Managing Risk When Considering App Only Applications – Article by: Shervin Rashti
Managing Risk When Considering App Only Applications
In 2019, I authored an article for Newsline entitled, Balancing Credit Risk with Collateral Other than Equipment – Finding Structure in ANY Deal. At that time, credit risk generally relied upon predictive models set by individual lenders to meet preset risk tolerance. I discussed how credit adjudication was driven by credit, collateral, or a combination thereof. That article was written in October 2019. Fast forward to March 2020, and the world was turned upside down with a global pandemic that no credit modeling system had considered in any algorithm.
With the advent of COVID-19, there was a tremendous amount of uncertainty surrounding the future of commerce, the economy, and the world in general. Many lenders were hit with massive requests for deferrals from their debtors and a large number of those debtors’ businesses were shut down. This caused a recoil in the flow of capital, resulting in tightened underwriting guidelines for many lenders, specifically in the fixed-income finance space. Many lenders narrowed their credit windows to exclude particularly vulnerable industries like hospitality, gyms, restaurants, etc. Others limited their capital to very targeted groups and yet others halted lending altogether. This was a very chaotic and uncertain time for all, as the predictability that had worked for so many decades eroded to an obsolete model, overnight.
As lenders watched equity markets push to all-time highs in industries that emerged from the rise of the pandemic, there was a new sense of excitement that surrounded the New Covid Economy. Consumer savings moved to an all-time high; credit card debt dropped for the first time in nine years and spending started to ratchet up quickly. With nearly a billion dollars of PPP Forgiveness Loans, EIDL Low-Interest Loans, and other government-sponsored assistance to bolster business and consumers spending, there was a renewed sense of excitement of how to pivot to the new world economy. New businesses and industries that never existed were in high demand and in need of capital to grow. We started getting more and more requests from disinfectant-related businesses and PPE manufacturers; servers to accommodate the surge in at-home workers; along with construction and transportation sweltering with demand. The change was real, and more and more capital started to flood the market to garner sectors that made a lot of sense.
The equipment finance world saw a spike in capital infusion from private equity firms, institutional lenders, private lenders, banks, and other independents. The increase in liquidity led to wider credit boxes and more competitive underwriting standards to capture market share. Application-only limits began to increase dollar limits and reduce credit requirements. For example, we raised our app only limit from $150,000 to $300,000, as we saw a great amount of opportunity to help these businesses grow in a unique time. This brings us to the substantial point of this article, which sheds light on how underwriting in an app-only model can be successful and effective while mitigating risk factors that are out of the purview of the full financial package underwriting method.
Application only submissions generally require three simple items:
1. Complete and signed application
2. Three months of complete bank statements
3. Equipment quote or invoice
The basic tenets of app-only underwriting involve the following:
- Business Credit History
- Personal Credit Score and History (Not required for corp. only transactions)
- Time in Business
- Average bank balances
*There are others, but for simplicity, I am presenting the most common and relevant in this article.
I will break down each of these to help provide insight into how these are important in risk mitigation.
Industry – Lenders will choose to exclude certain industries they lend to for a number of factors. Some may avoid a particular industry based on their ability to collect or recoup from a certain asset class. For example, server equipment has a much lower resale value in the open market versus construction equipment. Some may not lend to certain industries due to their capital or legal restrictions. Cannabis lending is a great example of one of which many stay clear. Others may have a focus on a particular industry because of their knowledge and understanding of the asset class, the businesses that use the type of asset, and the lender’s resources in recouping from that particular asset class or industry. There are also many considerations with respect to concentration risks associated with certain assets as a disproportionate amount of a particular portfolio. For example, if a lender has 80 percent of their portfolio dedicated to long-haul transportation, they should certainly have a clear plan to collect and remarket assets in the event of a transportation drop.
Business Credit History – Every lender has its own definition of business credit history. Generally, the analysis is done based on payment history reports that will determine the business borrowing habits. There is weight given to comparable borrowing, delinquencies, charge-offs, etc. Comparable borrowings are considered for similar types of historic borrowing. Credit-based lenders will typically want to see anywhere from 50 to100 percent of comparable borrowing as compared to the amount of financing being requested. The payment history and correlating score are factored into the decision. Other simpler methods of business credit history can come from conducting a web search of the applicant’s business to understand how their products or services are performing from the end-user’s perspective. It is always surprising to see how much we can learn by conducting basic searches to determine creditworthiness.
Personal Credit Score – This is probably the most misunderstood and oversimplified factor when presented to our originators. Our top-tier pricing calls for a 675 FICO; however, not all 675 FICOs are created equally. Much like the business credit report, depth and history shed a lot of light on the score to accurately predict the likelihood of repayment. We often get submissions that present the applicant as having, “great credit” and a score of, “700 plus”; however, many of these come in with three or four tradelines that are no more than a few small credit cards that don’t show a lot of history or strength. Often, we will get a lower score client that has ample borrowing history, homeownership, comparable borrowing, low revolving debt utilization, and clean payment history. All great facets, except for the medical charges that went to collections and resulted in a 100 point drop in score. I always say, a good 600 is a lot better than a light 700. This is something great to consider when reviewing the aforementioned personal credit parameters.
Time in Business – Although we have a start-up program in which we provide capital to start-up ventures, there is no greater way to determine future success than his- toric habits. This comes in large part from experience. In scoring our underwriting model, we put quite a bit of weight on the time in business variable. The length of time in operation tells a lender that the management has withstood time, overcome challenges, possibly faced economic downturns, and has successfully navigated through such times to come out whole on the other side. With experiences such as these, there is a much greater chance for success and repayment.
Average Bank Balances – Although bank balances were not always a major part of app-only underwriting, they have become more and more useful in understanding business spending and cash flow management habits. There are several factors that we look for when reviewing bank statements. First, we look for deposits. Given the fact that we are offering up to $300,000 with very basic information, we want to be sure that the company is operating as a company that has deposits that can substantiate such a debt service. We look at the nature of the deposits and withdrawals. Are the deposits transferred from another account of theirs? Are there a couple of large deposits from one source that can indicate concentration risks with their clients? What are the balance averages? We look to see that there is a relatively steady amount of cash that correlates to the requested amount of capital. With all of the government loans and programs, we look to see if the business balances are artificially inflated due to extraordinary events, such as a PPP loan. Lastly, we look to see if there are recurring ACH drafts that can indicate any sort of cash advance loan that can mean they are having cash flow issues that required them to obtain high-yield loans that can negatively impact the debtor’s ability to cash flow our payments.
By taking into consideration all of the above factors and rolling them into a scoring model that weighs each component based on the lender’s personal preferences, there is a high likelihood that much of the risk of app-only underwriting has been mitigated and offers a streamlined process to allow businesses to obtain the cash they need in a quick and efficient timeframe, with limited risk. The issues that plague the global supply chain are impacting the delays that slow delivery of the equipment to be financed. It is important to consider when the equipment is needed versus the timeframe before delivery, coupled with pre-funding risks, commencement timeframes, etc. These are factors that are secondary to determining if the credit fits the lender’s box.
All in, app-only underwriting is a competitive means to get businesses fast capital with a partial view into the applicant’s financial stability; however, with attention to these points, much of the risk can be absolved to safely increase market share and growth.