Should You Leverage Illiquid Assets to Borrow?

Many people may assume ultra-high-net-worth (UHNW) individuals have few financial concerns or challenges, but that assumption is usually far from the truth. In fact, given the sheer magnitude of their financial transactions and wealth goals, there’s often much more at stake regarding their specific concerns and challenges.

For instance, UHNW individuals may need to take on debt for any number of reasons, such as to fund investments or business acquisitions/expansion, or to cover certain personal expenses. Whatever the reason, it’s not uncommon for UHNW individuals to incur debt periodically in the form of a loan. Where a challenge may arise is the pledging of requisite assets used as security for loan repayment (i.e., collateral), which can be forfeited to the lender in the event of a loan default. Let’s explore the ins and outs of getting a loan by using collateral.

Pledging illiquid assets

Many UHNW individuals have built their substantial wealth through assets that are considered “illiquid,” which means they’re not readily accessible to be converted into cash. Here are some examples of illiquid assets that are often used as collateral for a loan:

• Real estate: Includes primary residences, vacation homes and investment properties 
• Private company holdings: Shares in private companies or private equity/fixed income funds 
• Art and collectibles: Fine art, antiques or other highly valuable collectible items 
• Private luxury vehicles: This category includes private jets or yachts, and expensive cars 

That’s why, in order to achieve a particular spending goal, UHNW individuals may need to pursue a collateralized loan facility rather than using cash or other liquid assets. Or, they may have sufficient liquid assets available but simply prefer not to use them at this time. Given that collateralized loans can be more expensive relative to conventional loans involving liquid assets, it’s not typically recommended to take out a loan against illiquid assets unless there’s an immediate liquidity need.

Potential benefits of UHNW lending

One possible advantage of using illiquid assets to secure a loan is that the UHNW individual only needs to pledge these assets for the loan, and not actually sell them. This can be a benefit when certain assets carry personal or sentimental value, or when the timing wouldn’t be ideal to sell (e.g., a depressed real estate market might mean that the current valuation of a particular property is below what the UHNW individual believes its fair value should be (or could be in the future).

If you borrow via the pledging of illiquid assets to pursue some type of investment growth, you create the opportunity to leverage these existing assets and potentially increase your overall investment returns. When leveraging an asset for borrowing purposes, you may wish to perform an analysis to compare the rate of interest you’ll be charged versus an expected rate of return on the asset. This will help determine your “break-even” point and whether or not you’re likely to come out ahead. If it’s decidedly unfavorable, consider a traditional loan at a lower interest rate, provided that you have access to enough cash or other liquid assets.

Borrowing via an asset pledge may also provide tax advantages relative to selling an asset and paying capital gains tax on the sale. This form of borrowing also allows you to maintain your chosen investment strategy, whereas selling assets could disrupt your diversification efforts if you become too concentrated in – or lack the desired exposure to – certain areas of investment, possibly causing undue risk.

Potential drawbacks of UHNW lending

If a UHNW individual is seeking a loan against illiquid assets from a bank, the institution will usually require evidence of an already-established, significant personal banking relationship. That won’t always be the case. However, if such a relationship doesn’t exist with a bank, it’s possible to use non-bank lenders for these facilities as an alternative. Also keep in mind that lenders typically set the maximum loan-to-value (LTV) relatively low when illiquid assets are involved. LTV represents the percentage of the asset’s value that the loan cannot exceed, so a lower LTV means you must pledge more illiquid assets for a certain loan amount than you would with most liquid assets.

As well, the interest rate charged on a collateralized loan may vary depending on factors such as the lender, the borrower’s creditworthiness and the type of illiquid asset being pledged. A lender will conduct thorough due diligence on the assets being used as collateral, to help determine their value and marketability (i.e., how easily the lender may sell these assets, if required, and at what price).

Also be mindful of potential margin calls. Should the value of the collateral decline significantly, the lender may demand additional collateral or require the borrower to repay a portion of the loan, in order to maintain a margin level that the lender finds acceptable for the risk being taken, while helping to cover potential losses.

Work with qualified professionals

Lending to UHNW individuals often involves the creation of customized loan structures and terms, to meet the borrower’s specific needs. If you’re thinking about pledging illiquid assets to secure a substantial loan, contact a Corient Wealth Advisor to see what debt-management options might be available to you, and what impact taking on more debt could have on your overall financial plan. As well, since you may face complex tax implications related to borrowing against assets, it’s usually wise to consult with a seasoned tax advisor before proceeding.

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