Another aspect to be aware of with securities-based loans is a margin call. A margin call is triggered when the market value of the pledged securities drops below a predefined percentage of the loan's outstanding amount. This decline means the collateral no longer provides sufficient coverage for the loan, elevating the lender's risk. The exact threshold varies but is usually influenced by the overall volatility of the securities in the portfolio and the borrower's creditworthiness.

To rectify a margin call or halt the default process, a borrower typically has three primary options: deposit additional funds to cover the deficit, pledge more securities as collateral, or sell a portion of the securities to reduce the loan balance. Engaging promptly with the lending institution is crucial, as swift communication can sometimes lead to negotiated solutions or extended timelines for addressing the margin deficiency.

Final Thoughts

When considered carefully and entered responsibly, loans secured with collateral can present a powerful financing option for personal and business needs. As with all financial instruments, their efficacy is contingent upon judicious use, a thorough understanding of their terms (especially in the worst-case scenarios) and a careful vetting of the proposed lender. Borrowers must weigh the inherent risks and advantages, ensuring their choice aligns with immediate financial objectives and overarching fiscal health. In a world of burgeoning financial opportunities, making informed decisions can enable you to let your valuable assets pave the way for your financial success.