“Traditional lending parameters tend to have rigid credit “boxes” in which they are able to lend. By taking a different approach to structuring deals, lending can break traditional credit molds to enable a solution for virtually every deal.”
Recently, I was approached by a participant of a conference educational session in which I participated as a panelist. This person told me that, after having been in the industry for a number of years, he finally understands what “deal structure” means. In this article, I’m going to offer clarity on how deal structures are assessed and designed.
When looking at building a portfolio, I always start with the end in mind. This means considering what challenges and opportunities lie within a particular credit niche and build the infrastructure around the anticipated result. To get to this perspective, it takes a bit more effort to learn about a business to design a solution that suits its specific needs. To offer some context, I break down underwriting appetites into two main historic categories: credit-based underwriting or collateral-based underwriting. First, I will describe how these two categories are typically designed, the infrastructure that is required to support each type and then I will offer a third alternative, The Hybrid Approach to Credit.
Traditional Credit-Based Underwriting
Generally, credit-based underwriting parameters rely heavily upon underwriting as a scoring model that considers borrowing history as the foundation for the determining the likelihood of future performance. The scoring considers factors such as conventional personal credit, comparable debt, time in business, revolving balances, background checks, business payment history, bank balances, cash flow, etc. As such, the credit quality has a targeted baseline and reduces the risk to the lender. This model generally relies on lower yields to stay competitive, but also achieves better performance, requiring less infrastructure to support collections. Overall, there are minimal expected losses, resulting in a fairly accurate predict-ability of performance and costs associated with managing the portfolio.
Traditional Collateral -Based Underwriting
Collateral-based underwriting will generally rely less upon the credit profile and more upon collateral to mitigate potential losses from the portfolio. This means there is more risk involved, resulting in higher yield thresholds. Lower attention to historic payment habits will generally result in higher losses and more infrastructure to support collections, repossession, re-marketing and other types of solutions for uncollectable accounts.
Most often, collateral-based lending is associated with asset-based lending (ABL), a form of lending that considers inventory, accounts receivable and purchase orders as general forms of collateral. These forms of collateral are valued based on the projected ability to monetize such assets in the event of a default. They are fairly standard in that they utilize a dis-counted advance rate against the asset value today, with a balance disbursement to the borrower upon receipt of funds for the underlying collateral.
Another type of collateral-based underwriting is related to real property secured transactions. These are generally structured as mortgages or deeds of trust and are subject to considerable reliance upon the real estate value and lendable equity in a first–lien secured position.
“This flexibility in approach can provide new lending opportunities even when a deal does not fit a particular category”
To read more on Balancing Credit Risk with Various Collateral by Shervin Rashti click here for the full article featured in NEFA Newsline Nov/Dec 2019 issue!