I’ve had a lot of conversations with investors in the last couple of months about Advance Rates.
I recently published an article about how entrepreneurs should think about negotiating to optimize for their Interest Rate, or Advance Rate: [here].
As a reminder, an Advance Rate is the amount of money a lender is willing to fund as compared to the underlying principal funded by the Originator.
Example: if an Originator wants to lend $100 to its borrowers, its Lender will often provide a 90% advance rate loan — meaning the Lender will fund $90 of the $100. The Originator will then be on the hook for the bottom $10 (10%) of losses.
The advantage of this, and the reason most lenders like it is:
(1) The Originator has skin in the game. If some of the money is lost, it’s the Originator who takes the hit, meaning they are incentivized to only make good loans.
a. As a reminder — during the financial crisis the home loan originators often didn’t keep enough risk on their balance sheet, so cared about originating volume, not quality.
(2) There is a first loss piece that makes the investment less risky. The facility can stand up to 10% defaults before any loss of income or principal is held by the Lender.
But two things within this framework have surprised me:
§ A lack of creativity in trying to solve the alignment problem
§ A lack of nuance in underwriting Loss-Coverage Ratios (how much worse things need to get before a loss of income or principal)
Alignment can go poorly if an Originator is getting paid an origination/closing/servicing fee on loans regardless of how well they perform, and when management is allowed to pull compensation out of the entity, such that if things break later there is no personal look back to their own assets.
But this doesn’t have to be the case. When we lend, while we will sometimes allow a modest origination fee to be taken (one that allows management to live okay, pay their staff, and survive), we never let those numbers add up to an amount where the Originator is agnostic to the performance of the actual loans.
In our ideal case, the Originator makes either 100% of its revenue, or a vast majority of its revenue, on the excess spread (if we lend at 15%, and the Originator is yielding 20% net after defaults, they should be making most of their money on that 5% spread).
And in many cases, there should be a clawback in the event that past cohorts perform well, and then one over-concentrated position goes bust.
This could be in the form of springing corporate recourse, a cross-collateralization across all future revenues, etc.
Part of making sure this happens is ensuring we are the only Lender/only facility the company has. In the event that we are not the only lender, we also want to ensure that if one facility defaults, ours defaults too, so that the company can’t get lazy about the performance of one portfolio, knowing there are alternative backers in the wings.
The main point is — there are ways other than Advance Rates to solve for alignment.
Advance Rates also create protection. If I lend at a 90% advance rate, the first 10% of losses are incurred by the Originator, not me.
That being said, I’d rather lend to a business at a 100% advance rate, if they have a 20% net-interest margin, than 90% to a business with a 5% net interest margin.
The math is never as simple as I’m about to pretend it is (timing of defaults, salvage value, etc. all play factors).
— If Company A makes 30% loans that are 1 year in term, and I lend to them at a 100% Advance Rate, at 15%, the company can incur a 15% default rate before I see my income get hit (in reality, the Originator now has no margins/operating capital and I may need to come in and service the loans myself… but whatever — you get the point).
— If Company B makes loans at 17% on the same 1 year term, and I lend at 15% with a 90% Advance Rate, I can only incur 12% default rates before my income gets hit.
I think a lot of lenders forget that Advance Rates are supposed to be tools to increase protection — but so many people get caught up in the implied protection/optics of Advance Rates, that they don’t spend the time to figure out how secure they really are.
Not only that — but in my first example, the company can incur 10% default rates and still earn a spread/operate their company. In example 2, there is only a 2% spread — meaning even if my income isn’t lost, the Originator is going bust and I’ll have to take over the process of servicing and collecting the loans.
— I’d always love to have a more conservative Advance Rate
— But I’d take a high margin business at 100%, before I’d take a commoditized loan product with lower margins at 95–90%.