Structuring and Pricing Debt Financing for Alternative Lending Platforms
A number of founders building marketplace lending platforms don’t hold the loans they originate on their own balance sheet.
They act much like mortgage lenders where they underwrite a borrower (decide if the borrower is likely to pay the loan back), originate the loan (make the loan) and service the loan (collect repayments).
But these lenders don’t have enough capital on their own balance sheet to send money to all of their borrowers. And if they raised equity capital so that they could, their return on equity just wouldn’t be high enough (that’s the rate of return earned on equity capital in the business).
So after these platforms make the loan, they typically sell it to a fund or a capital partner. That capital partner pays capital to the platform to purchase the right to all of the repayments on that loan and the interest income, but also bears the risk that the loan might default.
The marketplace lender in return takes two things (1) fees in exchange for doing all the work (these could be closing fees, origination fees, servicing fees, etc.) and (2) a spread. Sometimes and in many cases the lender will hold some of the loan on its own balance sheet to align risk and interests or to take some of the excess spread. In some cases they’ll price the spread into the fees they are charging, especially if they are getting a higher return than required by the market (if a lender is getting a 30% rate of return they may want to at least keep 10% of that!).
But here’s where things get tricky — what rate of return do you need to offer to your debt capital partner, and under what structure?
The most attractive “structure” for the underlying origination platform is a straight purchase agreement. Under that kind of agreement the debt capital provider typically is saying “we will purchase all of the loans you originate that fall under x, y and z characteristics.” Let’s imagine those characteristics are things like “loan to value,” “size,” “credit score” of the underlying borrower, type of asset being secured against, etc.
This structure is awesome for the company (they’re taking no capital risk on loans defaulting and are clearing up their balance sheet so they can focus on customer acquisition and origination volume), but also bears risk for the capital provider, which means two things (1) the capital partner is going to ask for a higher rate of return to compensate for the founder-friendly terms (2) and will ask to include terms that protect the capital provider in the case the underlying company underperforms.
(1) The most common case in which a company underperforms is when it asks for too much money and can’t originate as many loans as it once thought.
(2) The worst case for a company is if the loans it originates begin defaulting at a higher rate than expected.
(Under the second scenario, the company is pretty much screwed, it’s game over, most other capital partners will be scared away so let’s not even address that. If you’ve got high default rates (like a lot of people in subprime auto and unsecured consumer credit are about to) you probably don’t deserve to run a company in the first place. And you’re in so much sh*t this post isn’t gonna help you no matter what I say).
Assuming the first case, in which the company just can’t originate quickly enough, it may have only used $50M of the $100M committed by the capital partner.
That’s really bad news for the capital partner. The reason is they had to set aside the full $100M and were expecting X return. If they only received X return on half the money they in reality got .5X return on the full amount.
So to protect against this, the debt capital provider will charge a fee on un-used capital.
So by having a fairly attractive structure you’re probably going to have to offer a larger rate of return to your capital partners and bear some risk that if you underperform it’s going to hurt you more later on.
The other option is to offer a guaranteed return to your capital partner. This is often even secured by the equity in the company — you’ve essentially put someone higher up on the capital stack than you or your equity investors. In the case you can’t actually return a fixed rate of return (because you did not originate enough loans, a couple of loans went badly, etc.) you might be giving up your company to the firm that is your creditor.
Most companies shy away from this, and in many cases, especially when the rate of return of the underlying security is high enough, we support them giving up economics in the short term to avoid the teeth this type of structure comes with. In some cases, especially in lower yielding cases where there is less room for error it’s inevitable. But it’s probably best to avoid.
What Prices Are You Going to Be Offering to Investors?
Well… it depends :) especially on the risk profile. But the lowest expected rate of return for the securities originated off of a startup’s platform are almost always in the mid-teens.
In most cases, investors are expecting similar yields to what they’d get in middle-market lending, and it’s for three core reasons:
(1) The types of people willing to touch securities originated by a new platform are typically hedge funds, family offices and private equity firms feeling creative about where they should sit on the capital stack. These firms usually have high costs of capital and therefore need a minimum return.
(2) The platforms are generally pretty un-tested (have not gone through multiple cycles, etc.). And in many cases the platforms are originating securities that are essentially inventing a brand new asset class, and there isn’t a market for new types of securities.
(3) These platforms are often originating illiquid securities (marketplace lending platforms want to have a stable capital base, and there isn’t a market that allows investors to buy, sell and trade these securities in real-time, yet). There’s a premium placed on anything illiquid.
Those three characteristics of securities originated off of a new platform contribute to the higher yield required of these platforms.
So for fairly de-risked securities, we’ve seen a minimum gross return of committed capital often sitting at 14–15%. This means that on a per security basis the return required is in the high teens, low twenties to account for cash drag (the drag on return caused by the fact that a fund usually has capital not being used).
Returns on a per security basis an fees on un-used capital are inversely correlated by the way.
The more un-tested a platform, the higher the rates. The less savory the borrowers, the higher the rates. The more illiquid, the higher the rates. The less available capital providers willing to touch the asset class, the higher the rates. The more founder-friendly the structure, the more covenants and fees added by the capital provider.
All of those items are trigger points for ultimate pricing. All done by firms typically targeting a mid-teens gross-return.