25 October 2018 • 14 minute read

Alternative funding for online lenders

In brief...

A growing number of institutions are investing in online lending businesses by providing finance on an asset-backed basis. The use of asset-backed facilities enables online lending platforms to access new sources of funding and to use this to originate more loans. Although the structures being used share many of the features of traditional securitizations, the nature of the online lenders and underlying assets means that a more bespoke set of eligibility criteria, events of default and asset warranties will generally be required.

Asset-backed origination facilities

As the number of new FinTech companies operating in the online lending space has increased in recent years, asset- backed origination facilities have proven to be an attractive funding option for online lending businesses looking for a flexible option that will provide the funding they need to originate more loans as their business grows.

Typical structure

Facilities are typically provided by one or more investors to a special purpose vehicle (SPV) on a limited recourse basis. The facility is secured against a portfolio of receivables which the SPV will acquire from the originator during the course of the funding period. The SPV is usually an orphan vehicle but transactions may also be structured where the SPV forms part of the originator’s group. Investors normally fund a certain proportion of the assets through a variable funding note (or loan equivalent) with the balance of the portfolio funded by a subordinated note (or loan) provided by the originator.

Finance and Markets Global Insight

Benefits

Investors are attracted by an investment in fixed income instruments that offer the potential for high yields. As this type of transaction is not limited to the established securitization asset classes, it can also provide investors with exposure to alternative assets. Many online lenders target niche markets such as point of sale loans, student loans or bridging loans. These transactions can therefore provide investors with an asset-backed investment that would not be otherwise available in the public market.

From the online lender’s perspective, an asset-backed origination facility provides a means of diversifying its funding sources. They are particularly well-suited to companies at a relatively early stage of growth because this type of facility will usually include some flexibility to increase or decrease the size of facility depending on market conditions and the success of the lending platform.

Although some lenders may enter into an asset-backed origination facility with a view to a future refinancing in the public securitization market, for FinTech companies that are not focused on one of the established securitization asset classes, it is more likely that building a long-term funding relationship with an institution that understands its business will be the primary objective.

Key features

Some key features of an asset-backed origination facility include:

Borrowing base	The portfolio of receivables in respect of which the investor(s) advance funds under the facility. The originator will want the definition to be as broad as possible to maximize the amount that can be borrowed under the facility at any given time. Investors will seek to ensure that only receivables of the highest quality are included.
Eligibility criteria	The criteria that govern the type of receivables that can form part of the borrowing base. Transaction specific criteria will reflect issues identified during due diligence.
Concentration limits	These are used to control the diversification of the receivables in the portfolio and avoid any excessive amplification of risks in the portfolio.
Advance rate	The amount that the investor(s) will advance against assets, which form part of the borrowing base and do not exceed the concentration limits. Where different classes of receivables can be sold by the originator, it is possible that different advance rates will apply within the same facility.
Asset warranties	The warranty package is typically more bespoke than would be the case for a public securitization by a more established originator.
Events of default	Events are tailored to the specific originator and asset class and are more extensive than in a public securitization. It is common to include events that relate to the performance by the originator and servicer of their obligations under the transaction documents.
Stop funding events	The SPV is permitted to draw on the facility during the funding period up to the maximum committed amount. The precise formulation of any events that trigger the start of the amortization period and an end to any further drawings such as a breach of default or delinquency ratios will be carefully negotiated.

In exchange for obtaining the new line of funding, FinTech lenders will generally have to accept a degree of restricted operational flexibility. Investors will often require the right to conduct regular audit checks at the originator’s premises. This can allow them to verify compliance with asset warranties and eligibility criteria. To ensure that there is no deterioration in the quality of loans being originated, investors will also seek to impose restrictions on a lender’s ability to modify its credit and collection policy as well as the form of credit agreement that it uses with customers. In some cases, investors may insist on the appointment of a board observer at the originator level to ensure that they are fully aware of any issues arising in the business.

Issues to consider

Asset-backed origination facilities generally constitute ‘securitizations’ from an EU regulatory perspective. This means that for transactions entered into prior to 1 January 2019 investors and originators will need to be aware of their obligations under the relevant EU sectoral legislation, including Regulation (EU) No 575/2013 (the Capital Requirements Regulation), Commission Delegated Regulation (EU) No 231/2013 (the AIFM Regulation) and Commission Delegated Regulation (EU) 2015/35 (Solvency II). Where the regulations apply originators will be required to retain a material net economic interest of not less than 5 percent. in the transaction and comply with the applicable reporting and due diligence requirements.

Transactions entered into on or after 1 January 2019 will be subject to Regulation (EU) 2017/2402 (the Securitization Regulation) and the risk retention and disclosure obligations set out therein. The Securitization Regulation does include grandfathering provisions but the parties to any transaction entered into prior to 1 January 2019 should pay close attention to the new rules to ensure that such grandfathering rules will apply.

Certain elements of the transaction structure are likely to be tax driven. At the outset of the transaction it will be necessary to perform an analysis of the location and status of the relevant assets to determine any potential tax liability and optimal location for the SPV. This analysis should include determination of exposure to withholding tax on cash flows, VAT on any services as well as any stamp duties and transfer taxes.

As is the case for any originator accessing the securitization markets for the first time, a considerable amount of work may be required to ensure that the originator’s systems are capable of the reporting required by investors and theapplicable regulatory framework. Investors will also need time to conduct thorough due diligence on any FinTech lender’s business and such factors should not be overlooked when assessing the time required to put this type of facility in place.

Conclusion

The use of asset-backed origination facilities is a well- trodden path for many different types of lender. Although this type of facility has traditionally been used as a stepping stone to a public securitization, for many FinTech lenders they can also be used as a longer term funding option.Although it is likely that a certain amount of operational control will need to be sacrificed, in return a FinTech lender can obtain a flexible funding line that will enable it to significantly expand its business.