Page 3
PAGE 3 | How Debt Funds Use Warehouse and Other Credit Lines
A proposed new structure–private placement of a non-revolving line of credit (NR-LOC)
In the remainder of this white paper, we will examine a possible new structure for non-bank lenders to capitalize their portfolios of investor loans. We’ll refer to this potential new structure as a “private placement” and the investor in that private placement as the “fixed income investor” or “private placement investor.” Note that the “fixed income investor’’ could be an endowment, pension fund, fund manager, bank or insurance company, and that the interest on the private placement could be either fixed or floating.
This structure resembles a warehouse line of credit, but it is non-revolving. In other words, every time an underlying investor loan gets paid off, the fixed income investor gets paid off by a proportionate amount, or potentially a little more, so that the loan balance decreases to zero naturally over time. Given that many BPLs pay off in one or two years, non-bank lenders might originate a private placement every year to the same or new fixed income investors. For simplicity, we will assume that there is a single fixed income investor in each private placement. The diagram below shows the relationship among the fixed income investor, the non-bank lender and the underlying loans.
Accelerated ammortization
The parties to an NR-LOC transaction may find it helpful to utilize accelerated amortization, if the fixed income investor places a premium on the safety of the investment and will price the NR-LOC more attractively as a result. Accelerated amortization relates to what happens when an underlying loan gets paid off. With accelerated amortization, the amount paid off on the line of credit is slightly higher than the proportionate amount of the underlying loan as a percent of the total loan portfolio.
As shown in the table below, this feature is accomplished by using release prices. In the example below, the investor’s attachment point (which is closely related to risk) declines every time one of the underlying loans pays off. This means a little less efficiency for the non-bank lender’s ability to use the LOC to enhance returns in their own funds or other investment vehicles. However, in many cases the LOC provider values security so highly that it may be advantageous to both to use this feature.
The following diagram shows how the loan balance outstanding might change over time for each in a series of private placements, which could be with the same investor. The underlying loans remaining in the collateral pool for the first private placement at the end of the first year could be included in the next private placement, allowing the first private placement to be paid down to zero and retired, even if all the underlying loans had not yet been paid off. This would of course require the approval of the investor in the second private placement, who might negotiate to accept or reject individual loans in the second private placement, if they had any concerns about any loan being included in the second private placement.
Advantages for the fixed income investor
The proposed new structure has a number of beneficial features for the fixed income investor, some of which are outlined below.
Minimal operational responsibilities
One reason many banks choose not to offer warehouse LOCs is that their revolving nature means heavy operations and specialized staffing for the bank. New loans must be reviewed and then once approved, boarded onto the borrowing base, while other loans are paid off, resulting in paydowns and an ever-changing loan balance outstanding.
In contrast, the NR-LOC features no work for the investor after making the initial investment decision. The NR-LOC is paid down automatically by a third party as underlying loans pay off. With the proposed structure, banks, insurance companies and other fixed income investors could potentially access the attractive returns in this market without having to hire and train specialized staff.
In case of a default by the non-bank lender, an independent third party lending platform would need to be in place to take over servicing of underlying loans, as shown in the diagram below.
