Off-Balance Sheet Financing Dr Clive Vlieland-Boddy Why is Off-Balance Sheet Financing Important? • In other words, why are firms so interested in “hiding” debt? – If analysis reveals that debt is excessive, companies may face the prospect of a reductions in bond ratings, resulting in higher cost of debt. – Likewise, excessive leverage can result in a higher cost of equity capital and a consequent reduction in stock price. “Window Dressing” Financial Statements: Examples #1 • A company is concerned that its liquidity may not be perceived as sufficient. • Prior to the end of its financial reporting period it takes out a short-term loan from its bank in order to increase its reported cash balance. The same result can also be obtained by delaying payment of accounts payable. • In both cases, the company’s cash and current assets have been increased. • Even though current liabilities are also higher, the liquidity of the balance sheet has been improved and the company appears somewhat stronger from a liquidity point of view. “Window Dressing” Financial Statements: Examples # 2 • A company’s level of accounts receivable are perceived to be too high, thus indicating possible collection problems and a reduction in liquidity. • Prior to the statement date, the company offers customers an additional discount in order to induce them to pay the accounts more quickly. • Although the profitability on the sale has been reduced by the discount, the company reduces its accounts receivable, increases its reported cash balance and presents a somewhat healthier financial picture to the financial markets. “Window Dressing” Financial Statements: Examples # 3 • A company may face the maturity of a long-term liability, such as the scheduled maturity of a bond. • The amounts coming due will be reported as a current liability (current maturities of long-term debt), thus reducing the net working capital of the company. • Prior to the end of its accounting period, the company renegotiates the debt to extend the maturity date of the payment or refinances the indebtedness with longer-term debt. • The indebtedness is, thus, reported as a long-term liability and net working capital has been increased. “Window Dressing” Financial Statements: Examples # 4 • The company’s financial leverage is deemed excessive, resulting in lower bond ratings and a consequent increase in borrowing costs. • To remedy the problem, the company issues new common equity and utilizes the proceeds to reduce the indebtedness. • The increased equity provides a base to support the issuance of new debt to finance continued growth. Motives for using Off-Balance Sheet Financing • In general, companies desire to present a balance sheet with sufficient liquidity and less indebtedness. • The reasons for this are as follows: liquidity and the level of indebtedness are viewed as two measures of solvency. • Companies that are more liquid and less highly financially leveraged are generally viewed as less likely to go bankrupt. • As a result, the risk of default on their bonds is less, resulting in a higher rating on the bonds and a lower interest rate. Off-Balance Sheet Financing • Off-balance sheet financing means that either liabilities are kept off of the face of the balance sheet. • In this module, we discuss leases, pensions, variable interest entities (called Special Purpose Vehicles SPVs or Special Purpose Entities. SPE’s in the past), and derivatives. Leasing • • A lease is a contact between the owner of an asset (the lessor) and the party desiring to use that asset (the lessee). Generally, leases provide for the following terms: 1. The lessor allows the lessee the unrestricted right to use the asset during the lease term 2. The lessee agrees to make periodic payments to the lessor and to maintain the asset 3. Title to the asset remains with the lessor, who usually retakes possession of the asset at the conclusion of the lease. Advantages to Leasing Leases often require much less equity investment than bank financing. That is, banks may only lend a portion of the asset’s cost and require the borrower to make up the difference form its available cash. Leases, on the other hand, usually only require that the first lease payment be made at the inception of the lease. Since leases are contracts between two willing parties, their terms can be structured in any way to meet their respective needs. If properly structured, neither the leased asset not the lease liability are reported on the face of the balance sheet. Financing or Capital vs. Operating Leases Financing / Capital lease method. • Essentially a way to finance the asset • This method requires that both the lease asset and the lease liability be reported on the balance sheet. The leased asset is depreciated like any other longterm asset. The lease liability is amortized like a note, where lease payments are separated into interest expense and principal repayment. • Example: A new Truck or Plane Operating Lease Operating lease method. • Under this method, neither the lease asset nor the lease liability is on the balance sheet. Lease payments are recorded as rent expense when paid. • Example: Renting a car for 3 days from Hertz! Accounts Receivable Factoring • One of the major assets of many businesses are the RA, the monies due from customers. • These can form the source of finance. • Either Recourse where the responsibility of collection is with the company or Non Recourse where the financing entity take on this responsibility. • Again “Substance over Legal Form” will apply Advantages of Factoring • A short term quick solution that can bring cash and help the company meet its short term obligations. • The fees are usually based on the credit worthiness of the company’s accounts receivable (the company’s clients) and not on the credit worthiness of the company itself. • The transaction is not secured with any of the company’s assets. • The company does not increase its debt putting at risk any bank covenants. Disadvantages of Factoring • Is it only a short term solution that should be used when the company faces liquidity problems. • The fees including any interest payment can be substantial. • It can be perceived by creditors and investors as a signal of debt and liquidity problems. • Often seen as first step towards bankruptcy! • Recourse Factoring • Here basically a loan or advance is provided to the company by the finance entity. • The assets remain the property of the company. • The AR are shown in current assets and the loan as a current liability Non Recourse Factoring • Here the debt is sold and the collection down to the financing entity. • The difference between what the dedt is sold for and what is received is recognised in the income statement. • Normally not 100% financed so balance unfinanced will still show under current assets. Pensions • After many bankruptcies where the employees retirement funds have been lost, the concept of taking the pension responsibility out of the company has gained considerable momentum. • Now only a few companies still hold the pension within their own control. Pensions Companies frequently offer retirement plans as an additional benefit for their employees. There are generally two types of plans: Defined contribution plan. This plan has the company make periodic contributions to an employee’s account (usually with a third party trustee like a bank), and many plans require an employee matching contribution. Pensions Defined benefit plan. • This plan has the company make periodic payments to an employee after retirement. Payments are usually based on years of service and/or the employee’s salary. The company may or may not set aside sufficient funds to make these payments. As a result, defined benefit plans can be overfunded or underfunded. Special Purpose Vehicles SPV’s or Special Purpose Entities (SPE’s) • Created to hold assets and or debt away from the sponsor company. • Takes risks away from the sponsor company. • To avoid consolidation must be under separate ownership and control from sponsor. Project and Real Estate Financing • • • • SPv’s are often used to take uncertainty away from the sponsors balance sheet. Real Estate transactions are usually heavily funded and can normally be separately funded by loans. Taking the asset and the debt away from the sponsors balance sheet can greatly improve the liquidity appearance. Likewise speculative activities such as say the development of a software project or developing a new product could be taken off the balance sheet to a separately controlled SPV. If it fails then it would have no negative effect on the sponsors Income Statement. Reporting of Consolidated SPV’s • Accounting Standards require consolidation. • Generally, any entity that lacks independence from the sponsoring company and lacks sufficient capital to conduct its operations apart from the sponsoring company, must be consolidated with whatever entity bears the greatest risk of loss and stands to reap the greatest rewards from its activities. Enron • They used SPV with disguised ownership through New York Attorneys. • They created false profits selling off assets for many times their real value. • To enable these to be done, they would back the SPV’s borrowings by loaning shares in Enron as security. Lehmann Brothers • They employed a system called Repro. • A day or so before the year end they would sell off a large portfolio of Sub Prime Loans to another bank at full book value. • The balance sheet then showed a false but strong position. • A few days later they would buy the loans back… As agreed!