12 2 Funding: Introduction
ments can be defined through three key characteristics: (1) pooling of assets (ei-
ther cash-based or synthetically created); (2) tranching of liabilities that are
backed by the asset pool; and (3) de-linking of the credit risk of the collateral asset
pool from the credit risk of the originator, usually through use of a finite-lived,
standalone special purpose vehicle (SPV).^27
In short, a typical structured finance transaction involves the pooling of assets
that generate a cash flow and the sale by an SPV of debt instruments (bonds or
notes) backed by those cash flows. Whether the SPV can repay its debts depends
on the cash flow generated by the pooled assets.
Project finance. There is a large variety of particular forms of finance. Project
finance is a form of “asset-backed finance”. It is provided for a legally and eco-
nomically self-contained project (a “ring-fenced” project). The project finance it-
self has two elements: equity capital, provided by investors in the project; and pro-
ject finance debt, provided by lenders. Project finance debt differs from normal
bank loans because the loan will be repaid from the future cash flow of the project.
Takeover finance. The firm may need to raise large sums of money when it ac-
quires a business undertaking. There are many forms of takeover financing. A
small-scale buy-out might simply be financed by bank borrowings. There may be
an exchange of shares. Mature companies may be able to raise this funding
through the stock market. There can be a mixture of debt and equity finance. If the
buy-out is very large, the loan may come in the form of a syndicated loan. The
assets of the target are an important source of takeover finance; private-equity
firms have perfected a technique called refinancing in order to repay short-term
takeover loans from the assets of the target.
Trends. Generally, a higher gearing was characteristic of corporate finance in
the early 2000’s. A higher gearing was caused in particular by three things: (a)
corporate takeovers; (b) the existence of a market for corporate control (i.e. the
threat of takeovers) as well as share-boosting measures that increased debt on the
balance sheet; and (c) the demand for higher-yielding assets (caused by low inter-
est rates and abundant liquidity in the early 2000’s).^28
The credit markets were therefore the motor for three of the big trends of the
first decade of the 2000’s. First, companies raised more and more capital through
privately-issued loan instruments. Second, the lending was increasingly designed
from outside the regulated banking industry. Third, much of the debt was raised
by leveraged buy-out firms and private equity funds.^29
(^27) BIS, CGLS, The role of ratings in structured finance: issues and implications, CGFS
Publications No. 23 (January 2005).
(^28) In the shadows of debt, The Economist, September 2006: “This means new firms, such
as hedge funds, have flocked into the loan market, where they can super-size yields by
investing in tranches of debt with a higher risk of default, and by borrowing from banks
to buy those loans.” “Also, the desire of pension-fund managers to buy long-term assets
to match their payout commitments has led them into most parts of the credit market.
Mutual funds and insurers have flocked in to diversify their portfolios and to spice up
their returns.”
(^29) In the shadows of debt, The Economist, September 2006.