This post was updated on May 21st, 2021
At Percent, we prioritize managing risk and commit to transparency about the risks encountered in private credit investing. On every part of our site — from deal pages to posts like this one — we remain honest and open about the risks faced by investors on our platform.
We embrace the times when investors consider this information and inquire about how Percent mitigates these risks. After many inquiries pertaining to Percent’s risk mitigation strategy, we realized it was time to share a detailed outline of exactly how our team mitigates and manages risk.
Components of Risk
We believe that risk must be understood on a holistic basis, taking into account all factors affecting investment performance across an entire portfolio. Yet for the purpose of explaining our risk mitigation procedures, it is easier to group risks for the sake of illustration.
As we outlined in a previous post, we usually divide risk into two categories: asset performance risk and counterparty risk. The former relates to when the underlying assets contributing to the repayment of an obligation do not perform as expected, on either an individual or portfolio basis. The latter deals with the risk that the performance of a note becomes de-linked from the underlying assets due to the actions (or inactions) of a transaction party.
Whichever category of risk we are referring to, and though the details may change deal-by-deal, the fundamental approach to risk management usually changes little.
Asset Performance Risk
For most investors, asset performance risk is the easier category to grasp and measure. When buying a piece of real estate, for instance, most people intuitively understand that their return depends on the ability of that property to generate cash flows, generally from rent or sale proceeds. Similarly, an asset-backed bond depends on its collateral pool to generate returns.
The notes offered on Percent’s platform are typically collateralized by portfolios of private credit assets. These could include loans, leases, cash advances, receivables, royalties, and more. These assets generate cash flows that can be predicted with some level of accuracy, but not with certainty and not without risk.
Nonetheless, the first step to mitigating asset performance risk is examining the payoff characteristics of the underlying assets. Relevant questions include:
- How frequently do the underlying assets pay?
- Are the assets amortizing or do they generate cash flows only at maturity?
- How long are repayment periods?
- What proportion of the assets will likely experience collection issues?
- What measures can an originator or servicer take to mitigate losses on a defaulted asset? And of the expected defaulted amount, what is the expected recovery amount?
- Are the assets in the portfolio very correlated, either because of obligor, geographic, or industry concentrations?
Percent reviews prospective originator partners’ loan books to answer those questions. Should we proceed with that originator, Percent also strives to make that information available to investors through Surveillance Reports that our internal risk team prepares periodically.
Despite best efforts to project asset performance, there will inevitably be some variability. As investors in Percent notes typically only have recourse to the underlying assets, should cash flows from those assets come in lighter than expected, interest and principal repayment to investors could be impaired.
To mitigate this risk, Percent usually requires that originators absorb losses on the collateral up to a predetermined point. This provides a cushion called “overcollateralization.” Overcollateralization is essentially the amount of collateral in a portfolio that is an excess of the amount required to fully collateralize a note’s principal value. Historically, this overcollateralization on Cadence notes has varied between 0% and 50% of notes’ portfolio value.
Percent arrives at an appropriate first loss cushion based on the term of the note and the projected default rate of the underlying assets. Other factors, including the presence of any foreign currency risk, delinquency rates, and recovery rates on defaulted assets, are also considered. We aim to have a first loss cushion that is some multiple of the projected default rate over the life of the note, which we refer to as the “Life Default Rate.”
To illustrate the protection provided by this cushion, suppose a 3-month note is collateralized by assets with a 5% historical default rate. If that note has 20% overcollateralization, the protection would amount to 4 times the historical default rate. In this example, even if defaults were to come in at twice their historical level, there would still be ample cushion provided by the excess collateral.
For some offerings, overcollateralization tests are incorporated into the transaction structure. These tests check for sufficient collateral on an ongoing basis. At the close of each note, Percent confirms that the collateral supporting any deal is sufficient to cover both the note amount and any overcollateralization required. The overcollateralization tests then check that the collateral continues to stay above some minimum threshold on an ongoing basis (generally either on a daily or weekly basis).
The overcollateralization just described is a form of ”credit enhancement,” so named because it improves the credit quality of a bond. Other forms of credit enhancement may include cash reserves and credit insurance. Any credit enhancements present in an investment offering are crucial factors in understanding its risk and, as a result, they are mentioned on our deal pages for investors’ benefit.
However, there are other credit enhancements common to Percent notes that are easily overlooked. As an example, in general, the underlying assets collateralizing the notes yield a return higher than what is due to the noteholders. This difference is called “excess spread” and provides yet another cushion to absorb losses. Excess spread is often classified as a “soft credit enhancement” since the spread in any one period is usually released to the issuer or originator before the note matures.
For example, imagine two Percent notes yielding 10%, one collateralized by assets earning 12% and another by assets yielding 22%. The excess spread is 2% and 12% for each note, respectively, and in either case that excess can be used to make up for losses from defaults.
It’s worth noting the support provided in the second note is far greater than in the first note. Excess spread is especially crucial for high-yielding asset classes like emerging market consumer credit, factored invoices, and merchant cash advances.
While asset performance risk is the more obvious of the two groups of risks we outlined earlier, counterparty risk shouldn’t be ignored. Counterparty risk refers to the risk of an entity involved in a financial contract not honoring its obligations. This could be due to the bankruptcy of that entity, but counterparty risk could also arise from operational failures.
Counterparty risk is especially relevant in private credit because the sector is more opaque. Whereas most public market transactions are executed through well-known, highly-regulated exchanges and clearinghouses, this is not so in private credit. In private markets, transactions are executed directly between two or more parties. This means the financial health and operational strength of counterparties matters a great deal more than in public market transactions.
