Part 7: How To Monitor a Credit Investment
*This post is a part of a series of posts we have written. To start from the beginning, click [HERE].
There’s a lot of discussion around the diligence, structuring and execution of investments. But not nearly enough attention is placed on the monitoring of an investment once it’s made. Monitoring a credit investment can be just as important as the initial underwriting itself.
[See here] for a sample tracking sheet we’d use, internally, to monitor an investment. (This is a sample sheet, in a normal deal a lot would likely be added per the specific terms of the investment).
As a part of the underwriting process and as mentioned in our section about modeling credit investments, we make assumptions about repayment rates, prepayments and default rates. When structuring deals, we normally have covenants that ensure we only have to keep funding/continue lending to a business if its performance is as good (or close to as good) as expected.
So once a deal is closed, we have to monitor the investment to see how accurate our assumptions were and how the current portfolio statistics impact the quality of the loan.
Monitoring a company who you are lending to in our mind is bifurcated into two parts:
- Compliance with the loan document and
- Underlying portfolio performance.
Both are equally important, but have very different approaches to implementing.
Portfolio Performance Monitoring:
Every month (or some times with more frequency), we receive a loan tape or portfolio tape from our borrowers that allows us to analyze the underlying performance of the assets securing our loan. For the sake of this analysis, we will focus on the pool of unsecured consumer loans discussed in the modeling portion of this series.
For a pool of unsecured consumer loans, we typically like to take two separate views: cohort analysis and static pool analysis.
The cohort analysis allows us to understand how individual cohorts perform (typically month of origination) and can provide indications of improving or declining performance of loan quality. Some of the statistics monitored would be as follows:
- Weighted-average loan size
- Weighted-average APR
- Total advanced
- Total repaid
- Percentage prepaid
- Total delinquent (bucketed by current, 30+, 60+, 90+)
- Weighted-average FICO score
- Weighted-average duration
For a static pool analysis, we focus on the overall quality of the loan book, to have a sense of the current collateral securing our loan. Some of the statistics monitored would be as follows:
- Total receivables outstanding (expected principal + interest + fee payments)
- Total / % delinquent (bucketed by current, 30+, 60+, 90+)
- This is important for tracking performance covenants around delinquencies
- Geographical dispersion
- Weighted-average FICO score
- Weighted-average duration
Through these two analyses we can identify the quality of the current collateral and also identify trends within the portfolio. If we notice any abnormalities, we will correspond with the originator to get a better understanding of what is happening, if the issue has not already been discussed.
Another important piece of the portfolio monitoring analysis is spot-checking certain loans. Each time we receive a data tape, we tie back advances to bank statements to confirm that what was advanced on an excel sheet, was actually advanced and what was received in the excel sheet was actually received.
Typically a fund administrator will also perform this function, but it is always good to have a second pair of eyes to make sure nothing is off.
Loan Document Compliance:
Loan documents are comprised of many covenants, representations and warranties. If the company is in violation of any of the above, the company may be in default of the contract, therefore it is very important to monitor them closely.
With each deal we execute, we create a spreadsheet of all of the covenants in a deal, who is responsible for tracking them and the frequency in which they need to be tracked. A few examples of covenants that we track are as follows:
- Liquidity requirement: the company must maintain a certain cash balance at all times
- Loan performance triggers: the default rate on the underlying assets shall never reach a certain %
- We typically break this up into a pause funding event threshold and a termination of the facility event, which is higher number
- We determine these numbers through our underwriting and modeling and what we feel comfortable with before our investment income and principal are impacted
- Borrowing base deficiency: the company must maintain a certain amount of assets (typically loan collateral) to collateralize the loan facility
- Cash management compliance: the borrower is compliant with the cash management systems laid out
- No additional liens: the company has not placed any additional liens on the assets collateralizing the facility
If certain items are close to the threshold, we have a conversation with the management team to let them know that they need to be careful to avoid breaking a covenant. The goal is never to trip up a borrower, but rather to provide a clear set of guidelines for operating the investment. If some element of the document is not working, but clearly does not impact the likelihood of success of the investment, we will discuss with the borrower how to remedy it either through an amendment to the document or through a series of operational changes.
Some of the covenants are more nebulous and are more difficult to track. The best way of approaching those is through regular on-site visits to the borrower. We like to leave room in the agenda to discussing covenants with the borrower and confirming compliance.
On-sites are also great ways of learning about business updates and a way to meet key personnel. We like to sit down with decision makers and underwriters to understand the way that they think and make sure that we feel comfortable with the team making important decisions.
Often, during the life of our investment with a company new people are hired/promoted or let go and processes change. It’s during these visits that we can make sure we’re comfortable with the evolutions.
We end up speaking to our borrowers weekly or daily (depending on how involved we are in the company). These aren’t always calls with the CEO, but often with the finance team, the originations team, etc. It’s this close communication that helps us keep our investments safe, and also allow us to act appropriately when things go off plan.
And finally, for [Our Conclusion]
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]