Editor’s Note: Al Christy, founder and president of Equities First Holdings, a securities-based lender based in Indianapolis, IN, compares types of lending and highlights points borrowers need to consider when raising capital. The views expressed are the author’s.

If much of your net worth is held in a stock-based portfolio and you are in need of liquidity, a stock-based loan can present an attractive alternative to traditional lending sources.  

Essentially, there are two types of loans that an investor can make using stock as collateral: margin loans and stock-based loans. Margin loans are offered by brokerage firms, which typically offer loans of up to 50 per cent of the stock’s value. On the other hand, companies specializing in stock-based loans can offer borrowers up to 80 per cent of the value of their stock.

Margin calls

Stock-based loans offer a great deal of flexibility in the amount that can be borrowed, which can range from $100,000 to $10 million, depending upon the lender. In addition, stock-based loans have other attractive features over conventional margin loans, such as lower fixed interest rates, which are usually 4 per cent or less. Almost all stock-based loans are not subject to margin calls. 

A margin call occurs when the margin posted in a brokerage account is below the minimum requirement. In the event of a margin call, an investor either has to increase the margin that they have deposited or close out their position. They can do this by selling the securities, options or futures if they are long or by buying them back if they are short. But if they do neither of these, then the broker can sell any of the securities from their portfolio to meet the margin call.

By contrast, a stock-based loan is nonrecourse. If the value of the collateral does suffer a steep decline, the borrower has the option of terminating the loan, or keeping the loan proceeds without further obligation. If the stock appreciates, the borrower retains 100 per cent of the upside market value after paying back the original loan. 

Stock-based loans offer investors a type of hedging strategy. In the current volatile market, many borrowers are turning away from margin loans due to the increased risk of a decline in their portfolios, resulting in greater losses in the event of a margin call. With a stock-based loan, the borrower has the downside protection of not risking a margin call against the whole portfolio, while retaining the upside potential of the stock over the life of the loan, which is typically a three-year term.

Most stock-based loans are relatively simple transactions. Virtually any publicly-traded stock can be used as the basis for a loan. The lender accepts any free-trading and transferrable shares that have at least $50,000 in daily trading value. US-listed, OTC, and most international exchange-listed stocks are eligible. There are no restrictions on how proceeds of a stock-based loan can be used. In our experience, securities-based loans have been used to expand a business, refinance a commercial mortgage, or even pay for medical expenses. Borrowers are free to use the proceeds to buy shares of the stock that’s been loaned, if they aren’t using the funds for other purposes. Other lenders may have different requirements.

In today’s volatile markets, stock-based loans have become an attractive alternative for individuals around the globe seeking liquidity for personal and professional use. 

Knowledgeable wealth managers have examined stock-based loans as ways to provide liquidity to clients who may not fit a traditional bank lending profile. Because transactions throughout the industry are customized and private, there is no publicly available information regarding the industry’s size, but based on our own growth and the market dynamics, we believe it is growing at a healthy rate.

Recommendations

In May 2011, the Financial Industry Regulatory Authority (FINRA) in the US issued an investor alert on stock-based loan programs, covering areas that include:

·         What are non-recourse stock-based loan programs and who markets them?

·         Who markets stock-based loan programs?

·         How do non-recourse stock-based loan programs work?

·         What are the risks and other considerations?

·         How can I protect myself?

(We recommend everyone considering a securities-based loan review this alert, here.)

While stock-based lending firms themselves are not regulated, the partners they work with, including the global custodians and law firms, are highly regulated.

Turning to the loan itself, prior to signing and the commencement of the loan’s term, it is standard best practice for the lender to offer resources regarding the proposed transaction so that the investor can conduct effective due diligence. 

We advise prospective borrowers to ask extensive questions about the lender’s track record in returning stock at the end of the term of the loan. They should also seek assurances from the lender that there is no ripple effect on the value of the borrowed stock while it is in the lender’s hands and if the stock is sold. The lender should provide references in this regard.

During the term, the investor is provided with statements every quarter that summarize their interest charge and any dividends to which their shares are entitled. The investor has the additional option to request the current valuation of his or her pledged agreement at any time during the loan term.

For some, stock-based loans provide a superior alternative for people who don’t want to liquidate securities to raise money they need by providing flexible access to a portfolio’s borrowing power. In addition, they offer many other advantages noted above, including higher loan-to-value ratios, lower interest rates, as well as borrower discretion in how the funds are used.