Single Funder Risk — the Pros and Cons of Having Multiple Lenders

We’ve spoken to a handful of our portfolio companies about their desire to bring in additional lending capital outside of what we provide. AKA — they want to bring in a co-lender.

And we’re normally okay with doing this upon the right circumstances.

Typically — when we invest in the debt of a company, we offer $X amount of capital, and want the right to either 100% of all of the origination volume a company does, or some significant portion of it.

(AKA — if we provide $20M of debt capital to a company — we want to be funding 100% of the loans they are making — that way they draw on as much of our capital as possible).

The reason is: when we commit to a company, we’re setting aside the entire amount we committed either in uncalled capital, or in liquid positions. If we can’t actually deploy the capital we commit, we’ll be sitting on cash, and thus incur cash drag which lowers the returns on our fund.

*Cash drag is the drag on returns caused from sitting on cash that is earning no income.

One of the problems inherent in any lender/borrower relationship is that — when we provide debt capital to a company, that company often wants to make loans outside of the “credit box” we initially agreed on.

Why? Because startups learn stuff as they grow, and find out their borrowers might have different needs than they initially imagined. They may need to borrow capital for 2 years instead of 1 year. Or at a lower rate/higher rate than once imagined.

And sometimes — as lenders, we don’t feel comfortable with these modifications, and have to say: “this is not an exception we are willing to make.”

This is a crappy conversation — because if we are the only lender to the company — not only are we not willing to finance the “exception” loan, but in many cases, the company we’re financing can’t make the loan at all! They have to give us 100% of their volume, and so they are prohibited from making a loan outside the box we provided, and selling it to another party. This could hurt their growth.

The natural response is: “let me go find a second lender, so I’m not so tied to my first one.” While this might intuitively feel like a smart thing to do, often, it’s not.

Let’s imagine a scenario where a lending company has two lenders instead of one (us, and a second party). The two lenders will make an agreement that neither will get any worse, or any better loans than the other party. (we try to avoid adverse selection bias). So if the lending company starts financing loans that are “exceptions,” both parties have to sign off on this. Because even if one lender is okay with the loan and is willing to fund it — the other lender has to agree that no negative selection bias has occurred.

On top of that — if the lending company wants to modify its loan product, or evolve it in any way, BOTH lenders have to agree. And since the lenders are often more aligned with each other than with the company, the second lender makes things WORSE for the borrower, and LESS flexible, even though that is against the intention.

*Overtime — companies become mature, create multiple loan products sold to multiple parties, etc. but if you’re at that point, this blog isn’t your primary source of education anymore.

As a relatable example, during the financial crisis, homeowners got hit by this. When banks used to make loans to them, they would then sell those loans via securitizations to multiple parties. That meant the poor homeowner had multiple lenders. Even without knowing it. If they wanted to negotiate a way to modify their loan to allow them to more affordably repay it, they needed the consent of MULTIPLE parties, not just one — making this harder.

That example shows why when a lending company has multiple lenders, their ability to move fast, be flexible and iterate gets worse, not better. They are not getting more leverage by bidding the lenders off of each other — they are just giving lender 1 an ally in lender 2.

Having multiple lenders is ultimately a good course of action.

The benefit is that you don’t rely on the credit risk of the fund backing you. Originators borrowing from Direct Lending Investments are probably scrambling to find a new lender and got stuck only having one source of capital.

And in other circumstances, companies need more capital than what just one lender can provide.

But net-net — originators should wait to find multiple sources of capital until they have product-market-fit, are comfortable that they won’t have to make many “exceptions,” because exceptions are harder with multiple parties involved.