*This post is a part of a series of posts we have written. To start from the beginning, click [HERE].
Much of lending is based in structure.
In venture capital, outcomes are usually binary and so the terms of a deal matter less, because if a deal works, it really works and if it doesn’t, “who cares.”
One of the first things I was ever told when I got into Venture Capital was:
“If you do a deal, you can only lose 1x. But if you miss Uber, you’ve lost 1,000x.”
Needless to say, credit is the EXACT OPPOSITE. Structure matters so much. And there are three primary ways Online Lending platforms get funded.
(1) Forward Flow Agreements
A Forward Flow Agreement, is an agreement where a lender offers to purchase loans originated by the Sponsor either entirely, or partially.
As an example, we may go to an Online Lending Platform and say:
- “Based on the loans you are making, and their performance, and the returns you are getting, we’d like to buy those loans from you and hold them on our balance sheet.”
If the Online Lending Platform agrees, they will:
- Go make a loan to a borrower
- Once the loan has been made, they will sell us the loan (aka, the borrower now owes CoVenture the principal + the interest)
- We pay the Online Lender money for going through all the trouble to make the loan, and in many cases, to monitor, service, and collect the loan repayments.
We can pay the Online Lender in a variety of ways. Some ways could include:
- An origination fee: The Online Lender gets paid up front for doing the work of making the loan
- A servicing Fee: “a fee paid during or after a loan has been made for doing the work
- Excess Income: The Online Lender can make whatever amount above our required rate of return
The high level terms of an agreement like this go something like this:
- Coventure will buy up to $30M worth of loans at any given time
- For the next 3–5 years
- In exchange for $x per loan, or x% on the portfolio
- For loans that are originated with X, Y and Z characteristics
Pro’s of this structure
A Forward Flow Agreement is often good for the Online Lender because:
- In some cases, the Online Lender is not taking on any more risk. If they make a loan, and then sell the loan to someone else, the Online Lender is no longer exposed to defaults (and doesn’t have to risk any of its own capital).
- Forward Flow Agreements are often non-recourse to a company’s balance sheet. So if the loan goes badly, the Investor cannot go after the Online Lender for the money.
- New companies often are uncertain about how many loans they are going to originate, and so cannot commit to paying a fixed amount of interest per year, when they don’t know how much capital they’ll actually need. But having a forward flow often allows them to originate up to a certain amount of loans, without any negative implications of not making as many loans as expected (and paying interest with debt capital that is not currently generating a return).
A Forward Flow Agreement is often good for the Investor because:
- In the event that the Online Lender goes bankrupt during the term of the facility, the Investor is not exposed to bankruptcy court proceedings, or having assets tied up in the bankruptcy. Instead, all of the money is still owed from the borrower to the Investor, and the Investor can step in and take over the work of servicing the loans
- Often, forward flow agreements can allow an Investor to customize their portfolio. They can optimize their loan portfolio to either skew more risky, or less risky, depending on the returns trying to be captured. Further, the Investor may have his/her own view of what types of loans may be best, or what kind of diversification could be best.
*Example: An Investor can go to an Online Lender and say: “I will buy up to $50M of loans, but I don’t want more than 10% concentration in any state, I want all the loans to be near-prime, I want to make sure each borrower has an income of above $60,000 and I’ll lend at a cheaper rate if you buy back the loans that default on a first repayment.”
This type of customized portfolio is often best achieved via a Forward Flow Agreement.
Negatives of this structure
Forward Flow Agreements are generally more work, and riskier for the Investor than a traditional loan facility would be. Rather than the investment just being a straight loan to the company with a fixed return, the Investor now owns a portfolio of loans it needs to buy, monitor, track, and take risk on.
So if the Investor was willing to take a 15% straight return guaranteed by the Online Lender, some return higher than that is often required for a Forward Flow Agreement. Which makes sense… If I know I’m going to get a 15% return on a portfolio, and that the Online Lender will take the first losses in the event of a few defaults, I’d need the opportunity to earn greater than 15% if I knew I was going to be taking the losses on the first defaults.
Additionally, Forward Flow Agreements create the potential for conflicts of interest because the Online Lender may lack “skin in the game.” This is because the Online Lender may be selling all of its loans to the Investor and not keeping any for itself, which could lead to sloppier underwriting in an effort to boost origination volume.
In general, the big risk with Forward Flow Agreements pertains to the stuff that can get thrown into the contract that make the deal different than what was initially expected.
- As mentioned previously, Forward Flow Agreements are likely more expensive than a traditional loan facility. The reason is that the Investor is taking most of the risk, so wants to get paid a higher price than she might in a traditional loan where the first losses are eaten by the company.
- It may be easier for the Investor to back out if she doesn’t like the way things are headed. If the loan book starts to perform less well than expected, there is often little recourse the Online Lender has to the Investor if the Investor decides to just stop funding (which is why the Online Lender will look for the Investor to commit to fund certain minimums)
- The Investor can add a lot of things that make the agreement feel closer to a normal loan: (a) They could add a clause that forces the company to buy back loans that default within a certain time period (b) They could require the Online Lender to put up the bottom 5–10% of each loan, so that if there is a loss, the Online Lender takes part of it (c) The Investor could put all of the loans into a single legal entity, and not allow the Online Lender to earn any revenue until the Investor has received x% return (essentially making the deal feel more like a loan facility than a Forward Flow Agreement)
- The Investor could make it hard for the Online Lender to bring on other capital. For example, the Investor could cherry pick the best loans, leaving only worse loans for all the other investors, making it unattractive for new investors to fund the Online Lender. The Investor could also ask for ROFR on “other types of loans,” making it unexciting for new firms to due diligence on the Online Lender, knowing that if they make an offer it could just get matched by the existing funder.
