We have recently seen an interest by certain marketplace lenders and other Web-based lenders in undertaking a securitization of some or all of the loans originated on their platforms. This article briefly explains the securitization process and how it could be beneficial to marketplace lenders and other nontraditional lenders.
Basics of the Securitization Process
Overview of Securitization Process
Securitization is a way for originators of loans or other cash-flowing assets to finance them. In essence, it is a financing technique with substantial other benefits to originators as described below.
The financial asset originator (Originator) sells a pool of loans, accounts receivable or other financial assets to a bankruptcy-remote special purpose vehicle (the SPV) for cash. The Originator initially retains an equity ownership interest in the special purpose entity (SPE). The SPE issues one or more classes of debt securities secured by and payable from the cash flows generated from the financial assets conveyed to the SPV by the Originator or an affiliate of the Originator. The SPE is generally formed in Delaware as a statutory trust or a limited purpose limited liability company. For purposes of this article, we will describe the process undertaken in a nonpublic or private securitization, where all of the debt or equity securities being offered and sold by the SPE are done so in private placement transactions to large institutional investors, family offices or others that qualify as either qualified institutional buyers (QIBs) or institutional accredited investors (IAIs) in a transaction exempt from the registration requirements of the Securities Act of 1933 (Securities Act) and the Investment Company Act of 1940 (Investment Company Act).
Typical securitizations involve a number of parties in addition to the Originator and the SPE and usually include (i) a placement agent or a Securities and Exchange Commission (SEC)–registered broker-dealer, (ii) an indenture trustee, (iii) a servicer (and sometimes a sub-servicer), (iv) a backup servicer, (v) a rating agency, (vi) the securities depository and (vii) the prospective investors in the securities.
The Placement Agent
The placement agent or the broker-dealer locates the investors in the senior and any junior classes of securitization notes. In many transactions, the placement agent will be the initial purchaser of the securities being sold by the SPE and will immediately resell the securities in a Rule 144A transaction to large institutional investors (referred to as QIBs). The securities may also be sold to sophisticated non-U.S. investors in a transaction that is outside of the United States and exempt from registration under the Securities Act’s Regulation S. In these transactions, the QIB and Regulation S investors will generally not receive a physical note or other security to evidence the security acquired by them, but rather they will receive an interest in a global note held in book-entry form by a securities depository, such as the Depository Trust Company, Clearstream or Euroclear.
The Indenture Trustee
The indenture trustee and collateral agent are trust companies or banking institutions. Under the indenture, the SPE grants to the indenture trustee, for the benefit of the investors in the debt securities, a perfected security interest in the conveyed loans or other financial assets and their associated cash flows. The indenture sets forth, in detail, the rights of the debt and equity investors in the SPE and the order of priority of payment of the cash flows received by the indenture trustee among the different classes of debt and equity securities and the service providers. In most instances, the indenture trustee makes all required payments due to the holders of the debt and equity securities. Similar to a loan agreement, the indenture also has detailed provisions governing the indenture trustee’s exercise of any rights and remedies against the SPE in the event of a default, bankruptcy or breach of the indenture or other transaction documents and the rights of the various classes of securities holders to direct the actions of the indenture trustee.
Servicer and Backup Servicer
In most cases, the loans or other financial assets held by the indenture trustee are serviced by the Originator or an affiliate. To provide comfort to the holders of the notes or other debt securities, the Originator has to arrange for a third party with experience in servicing the particular type of assets held by the SPE to act as the backup servicer in the event that the indenture trustee is required to replace the servicer due to the servicer’s bankruptcy or material breach of its obligations or covenants set forth in the servicing agreement or in any other transaction document to which the servicer is a party in any capacity. In addition to managing the collection of the loans or other financial assets, the servicer is usually charged with preparing detailed reports pertaining to the performance of the financial assets held by the SPE for the indenture trustee, the investors in the debt and equity securities and, where one or more of the classes of debt securities issued by the SPE are rated, by the rating agency.
