Old Wine in New Bottles: The Emergence of the P2P Small Business Lending Securitizations

more+
less-

This last year has seen an uptick in activity in the peer to peer commercial loan market in the U.S., which, broadly speaking, includes loans made by non-traditional financing sources to small businesses (“P2P Commercial Loans”). Although there is no standard definition for what constitutes a P2P Commercial Loan, these loans can be as small as $10,000 but are typically less than $250,000. They are generally extended to borrowers who are either shut out of traditional financing sources or find such sources too time-consuming and instrusive or too costly. More recently, a number of institutional investors (such as hedge funds) have shown an increased interest in purchasing these P2P Commercial Loans directly from the originators on a whole loan basis (“Third-Party Purchasers”). These trades are driven by the fact that such investors cannot or will not make these types of loans themselves, but are interested in the attractive yields offered by this asset class.

Increasingly, both the P2P Commercial Loan originators (“P2P Originators”) and these Third-Party Purchasers are looking to securitize these loans. However, securitizations of this asset class pose unique legal risks due to the nature of the assets. For those accustomed to investing in or lending against pools of middle-market loans, these downstream cousins present specific challenges not seen in the middle market space. In this context, for both those contemplating securitization and those contemplating lending to or investing in such securitizations, it is important to understand the legal landscape and the risks that are unique to this asset class, as these factors drive the types of terms/provisions to be negotiated in both agreements to purchase P2P Commercial Loans and securitization documents financing P2P Commercial Loans. 

Issues Arising in any Securitization of P2P Loans

All securitizations of P2P Commercial Loans have the following considerations which are not as prevalent in other types of commercial loan securitizations:

Back-up Servicing: For those accustomed to dealing with middle market securitizations, back-up servicing arrangements are rarely seen as of late. In middle market or broadly-syndicated loans, the administrative agent for each of the underlying loans performs most of the “heavy lifting” involved in administering the loan (including monitoring compliance, wiring payments directly to lender accounts, etc.) and interfacing with the underlying borrowers. Thus, the “servicing” or “managing” to be performed for these securitizations generally revolves around selecting the loans to purchase or sell, analyzing the credits, compiling reports, and occasionally voting on amendments or restructurings. In the P2P Commercial Loan space, however, a servicer entity is needed to interface with each borrower and is responsible for collecting and processing payments, answering questions from borrowers, and other administrative type functions. In some P2P Commercial Loan platforms, the payments are set up to be debited directly from the borrower’s operating account on a daily basis. Thus, it is essential to have a replacement ready to step in at a moment’s notice, as even a few days of servicing failure can have a detrimental effect on the portfolio. A back-up servicing arrangement which includes a warm back-up servicer and “early-warning” trigger events for racheting the role to a “hot” back-up servicer is recommended.

Thorough Eligibility Representations and Repurchase Obligations: In the broadly syndicated and middle market realm, buy-backs for breach of eligibility representations have largely been dropped from collateralized loan obligations (“CLOs”) in recent years, although they tend to remain in private loans made to special purpose entities (“SPEs”) in the middle market category. However, as a matter of practice, instances in which breaches are found and these repurchase obligations are called upon tend to be rare or non-existent. Some of this may be due to the sophistication of the banks and specialty finance companies that originate middle market and broadly syndicated loans and the fact that basic underwriting standards have become industry-accepted. However, in the P2P Commercial Loan space, origination is not as thorough or lengthy of a process, and much of it is automated. In other words, no diligence visits, no corporate/enforceability opinions given at closing, no audited company financials and so forth. Despite precautionary measures that a P2P Originator may put in place to police this process, these loans inherently carry more fraud and transparency risk. In addition, there is an increased likelihood that the proceeds of the loans may be used for non-commercial purposes or prohibited industries, all of which can create liability for the securitization SPE as the holder of the loan. Although in the middle market or broadly syndicated space, the originator entity is often able to escape bearing the risk associated with borrower fraud (typically originators or sponsoring entities will negotiate knowledge qualifiers around such eligibility criteria), due to these heightened risks in the P2P Commercial Loan realm, the existence of such knowledge qualifiers will likely be a more contentious issue in securitizations.

  • Methods of Allocating P2P Commercial Loans to the SPE: Inherent in any P2P Commercial Loan securitization is the risk of adverse selection. Most P2P Originators have multiple vehicles that can serve as home for their new originations aside from the securitization SPE, and a securitization provider would want to ensure that their SPE is not saddled with the lowest-quality assets. While this risk is present in any asset class, what makes this task particularly difficult in the P2P Commercial Loan context is that credit risk is difficult to analyze on an individual loan basis. While most P2P Originators have some type of internal scoring mechanic for assessing the risk level of the loans, these are generally not as reassuring as credit ratings or credit estimates that come from independent rating agencies with a long track record of developing methodologies for assigning such ratings. Further, P2P Commercial Loans vary in maturity and interest rate, both of which are in part based on the originator’s assessment of the underlying borrower’s credit risk. Thus, any securitization provider should carefully review the allocation method for which the SPE is allocated loans, whether it be a random basis or otherwise. In addition, concentration criteria can be useful in ensuring a desirable mix of the overall pool for items like the internal “credit score” of the loan, principal balance, term to maturity and geographic and industry concentrations.   
  •  Underwriting Policies: Each P2P Originator uses a different mix of data or inputs to decide whether to make a loan and how to assess credit risk (which influences the interest rate charged), which could include individual credit scores, account balance history, social media data, or transaction history from third party vendors or online marketplaces. A significant portion of the review is automated and the algorithims employed by the various originators tends to be proprietary. Thus, the challenge becomes striking the correct balance between an underwriting process which is quick and minimally intrusive (which makes these loans attractive to the underlying borrower in the first place) and a process that includes more verification and diligence (which helps minimize fraud/misrepresentation risk and ensure credit quality). Given this inherent tension and the lack of industry standards, the underwriting policies of any P2P Originator merit a careful review. In addition, if possible, any modifications made after closing should be subject to pre-approval by purchasers or lenders.
  • Servicing Policies: Policies regarding when to charge off loans or when to make modifications or allow for payment delays will influence the overall performance of the portfolio going forward. Thus, any changes to either underwriting or servicing policies could have a dramatic impact on the loans being securitized. If possible, a financing party should seek as much information as possible regarding servicing policies at the outset and seek to have all such changes subject to prior approval going forward.

