*This post is a part of a series of posts we have written. To start from the beginning, click [HERE].
By the time we’ve had an initial meeting and reviewed introductory materials, we have a pretty good idea of whether or not an investment fits within our thesis.
If an investment doesn’t, it’s time to give productive and specific feedback. If it does, we make a request for materials.
Here is a list of the items we ask for:
It’s a lot of stuff — and if we’re asking you to do this much work, it means we’re serious.
We’ll help you gather it, and know that many of our Online Lending platforms may not have all the materials we ask for. In the event that they don’t, we help them create the materials (we want to be partners throughout the process).
Underwriting the Credit
We’ll also begin requesting a loan tape, and building our own credit models to determine how risky the opportunity is, and how we should structure the loan if we were to move forward. In many cases, we feel comfortable that we’ll want to make an offer, but the answers on some of these risk questions determines what rate we’d need to get paid, relative to other investments.
There are generally 6 key items that we look for, in the following order of importance:
- Certainty of cashflow
- Reliance on the sponsor
- Asset liquidity
- Correlation to the economy
- And historical data
To help illustrate a high-level framework of how we’d assess each of these 6 items, we’ll compare to potential opportunities to each other:
INVESTMENT OPPORTUNITY 1 | A portfolio of annuities (e.g., a portfolio of 100 annuities of an average balance of $10,000 and 20-year maturities)
*An annuity is an obligation of an insurance company to make monthly or annual payments for a fixed duration.
INVESTMENT OPPORTUNITY 2 | A portfolio of unsecured consumer loans (e.g., a portfolio of 1,000 loans with an average balance of $1,000 and 3-year maturities). Therefore, both portfolios are worth $1 million.
*An unsecured consumer loan is one made to an individual for a fixed interest rate and a fixed period of time, one similar to what you’d get from a bank.
(1) Certainty of Cash Flow
For Investment Opportunity 1, the quality of the investment is hinged on the certainty of cash flow (the certainty we are going to receive our income) because that is the only way the investment makes money.
In this example, the annuities are guaranteed by the insurance company — meaning that our risk (what would have to happen for us to lose money) is that the insurance company goes out of business and cannot make the payments.
We look at the Schedule of Payments, which is the excel model we receive that tells us when we are going to get paid, and how much.
The Schedule of Payments is therefore known in advance (e.g., $100 per month for 20 years), and there will be no deviations unless an insurance company goes bankrupt — which is highly unlikely since most have strong investment-grade ratings.
(As a way to put the likelihood into context, Investment-grade companies have very low probabilities of going bankrupt and enjoy low rates of interest (e.g., 2–4%) because they are so creditworthy.)
That basically means if we are earning anything above a 2–4% yield on an Investment-Grade risk, we are getting better than market returns (in exchange for some illiquidity).
Another reason we think the “certainty of cash” in this type of investment is so high, is that even in the bankruptcy of an insurance company, which is the company responsible for paying us back, annuity payments are paid before all its other debts, so there’s a very high likelihood that the annuities will be paid.
In the second example, the unsecured consumer loan also makes fixed payments, but each loan bears the risk of the underlying borrower defaulting. AKA, if we buy a portfolio of loans, and one of the loans is made to a person who doesn’t pay back, we can lose our money on that specific loan.
Generically speaking, “prime” borrowers default at rates of 5%, whereas “subprime” borrowers default at rates as high as 20%+. Therefore, the cashflow of the unsecured loan portfolio is more volatile and less certain.
In this case — we would look at Investment Opportunity #1 as a more attractive investment based on the “certainty of cash flow.”
(2) Reliance on the sponsor / servicer
A secured lender always thinks about what happens to the assets if the Sponsor goes out of business.
The Sponsor is the company we are investing in, which does all the actual lending. It is responsible for:
- Originating (making the loans)
- Servicing the loans (billing and collecting on the repayments)
Due to its responsibilities, the Sponsor plays a crucial role in capturing the cash flow. Per CoVenture’s primary business model, we lend money to a Sponsor, who in turn makes sure it gets the money back.
here’s a diagram of how it works:
As you can tell from the chart, because we don’t actually deal with the underlying borrowers ourselves, we rely on the Sponsor to do so.
Imagine if no one called delinquent borrowers to remind them to make payments or set-up a workout plan? They wouldn’t pay.
Therefore we first think about:
How reliant are we on the servicer? If they go bust, are we screwed?
For the insurance opportunity, we aren’t relying on the Sponsor to do much. They just need to receive a check from an insurance company every once in a while, and call them to remind them if they miss a payment. If they go out of business, or are bad at their jobs, we’re probably okay because we could take over what they were doing.
In the second investment opportunity (lending to thousands of consumers), we rely heavily on the Sponsor to do a good job, because it’s more complicated. They need to call thousands and thousands of borrowers to help collect. If they go out of business, it could be complicated to get our money back.
So the pressure is on with the unsecured consumer loan business, more so than it is with the annuity business.
And sponsors really range in quality. Some are good at their jobs, others are bad. Some are creditworthy (are likely to be around for a while) , others are not (some servicers don’t have much cash on their own balance sheets, and cannot be counted on to be in business long enough to collect the loans).
