Specialty Finance - Post 3
Things to consider as you originate your first loans and begin building a loan tape
Are you an emerging fintech lender or early stage specialty finance company that has identified a market niche or underserved segment of borrowers? At some stage you will need to arrange your first warehouse line or revolving credit facility. This process is a significant undertaking and a mysterious exercise to many founders. I will spend time in future posts providing more information on these credit facilities (and other financing alternatives) and what considerations lenders are looking at when formulating a term sheet.
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Today however, I want to focus on three things before diving into credit facilities:
First things first (where to prioritize)
Securing the first couple million dollars to start originations
Securing haircut or first-loss capital.
First things first
Until you can
1) find a borrower interested in your new loan product
2) originate a loan opportunity
3) underwrite the credit
4) document the transaction
5) close and fund the loan
6) service the loan and
7) get repaid (on time), everything is pretty much theory and ideas. If you can successfully repeat this cycle you are on your way.
While these ‘mundane’ sounding tasks may seem less fintech 3.0, and could lead to fewer first meetings with VCs or fintech conference speaking gigs, they are the nuts and bolts of lending. At the very earliest stage I would argue a future fintech lender breakout or specialty finance company with unique edge is going to be more fin than tech.
If you plan to one day raise debt financing in the form of a warehouse loan or revolving credit facility, here are a few things to consider from the very beginning:
How do you make money? Explain your analysis.
What is your credit product? Does it pass all legal and regulatory checks?
What is your credit box? Has it changed over time and why?
How will you find your first set of borrowers (or ensure they find you)?
How will you identify borrowers at scale?
How are you going to underwrite borrowers?
What are the typical terms of your loans?
What is the collateral?
How will you document and secure the collateral involved in the loan?
While your TAM and SAM are interesting, in the early days, you need to focus on express spread and building a loan tape.
What are all of the data points to a typical loan?
Walk us through your pro forma and assumptions.
Build your own financial model. As hard as it may be, and you may not be a numbers person, you are in the lending business. You have to know this stuff cold. You also have to be able to walk investors, lenders, and partners through your model from start to finish. If you outsource model building to a third-party, this is a sign you don’t fully understand the business you are competing in.
How are your loan economics impacted by different costs of funds and critical inputs such as marketing, originations, underwriting, servicing, and recovery in the event of default?
How have you (and will you) handled defaults?
Can you enforce your security interests under your UCC and exercise remedies?
Can you demonstrate through data the story you are telling is scaleable?
This is not an exhaustive list but a healthy start. As a founder, it boils down to three key factors:
prove you have something viable e.g. a loan product or solution that you can scale
that can make money e.g. excess spread exists above and beyond your cost of funds
that customers actually value enough to try and get a loan e.g. the pipeline is flush
If you have quality borrowers lined up at the door demanding loans AND you have the funnel to back this up - show your earliest backers. Even if you have turned down borrowers (or they chose another capital provider) it is important to track this information. Your team should assess what you have learned from these interactions. Data is critical in the early days. Beyond spreadsheets, find opportunities to capture, analyze, and utilize your data to improve decision making.
I find it fascinating to speak with founders and teams who are starting lending businesses. The team typically has identified a consumer or business with a serious financing pain point and they want to solve for this friction. The solution is often a lending product with a CX/UX better than what currently is on offer. Personal experience often informs the founder’s solution and is a great source of inspiration. The targeted customer base is underwhelmed by offerings from traditional financing sources and a business idea is born. Here is where emerging lending firms often choose to pursue different paths.
One path I have seen is where the founding team spends precious months and hundreds of hours and tens of thousands (maybe even hundreds of thousands or millions) of dollars building a marketplace or beta software product. Some choose to assemble a lending tech stack using third-party software and others go all-in on building proprietary technology. Meetings are held to raise venture capital based on this beta product and discussions with a number of prospective paying customers.
Another path, one that I think we will see more frequently in specialty finance and fintech lending, is the ‘Lean’ Lending Startup. Check out Steve Blank and Eric Ries for much more on the Lean startup methodology. I would argue that instead of focusing on getting equity backing, creating tech, and boiling the ocean - the founding team spends the weeks finding and engaging with underserved borrowers to devise a lending product and use available capital to find an experienced attorney highly experienced in your loan area for documentation, regulatory matters, etc. and begin making loans. Only when the team finds themselves having maxed out their internal ability to make loans off their personal balance sheets (or those of early angel investors or HNW individual backers, former colleagues, friends, networks, and maybe if they are one of the lucky few - family) do these teams typically begin to seriously contemplate true outside funding options. I want to meet these kinds of startups and specialty finance companies.
Yes, I get it, some ideas are going to require that you spend money on tech, build a team, focus on raising a venture round, and signing up channel partners - but before almost all of that, its probably best to prove out the idea, test your assumptions, and build an MVP with paying customers/borrowers. Making just a few loans will teach you more than the best tech stack and so long as your first loans aren’t complete zeros, you should have acquired critical insights from these early customers. But how do you get out of the gate? How do you raise that first few million to begin ramping up originations? Here is my take:
Securing the first couple million dollars to start originations
Raising the initial capital to launch originations is an exercise in preparation meeting execution. Generalist venture investors are likely not going to have much, if any interest as they likely don’t understand the profitability and economics of a lending business. They also don’t often make loans. Larger private credit funds have the powder but they typically don’t have the time and interest to do $1-$3 million facilities and take venture-stage risk. The sweet spot is elusive but does exist. Focus primarily on lenders and investors (and their networks) who have the understanding, desire, and means (e.g. vehicle, mandate) to fund startup and early-stage fintech originators and specialty finance companies. Investing in these relationships is time well spent if you are playing the long game. Founders are mistaken in thinking the record interest in private debt, dry powder, and liquidity in money-market funds and other cash-like investments means raising the first few million will be quick. Securing the first few million dollars of lending capital has arguably gotten harder.