Issuer SPE Is Usually a Bankruptcy-Remote Entity
One of the essential features of a securitization is the careful structuring of the issuer SPE to make it bankruptcy remote from the Originator and any affiliates of the Originator and the holder of the equity interest in the SPE and "ring fencing" the SPE’s assets from the assets and liabilities of the Originator, servicer or other third party. In addition, it is imperative that the transfer of the Originator’s loans or other financial assets to the SPE be treated as a true sale, as opposed to a loan secured by the assets being conveyed. Strict corporate formalities must be maintained to ensure that a court would determine at a later point that the SPE should be treated as a separate and distinct entity and its assets should not be combined with those of the Originator, the equity holder of the SPE or any of their affiliates. The investors in the debt securities of the SPE require as part of the closing that the Originator and the SPE deliver an opinion of counsel to the effect that the sale of the assets should be treated as a true sale (a true sale opinion) and that the SPE will not be consolidated with the assets and liabilities of the Originator, the SPE’s equity holder or any of their affiliates in the event of a bankruptcy of the Originator, equity holder or any of their affiliates (other than the SPE) (a nonconsolidation opinion). Not surprisingly, the trust agreement or limited liability company operating agreement strictly limits the business activities of the SPE to only those activities that are necessary for the securitization. To prevent the SPE from incurring any additional indebtedness or liabilities that could adversely impact the financial solvency of the SPE or subject it to third-party liability, the SPE’s governing documents strictly prohibit the SPE from incurring additional indebtedness or entering into any material agreements not expressly contemplated by the securitization documents. The SPE’s governing documents also require the prior written approval of an independent director or manager/member to enter into any such transactions. Similarly, the consent of the independent director or manager/member is required to file a voluntary bankruptcy petition, which has the practical effect of eliminating such a filing by the SPE.
Time to Complete; Roles and Process
The securitization process usually takes about two to three months to complete. The process may take slightly longer if the senior class of debt securities issued by the SPE is being rated by a rating agency, which is frequently the case. Senior debt securities with an investment-grade rating are much more marketable and easier for a placement agent or broker-dealer to place with institutional investors because many such investors (particularly insurance companies and other regulated entities) are limited in the amount of unrated or noninvestment-grade-rated debt securities they are permitted to invest in. The placement agent or broker-dealer usually takes the lead in assisting the SPE in engaging the rating agency and facilitating the exchange of information between the SPE/Originator and the rating agency with respect to the expected performance of the loans or other financial assets that the Originator wishes to securitize. The placement agent/broker-dealer, the rating agency and the potential investors in the offered securities all play important roles in determining the pricing of the debt securities and the appropriate amount or level of overcollateralization or other credit support that needs to be provided to the SPE in order to successfully market the senior debt securities and with respect to the senior class or classes of debt securities to obtain an investment-grade rating for this tranche of securities.
Issues for New Issuers, Including Marketplace Lenders
For loans underwritten and originated on new or nontraditional lending platforms, such as Web-based loan originations or loans from marketplace lending arrangements, the initial modeling by the rating agencies or institutional investors may take slightly longer. One of the initial difficulties in obtaining investment-grade ratings for early-stage marketplace lenders was the absence of any substantial track record on loan portfolio performance. As the industry has grown and the volume of loan originations by such lenders has skyrocketed, the rating agencies and institutional investors have become much more comfortable with the quality of the loans and the efficacy of the algorithms underlying the loan underwriting decisions. Significantly and not surprisingly to us, many of the early marketplace and Web-only lenders have turned to the securitization market, notwithstanding its initial cost and obvious complexity. We will explain below the reasons for this and why marketplace lenders should consider the securitization market as a potential approach to grow their businesses.
Reasons Why Marketplace Lenders Should Consider Securitizations
Based on the short description of the securitization process, it is clear that the process is complicated and does require an upfront investment. However, there are a number of reasons why marketplace lenders should seriously consider undertaking a securitization program with respect to some or all of their loan originations.
Maximize Growth and Expansion
The securitization will permit the marketplace lender to originate a greater volume of loans by allowing the recycling of the investor’s or lender’s funds into new loans. Because many marketplace lenders derive a significant portion of their revenue from servicing the loans originated on their platform, the greater the amount of outstanding loans the greater the servicing income flowing to the platform sponsor. As discussed above, the Originator generally continues servicing the loans or financial assets, even after they are transferred to the SPE.
Leveraging the Portfolio’s Increasing Profits
Marketplace lenders also frequently receive a spread between the amount of interest and fees paid by the borrower and the amounts paid to the investor in the loans originated on the loan platform. If the securitization is structured properly and efficiently executed, the platform Originator will be able to effectively leverage the loan portfolio at a much lower interest rate than was being passed on to the platform investor and thereby increase the net interest spread and income to the platform Originator while providing funds to generate even more loans on the platform. The economic benefits to the equity owners of the platform sponsor or loan Originator could be significant.
Securitization Programs Drive Down Costs
The time and cost involved in completing a securitization transaction drops significantly with each subsequent securitization. In addition, the pricing on the senior and junior debt securities issued by the SPE becomes more efficient and less costly as the Originator does more transactions.
The securitization process provides another means of enhancing the liquidity of the platform sponsor and loan Originator.
Pepper has a long history of securitization experience. We have represented issuers, indenture trustees, servicers and investors in securitization transactions since the first public credit card securitzation in the 1980s. We bring this depth and breadth of our experience to the marketplace lenders who wish to undertake this financing technique with many added benefits as outlined above. We can provide you with "one-stop shopping" as our Delaware office has a very active practice in representing issuers in securitizations and structuring the bankruptcy-remote status and providing the many complex opinions required by the underwriters and investors in these transactions.