The two most important counterparties involved in the notes offered on the Percent platform are our originator partners and Percent itself.
Originator Counterparty Risk
The first step to mitigating counterparty risk is understanding the role of the counterparty and assessing the potential for their financial and operational failure. Our prospective originator partners go through an extensive due diligence process that assesses these risks. Indeed, quite typically, the volume of questions that pertain to the originator as a counterparty exceed those related to the underlying assets themselves.
Our due diligence process reviews prospective originators’ operational and financial capacity, the technology they employ, and various other internal and external risk factors. Our counterparty risk mitigation process also includes an operations review of the originator. An operations review typically features a demonstration of an originator’s technology platform and also covers staffing, portfolio monitoring, and underwriting and servicing practices. Once again, these initial steps are merely meant to understand the risk of working with a particular party. We also attempt to understand the consequences of an operational or financial failure of an originator partner and how to mitigate such consequences.
In addition to our due diligence, we put every originator partnership through an internal committee process where several internal experts in operations, capital markets, and risk share their thoughts on potential partnerships. We also leverage outside advisors to provide further perspectives on a particular counterparty or asset class. Whereas many credit committees focus overwhelmingly on financial health or asset performance, we believe a broader scrutiny is particularly important in private credit.
Finally, our agreements with originators also provide various legal protections to investors. As an example, originators represent that they are in good legal standing and that our agreements with them are not in violation of other contracts or regulations that might encumber them. They also represent that they have proper title to the assets they are selling to collateralize the Percent notes. Originator partners also attest that no other entities have a claim to such assets, except in the case of subordinated notes where a specific senior claim is identified and disclosed. Some of these representations can be verified by background checks that include lien searches, incorporation checks, and more. Breach of these representations allows for the cancellation of a transaction by requiring that the originator repurchase the assets they sold. The proceeds from this repurchase would then be paid to noteholders.
If a counterparty risk were to materialize, either from an operational oversight, an information security breach, or even an originator bankruptcy, it is worth noting that noteholders’ investment would still be collateralized by the underlying assets, whether they are receivables, term loans, cash advances, and so on. To the extent feasible, Percent would manage the recovery process on behalf of investors in such an unforeseen scenario.
Percent Counterparty Risk
Just as we thoroughly diligence any prospective partners, we perform a similar exercise on ourselves and, in the process, have developed a robust risk management framework to address potential issues.
Not only do we use our committee process to scrutinize potential originators, we also use them as a forum to discuss potential operational issues that could arise on our end during the life of a transaction. This is especially pertinent to offerings with certain deal features, like embedded call options, more complex cash control arrangements, or transactions that involve a partner domiciled in a foreign country.
In the unforeseen event that Percent ceases its operations, investors on our platform are protected. Percent employs a backup manager that is responsible for continuing to service note programs in the event Percent is unable. Also, investors’ uninvested funds are deposited in an FDIC insured bank account and are not commingled with Percent’s operational bank accounts. The separation of these funds is reviewed by external accountants.
Investors’ funds invested in current opportunities, yet to mature at the time of a hypothetical insolvency, would also be protected. This is done through our use of industry-standard special purpose vehicles (SPVs) that segregate the assets of the note issuer (the SPV) from any of Percent’s assets and liabilities. Percent also employs an independent director and backup manager for its SPVs, the latter of which commits to intervene in the unfortunate event Percent were to cease operations. This backup manager would wind down the note programs then outstanding by remitting funds collected from the collateral to investors.
To be clear, when you purchase a note on the Percent platform, you are typically not looking to lend to Percent, so we strive to make sure your investment is insulated from any counterparty risks arising from Percent itself.
What are SPVs and How Do They Protect You?
SPVs are separate legal entities, typically formed through limited partnerships (LPs) or limited liability corporations (LLCs), that are used to separate an entity’s assets and liabilities from those of other entities that might otherwise be related. SPVs create a “bankruptcy-remote” entity whose creditors and other interested parties are substantially less exposed to the financial, operational and legal health of any other entity, at least from a bankruptcy perspective. For instance, even if a parent company goes bankrupt, an SPV it owns equity in can continue to pay its creditors, provided proper precautions were taken to make it truly bankruptcy-remote.
The use of SPVs in structured finance and other financial market applications has been around for decades. This is because investors value the protection that they offer in preventing hidden risks from materializing because, for example, a creditor somewhere else in an organization was able to lay claim to collateral they thought was meant to secure their claim specifically.
In its typical asset-based investment offerings that Percent makes available to investors on its platform, a bankruptcy-remote SPV is usually used. These SPVs typically only have a single set of assets and liabilities. The assets are the invoices, royalty agreements, loans, and other financial assets that collateralize the notes. The liabilities are the Percent notes issued to investors. We believe this structure is more investor-friendly than lending to the originator partners directly because it reduces dependence on the originator and the impact of the health of the originator deteriorating for some unforeseeable reason. We also believe that with scale, setting up SPVs can be done in a very cost-efficient manner, reducing costs that would otherwise be borne by the investor, the originator, or Percent.
Recall that we explained that counterparty risk could cause the performance of a note to become de-linked from the underlying assets due a transaction party not honoring a commitment, either out of intentional breach of contract or operational shortfall. We hope it is clear now why using an SPV helps reduce counterparty risk. This applies to the counterparty risk introduced by Percent or our originator partners.
By understanding the different components of risk and how they work in conjunction with Percent’s investments and operations, you should now have a clearer understanding of the risks involved in private credit investing and how Percent mitigates those risks. At Percent, we believe that making private credit less opaque opens up the asset class to investors who would otherwise be unfamiliar or uncomfortable exploring this alternative asset class.