Issues Unique to Securitizing Third-Party Acquired P2P Loans

Securitization of third-party originated P2P Commercial Loans poses some additional risks, which Third-Party Purchasers should consider in negotiating purchases of these loans in contemplation of securitization:

  • Confidentiality: Standard confidentiality provisions would typically limit the ability of a Third-Party Purchaser of P2P Commercial Loans to share information regarding the P2P Commercial Loans purchased or the terms of the purchase agreement with key parties such as equity investors, potential financing sources, or rating agencies. Exceptions to accommodate the need to share with these parties should be negotiated.
  • Diligence, Audits and Reporting: Given the key role of a P2P Originator in an industry with no industry-wide standards, rights to third party diligence visits and audits may need to be negotiated with the originator, particularly in instances in which the originator continues to service the loans after purchase. As the financial health of the originator may also be key to a party seeking to purchase or finance these loans, financial reporting delivery requirements should also be considered.
  • State Licensing and Usury Laws: Any Third Party Purchaser should diligence how adequately the P2P Originator developed its platform to comply with state-level licensing and usury laws. Further, a Third-Party Purchaser should also consult with its own legal counsel to ensure it obtains all necessary licenses to purchase and hold the loans, or that it places appropriate parameters around the purchases so as to avoid the need for obtaining such licenses, as applicable. This may involve placing a seasoning time frame prior to purchases or limiting purchases in certain jurisdictions unless a license is obtained.
  • Refinancing Risk and Solicitations: Since a key source for new loans for some of these P2P Originators is the existing borrower pool, often they will solicit existing borrowers to refinance their existing loans with proceeds of a new loan. While prepayment risk is inherent in any pool of loans, active solicitation by an originator party (with whom the underlying borrowers already have a relationship) poses an additional layer of risk. For Third-Party Purchasers who have the leverage, a negative covenant limiting or prohibiting active solicitation towards the borrowers with already-purchased loans should be considered. Another alternative is to adjust the terms of the purchase (such as the upfront purchase price or fees paid) to compensate if the prepayment rate ends up being higher than anticipated.

The Past: Similarities with Early Middle Market Deals

For those who remember middle market securitizations in their infancy, many of the above factors should ring familiar. When middle market deals first cropped up, similar concerns were raised. Compared to the broadly syndicated loan category of the day, middle market loans were less liquid and more difficult to evaluate from a risk standpoint (as most were not rated). In addition, since the early loans sometimes did not have an agent bank, the middle market originator typically retained many of the loan administration obligations as well as future funding obligations, thus making the loans more vulnerable to an insolvency of the middle market originators. Partly for this reason, most of these early middle market securitizations done in the early 2000s had close tie-backs to the originator entity (including buy-back provisions for breach of eligibility, financial covenants, and cross-defaults) and usually employed a back-up servicer. However, as the middle market industry expanded, the loans became more liquid, an increasing number were rated or given credit estimates, and the loan-level institution of an “agent bank” role made the administrative functions more streamlined. Today, middle market CLOs tend to have few, if any, tie-backs to the originator entity and rarely have back-up servicers, and most underlying middle market loans have some kind of rating or estimate. In many ways, the terms and structure of middle market CLOs continue to move closer to the broadly syndicated CLOs.

The Future: Anticipated Evolution of the P2P Commercial Loan Space

As the P2P Commercial Loan field expands and more institutional players invest in these assets, we anticipate that the loans will become more liquid. In addition, the increased interest in securitizing these assets should also serve as a catalyst to make the underwriting process more standardized and the assessment of credit risk more universal. As more P2P Commercial Loan securitization transactions take place, the banks, bondholders and rating agencies involved will likely begin to expect more standardization of the loans themselves (i.e., standard eligibility criteria) and the pools (i.e., concentration limitations), as well as metrics for assessing risk on individual loans that are more quantifiable, standard and transparent. Although the path of P2P Commercial Loans will not exactly replicate the early path of middle market loans—as the size of the loans and nature of the borrowers will inherently push against some of these trends—we expect that the structure and discipline of a healthy securitization market for P2P Commercial Loans will benefit both the asset class and its investors.

 

Topics:  Funding, Hedge Funds, Loans, Peer-to-Peer, Popular, Securities, Securitization, Securitization Market, Small Business, Startups

Published In: General Business Updates, Finance & Banking Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Dechert LLP | Attorney Advertising

Don't miss a thing! Build a custom news brief:

Read fresh new writing on compliance, cybersecurity, Dodd-Frank, whistleblowers, social media, hiring & firing, patent reform, the NLRB, Obamacare, the SEC…

…or whatever matters the most to you. Follow authors, firms, and topics on JD Supra.

Create your news brief now - it's free and easy »