Direct investing has become an industry action point, driven by hunger for yield, a desire to use one's expertise and cut out what appear to be unnecessary fees. There are risks and costs that may come with direct investing and lending, however.
A major theme in the wealth industry over recent years has been direct investing. In other words, lending without a bank. (This area might sometimes be called “shadow banking” or alternative lending - the terminology can vary.) It is not hard to see the attractions: removing a layer of fees, earning a premium for lower liquidity in a low-yield world, and tapping the specialist knowledge that many ultra-wealthy people have about a sector. But of course there are no free lunches in capitalism. To go direct no longer requires outsourcing certain functions to a presumed expert; the due diligence required can add costs and take time. There are risks/rewards to balance.
To discuss these topics are Jon Barlow and Caroline Hayes. Barlow is co-founder and CEO of Finitive, an institutional private credit platform based in New York. Hayes is the firm’s co-founder and president. The editorial team is pleased to share these views with readers and invite responses. Do jump into the conversation! To comment, email firstname.lastname@example.org and email@example.com
A decade of low interest rates and easy money has increased the number and variety of investors and investment vehicles allocating capital to direct lending strategies.
According to the data site Preqin, assets under management allocated to private debt strategies increased by three times from 2009 to 2019, helping fuel the growth of an ecosystem of private credit fund managers, specialty finance companies, peer-to-peer lenders and online lenders across almost every category of lending, including credit card refinancing, auto, real estate, and small business lending.
Deploying capital into the non-bank lending sector may take many forms, such as whole loan purchase agreements, warehouse lines of credit and participations. However, as the economy slows due to the COVID-19 crisis, funding dries up and job losses spike, credit losses on loans of all types are expected to increase. Such environments can expose faulty investment structures, and even fraud, by underlying borrowers and non-bank lenders.
Many new investors in the sector have used sub-optimal investment structures to deploy capital to non-bank lenders. These structures can go unnoticed when credit is flowing and defaults are low, but when the cycle reverses, investors can realize unexpected losses, often well beyond what they would have experienced with proper structural protections.
Providing capital to non-bank lenders inherently involves credit risk, but family offices should do everything in their power to minimize the non-credit risks in these transactions. Here are seven ways to create institutional-quality structures for direct lending investments:
1. Form an SPV to protect assets against bankruptcy
A hallmark of a structured finance transaction is the use of a special-purpose vehicle (“SPV”), where the non-bank lender forms and sponsors an affiliated trust or limited liability company to effect a transaction.
The sponsor sells assets, such as loans, to the SPV in a “true sale.” This ensures that the assets will be “bankruptcy remote,” isolating those assets from the sponsor’s liabilities in the event that the sponsor files for bankruptcy. The SPV can also open bank accounts in its own name, providing additional structure around the movement of assets and cashflows, according to Gareth Old, partner at Clifford Chance US LLP, a law firm that specializes in private debt transactions.
Using an SPV structure provides protection against the fraudulent use of sold or pledged assets by the sponsor (such as diversion of transaction cashflows for an improper purpose) or other parties by creating a structured and secure environment separate from the transaction sponsor.
2. File UCC liens to establish priority as creditor
Uniform Commercial Code (UCC) liens prevent debtors from double-pledging the same assets with different creditors. In structured debt transactions, creditors, or a trustee or agent acting on their behalf, creates security interests and liens against the SPV and the assets held by the SPV.
This is perfected under the UCC including by filing financing statements, according to Clifford Chance’s Old. These filings establish priority among creditors, enabling additional creditors against the same assets to search for prior liens on those assets. The UCC filing system thus operates as an important protection against fraud involving the assets pledged to support a transaction.