Some are aggressive debt collectors, others are lackadaisical. Some have complicated servicing practices that are not easily replicated (which is bad in this context because if they went out of business, it would be hard to replace them), others have simple businesses.
So with the annuity investment, we don’t feel like we are taking much servicing risk, but in the consumer loan business we are, and we’d have to apply some sort of risk premium to the fact that the servicing will be harder.
(3) Asset Liquidity
Asset liquidity — i.e., the ease with which you can sell an asset — is extremely important to a lender, because if the lender needs to foreclose on the collateral, they have to be able to sell it as a way to get a return in cash.
The less liquid the asset, the more difficult it is to sell, and therefore the higher the likelihood that you’d have to take a big “haircut” — or discount — when selling the asset. In the midst of the financial crisis, for instance, liquidity for almost all assets dried up, and illiquid assets — even high-quality ones — sold for “firesale” prices.
Imagine you had to foreclose on a car to recover your investment in an auto loan: you’d have to physically repossess it (not an easy feat), pay the repossession fees, arrange to sell it at an auction, and pay the auction fees — all to get your money back. And if the car you are repossessing is 15-years old, or you are in the midst of a financial crisis, then your ability to sell at auction is difficult.
A simple example would work as follows:
So the illiquidity of the asset actually revealed that the loan was under-collateralized compared to expectations.
From a liquidity perspective, the shorter the life of the asset, the better. In this regard, the portfolio of unsecured loans is actually more liquid than the annuity, because they are 3-year loans whereas the annuities are 20-year streams of payments.
The second factor in determining liquidity is transferability — i.e., how easy is it to transfer title (e.g., ownership) to the asset. Here, the consumer loans are easier to transfer, because title to them can be easily sold, whereas an annuity transfer requires more documentation and must wait for confirmation from the insurance company (which could take up to 180 days).
The third factor in liquidity is the size of the universe of potential buyers. Here again, the universe of unsecured loan buyers is greater than that for annuity buyers. So the loans win this one.
(4) Correlation to the economy
An asset’s correlation to the economy is extremely important — because ideally, you want to solely take asset risk, not macroeconomic risk that’s layered on top of asset risk.
The more macroeconomic risk, the more you are exposed to market cycles, or “beta.” In an ideal world, you want to lend against assets that are completely uncorrelated to the macroeconomic environment — i.e., those that have no beta. That’s because you won’t have to worry about exogenous forces such as: is the economy growing or shrinking, are interest rates increasing or decreasing, are regulations getting stronger or weaker, are commodity prices increasing or increasing, etc.
The annuity payments are highly uncorrelated to the market — because they will be paid on-time and in-full as long as the insurance companies are solvent. While the financial strength of the insurance companies is arguably correlated to the market, they are not nearly as correlated to macroeconomic conditions as the livelihoods of individual people and their ability to pay their loans, which will directly impact the performance of the loan portfolio. Therefore, the annuities win this one.
The diversity of a portfolio is extremely important to mitigate anomalies or unexpected events that may occur with individual assets. Generally speaking: the more diversification, the better. However, as you’ll see, diversification doesn’t cure all ills — if one had to choose between a concentrated portfolio of high-quality assets versus a diverse portfolio of low-quality assets, the concentrated portfolio may be better.
Here, the portfolio of unsecured loans is more diverse than the portfolio of annuities, because the average size of the loans are $1,000, whereas the average annuity is $10,000. The unsecured loans win this metric.
(6) Historical data
The historical data is what helps validate all of the assumptions made in our earliest meetings and in our credit underwriting analysis. It’s in using this historical data that we can build assumptions for our own model.
We want to see companies whose data outperforms their peers who lend in comparable asset classes. If you lend to subprime borrowers, and those borrowers mostly default at 20%, we want to see your borrowers defaulting at 10%. (This would be proof to us that your innovative loan product was beating the market, and that if we invested at the same rate other lenders were funding at, we’d be getting a better than market risk-rewards return.
In most of our deals, we are looking for things to have gotten at least twice as bad as modeled for us to lose any of our expected income, and 4x as bad for us to lose any of our principal. This of course ranges based on our certainty in the deal, and the amount of data we are provided (but they are good general rules).
In cases where the ratios are more in our favor (5:1 and 10:1 or something similar), we can offer lower rates, or more flexible structures. It really just depends deal-by-deal, and we can dive into that more in our next post.
Once we have gone through our diligence process — we begin thinking through structure with the potential borrower.
Click this link to go to our post on [Lending Structures].
For the Full Series of Posts, Please See Below:
(1) Part 1: An Intro to Online Lending (LINK)
(2) Part 2: An Intro on How To Source Deals [LINK]
(3) Part 3: Initial Diligence [LINK]
(4) Part 4: Deeper Diligence [LINK]
(5) Part 5: Structuring The Deal [LINK]
(6) Part 6: Building a Credit Model [LINK]
(7) Part 7: Monitoring Your Investment [LINK]
(8) Part 8: Conclusion [LINK]