- If the assets being purchased are short duration in nature, the transfer of money back and forth between the buyer of the loans and the seller could hurt the portfolio’s returns. If an ACH takes 1 day on a 30 day receivable that is ~3.33% of the return.
Forward Flow Agreements are often a great way for a new company to start originating loans without having a set interest rate it needs to pay back. This is good if the amount of loans about to be originated are difficult to predict, or volatile/seasonal in nature.
But they are often more expensive, can be complicated, and could end up mirroring a less friendly loan structure via terms added into the definitive documents.
Asset Backed Lending Facilities
The other primary way a company could be financed is through a more traditional Asset Backed Lending Facility.
In this type of investment, an Online Lender makes loans, puts those loans into an SPV, and the Investor lends money to the SPV. I have re-attached the chart from a previous blog post which reflects this type of arrangement.
Basically, the way it works is:
- An Online Lender will make a loan to a borrower
- The loan is then sold into an SPV, managed by the Online Lender
- The Investor would lend to the SPV, which holds all of the loans and obligations of borrowers to repay their principal + interest
- The Investor’s loan to the SPV is secured by all the assets and loans in the SPV
This is the preferred way for most, more mature, Online Lenders. The pros of this structure is that:
- Loans are usually held within an SPV, and there is some first-loss piece covered by the Online Lender. This means that the investor has a bit more certainty around the return he is likely to receive because of the cushion provided by the first-loss piece.
- The monitoring of the portfolio is also much easier, because the SPV is managed by the Online Lender, not by the Investor, so the manual intensity of operating the investment is much lower.
- The loan is usually limited recourse to the Online Lender’s balance sheet. This is good for the Online Lender, and necessary for the Investor. If the portfolio of loans goes badly, the Online Lender’s reputation will be hurt, and it will lose much of the income from the loans, but platform likely won’t go bankrupt. The Investor cannot force the company to guarantee the whole portfolio, because then the SPV won’t be considered “bankruptcy remote,” meaning that if the Online Lender goes bankrupt, the assets in the SPV could be considered assets of the Online Lender.
- In the event of a bankruptcy, the Investor in an SPV does not have to worry that its assets will get trapped in bankruptcy court proceedings. Often, companies are given ~4 months to try and work themselves out of bankruptcy. During that time, lawyers will spend significant time working out the details of the bankruptcy, subordinate lenders may make appeals, and much of the revenue the Investor thought was coming to it could go to those expensive few months of a workout. During that time, the loans could have gone bad, or the proceeds could have gone to the lawyers instead of to the Investor.
The negatives of this structure pertain more to a new company than a more mature one. But some of the highlights for the Investor are:
- It’s harder to create a custom portfolio. Whereas forward flow agreements can essentially feel like SMA’s to an investor who can customize a portfolio, ABL facilities are usually less granular. This is okay, because the Online Lender is often taking a first loss, but it’s harder to create the perfect risk profile.
- The Online Lender could be taking out origination fees or servicing fees at the top of the waterfall (i.e., before the Investor is getting any of its principal or investment income). If this happens too aggressively, the Online Lender could make a lot of money even if the Investor hasn’t.
- Often it’s hard to avoid this. An Online Lender cannot survive without getting revenue on a quarterly basis. But if the Online Lender takes out its revenue quarterly, and then on the second year of the loan things fall apart, even with a clawback there may not be enough cash in the Online Lender’s operating account to pay back the full obligation of the loan to the lender.
- There is no recourse to other assets of the Online Lender. Because the SPV is off the balance sheet of the lender, there is limited recourse in terms of what can be claimed.
- Often, the capital may not get fully called, and so if the lender has set aside $20M, and only $10M is being used, there could be 50% cash drag on the deal and the interest is only being earned on half of the money (this would lead to a 50% return of what was initially expected).
Some negatives for the Online Lender are as follows:
- For the Online Lender, there is often an obligation to pay interest on the facility, even if no loans have been made.
Example: imagine a $20M loan has been made at 20% interest. Lenders will often include a maintenance fee, or some minimum interest that must be paid. So if the minimum utilization is 50%, then the Online Lender is obligated to pay the investor $2M per year, no matter what. If non borrowers have bee found, and the Online Lender is therefore generating no revenue with the capital, this could become unaffordable.
- The deals are complicated and often expensive. In an ABL there can be: Joinders, subordination agreements, Servicing agreements, the actual loan document itself, legal opinions, receivable purchase agreements — and sometimes it can add up to 500 pages (or more!). For some Online Lenders who are just starting out, this can be unaffordable.
- It can make it hard to find other lenders. Often, other lenders will not want to come into the same SPV as another Investor, so there needs to be two SPV’s set up, each holding different assets. This can create conflict and competition. The best way to handle this is to hire a third party to decide which originated loans go into which SPV in an unbiased way.
- In some cases, if the facility is over a long term, the Originator may not be able to pull out much of its revenue until the wind down of the facility. Or the Online Lender must hold a liability on its balance sheet if there is a clawback on income in the event that the loan goes bad towards the end of the term.
Each type of loan structure has positives and negatives. These few pages on the two most popular structures we see are abridged, and a whole book can be written about each type of document.
But in an attempt to go a bit deeper, we have included a sample term sheet of an ABL deal, and will analyze each term to help think through how each section matters and can affect the safety and risk profile of a loan.
And click on the following link to read about [How We Build Out Our Credit Models].
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]