If you have a novel loan product, are a first mover, and are early stage with some traction (even a small tape that is performing), why has it become more difficult? One reason is the firms who were doing $5-$10 million loans a few years ago are now doing $20-$30 million loans. Why? Largely because they have done all the underwriting and diligence work on an existing borrower, extended their partnership, invested capital and resources, and now would rather scale up with this partner than replace and recycle their portfolio constantly. Additionally, from the business standpoint of the specialty finance fund (or private credit fund) they have access to more capital than ever before (and all else being equal) can make bigger loans. Most lenders find it easier to manage ten $20 million loan relationships versus twenty $10 million loan relationships assuming they manage their own portfolio concentration risks. It’s why every commercial banker wants to be a corporate banker as the old joke goes. Venture funds that focus on lending businesses do exist but finding ones who also provide debt capital is an even smaller population.
Who provides the first few million then? Potential sources include hybrid funds looking to do equity/debt in pre-seed and seed stage fintech lenders and tech-enabled originators, certain single family offices, fintech focused venture capital funds who like new lending businesses as evidenced by the loans and equity checks they have done previously, and private credit firms with a sleeve dedicated to startups.
Securing haircut or first-loss capital
While future posts will be devoted to breaking down important elements of the debt term sheet, one of the most misunderstood concepts worth discussing here is that of haircut equity capital. In my estimation originators just getting started can’t begin preparing and executing on this money soon enough. If you are a little further along and believe a warehouse or asset-based revolving credit facility is necessary, it is important to begin discussions with haircut capital investors. Lenders will require you to have some ‘skin in the game’ and if you don’t have it already, you will need to raise it. This ‘skin in the game’ will take the form of what is known as equity haircut capital, haircut capital or first-loss capital. This capital is not provided by your asset-based and warehouse lenders.
Let’s take the standard house buying and conventional financing process for a first-time home buyer to illustrate the idea. Conventional mortgage lenders will not provide this borrower with a 100% mortgage to buy their home. These lenders will require the borrower to put up some kind of down payment. This is the borrower’s ‘skin in the game’. Borrowers can avoid taking out private mortgage insurance (PMI) if they contribute 20% or more of the purchase price in the form of a down payment. Most savvy first-time home buyers won’t go looking for their first house until they know the source of this down payment capital. Fintech originators, specialty finance companies, and others seeking an asset based or warehouse loan should wisely do the same.
How does haircut equity capital work in practice? Let’s say you are a fintech lender that provides small businesses with loans. If you and your lender are able to negotiate an advance rate of 80% on the outstanding principal amount of eligible receivables (eligible receivables is basically the legal term for an acceptable loan that you and the warehouse lender partner have agreed upon in your term sheet) on $5 million of eligible receivables you will have to contribute $1 million of equity before the lender will approve funding the $4 million of eligible loans. This equity serves as a buffer against potential losses for your lender and it is your equity in the first loss position.
Remember, the underlying small business doesn’t care about all these moving parts but as the leader at a new or growing originator this stuff is essential. Remember: Make sure from Day 1 of making loans and attempting to deploy debt funds out of a warehouse line or asset-backed revolver, that you are prepared to contribute your portion to fund the eligible receivables. Have this haircut cash readily available in advance, or simultaneous with closing your credit facility. Advance rates also can go up as the risk overall goes down. As the loan tape seasons, performance holds up, and origination volume grows, the amount of equity capital required should go down.
As a quick aside, and because I find it interesting, I wanted to spend a minute on a related topic. As the alternative asset management industry has grown in size, scope and complexity over the past two decades, more bespoke and tailored financing options are required to meet the needs of sophisticated fund sponsors. GP commitment sizes are growing, working capital needs evolve constantly at fund platforms, and debt as an attractive alternative to selling a GP stake is potentially worth exploring. The result has been a rise in specialty finance focused lenders to meet this capital need. I will explore this area of specialty finance in a future post.
Raising haircut capital can take several forms. Fintech originations startups and early-stage specialty finance businesses should start with their own capital and if possible family, friends, and professional networks. High net worth individuals and family offices would be likely options. Early stage focused private credit funds and some specialist venture capital funds may also provide haircut capital. Leverage networks in adjacent verticals (technology, alternative asset management, law firms, capital markets) as you cast your nets.
Firms at an early stage have little or potentially no track record. However, they could be unlocking a massive opportunity in a new lending area by engaging with borrowers in new ways. I personally find this to be the most exciting area of specialty finance. When combined with the rapid pace of technological innovation, this will be a busy space in the decade ahead. These innovators are the future. Identifying first loss backers and closing deals requires creativity and alignment of interests but perhaps most of all, a partnership mindset and framework.
About me:
My name is Andres Sandate and I am based in Atlanta, GA where my family and I have lived since 2006. My wife and I have three young children who keep us very busy, but also making lots of memories. I grew up in Newton, Kansas, attended The University of Kansas and then did an international MBA while living and working in Italy for several years in the early 2000s. For fun I love to coach my kids sports teams, cheer for the KU Jayhawks in basketball and Kansas City Chiefs in football, exercise, and read. I have spent my professional career in capital markets, alternative investments, the securities business, and most recently a couple of fintech startups and a private credit fund. I am passionate about innovation, exploring new topics in our industry, and meeting (as well as learning from) new people. Three years ago I created a podcast called ATLalts to share what I discovered across private markets, alternative assets, startups, and the world of non-traditional asset investing. Interviewing CEOs, startup founders, investment managers, and investors in order to inform, educate, and inspire listeners is a goal of each episode. If you want to reach me email andres@atlalts.com.