Asset-based lending is a strategy employed by some hedge funds that has been gaining popularity in recent years. Asset-based lending is where a company (the hedge fund) loans another company a set amount of money, and that loan is backed by collateral (an asset).
Let’s say a builder is in the process of constructing a tower and funds run dry. The builder will receive a loan from the hedge fund and put the tower up as collateral. If they fail to repay the loan, the hedge fund gets ownership of the tower. Usually, asset-backed loans have a very high percentage rate, and are generally considered to be a last resort for some companies. However, if they cannot secure a loan from a bank, an asset-backed loan may be their only option in order to complete the project.
While hedge funds that employ the asset-backed lending strategy are thought to be independent of market conditions, the current economic conditions are the ideal setting for these types of funds. With the subprime mortgage meltdown and the $285 billion in losses suffered by the banks, loans are much harder to secure. If the company must choose between an abnormally high interest rate offered by a hedge fund or to leave their project unfinished, they are going to choose the higher interest rate.
So how does an investor make money off an asset-based lending hedge fund? Quite simply, the investor shares profits from the high percentage rates. As long as the companies do not default on their loans, the hedge fund will make a sizable amount of capital from those percentage rates. If the companies do default on their loans, the hedge fund manager then moves to reorganize the project. This may include finding new project managers, completing the project, or finding a buyer.