INTM579010 - Thin capitalisation: lending against asset values: Lending against assets in general

Lenders may be cautious or ready to take risks, but where they can they will seek to reduce that risk as far as possible. The lender does not want to be exposed to the commercial risks of the borrower - that the business might fail. A secured lender is able to enforce its rights in the event of a default by seizing and (in most cases) selling the property against which the debt was secured. Enforcing such a right may spell the end for a struggling business, since realising these assets may take away the debtor’s means of trading. This is why there may be legal restrictions on the ability of secured creditors to enforce their rights, such as administration in the UK and Chapter 11 bankruptcy in the USA, both of which offer periods of protection against creditors. Equally, if there is a reasonable chance of recovery, the bank will not want to “pull the plug” and deprive the company of the assets with which it trades. In that light, any contention that assets of a company may be used as security for a loan from a connected party, and perhaps thereby increase the amount of the loan, needs to be looked at closely.

In all cases, consider what might happen if the borrower defaults on the loan. The lender may take possession of the assets which have been pledged as security, and arrange for their sale. Not only will there be expense incurred in doing this, but there is likely to be uncertainty as to the realisable value of the asset, for a number of reasons:

• it may be known by the market that the sale is a forced one
• assets appropriate to a particular trade or industry may not be attractive to buyers where the circumstances -from personal through local to global - which led to the business failure, may still apply to a successor
• assets may be so specialised that there is no market for them, competitors already being similarly equipped
• lenders are not in the business of buying and selling a possibly wide range of assets and naturally prefer not to get involved.

A lender will never lend 100% of the value of an asset solely on the strength of that value, though it may appear so if the lending is low risk for extraneous reasons. The amount which a lender will advance depends on the nature of the asset. Plant and machinery, for example, will be heavily discounted. Buildings and land on the other hand, while still being discounted to some extent, generally retain value and can attract a loan which represents a higher proportion of the asset.

Lenders sometimes refer to the loan to value ratio, or LTV ratio, in a particular case. This is the proportion of the value of the asset they are prepared to consider as the maximum amount of loan. For plant and machinery the LTV ratio will be quite low, while buildings and land can have higher LTVs. The following pages of this chapter consider this in more detail.

In all cases where an LTV ratio is in point, it should be remembered that it is just one factor among several that a third-party lender takes into account. Lenders will always be asset aware because they look for security, but the ability to service a debt - pay back both the interest and the borrowed capital - remain key factors to which an LTV ratio is a contributor.