Percent as an Underwriter: Our Diligence Process

At Percent, prospective originators and their asset portfolios are reviewed with a primary focus on two broad types of risk: counterparty risks and asset performance risks. The former relates to the risk posed by shortcomings on the part of a transaction party, typically due to some financial, technological, operational, or other failure. The latter deals with the underlying assets contributing to the repayment of an obligation and the risk they do not perform as expected, on either an individual or portfolio basis.

To aid in the understanding of our due diligence process, we can use a hypothetical originator as an example. Suppose a firm called ProLoan is a specialty finance lender specializing in extending loans to small contractors, freelancers, and other independent workers in the United States. Also imagine this company were to apply to be an originator on the Percent platform. As an underwriter, Percent would assess the capacity of ProLoan and its portfolio of assets to support a note sold to investors. 

As part of this process, Percent would require certain materials. Most of these are general and would apply to virtually any specialty finance lender, regardless of its lifecycle stage, asset class, geography, and so on. Below are some of the principal inputs used in Percent’s due diligence process. 

Materials Requested from an Originator

  • Responses to a due diligence questionnaire
  • Corporate Structure 
  • Sample underlying loan agreements
  • Originator financial statements
  • Portfolio data tapes showing assets and payments
  • Underwriting manuals 
  • Agreements with other capital providers

The above are just the most critical diligence inputs; Percent would also typically receive other documentation from a prospective originator as well. These would include insurance policies, business continuity plans, formation documents, management biographies, and more. Percent would also conduct an operations review either on-site or by video call.

Depending on the nature of an originator’s business, other information may be requested. For example, the hypothetical lender we introduced, ProLoan, lends to sole proprietors for business purposes and as such it may not be obvious if consumer lending regulations, which can be extensive, would apply to it. Consequently, Percent may request any regulatory or legal analysis the originator has access to and even more information about its legal and compliance team and related policies. 

Originator Level Diligence

In its underwriting role, Percent analyzes the materials it receives from an originator to measure originator-level counterparty risk. This encompasses an analysis of a prospective originator’s financials, operations, technology, and other internal and external risks. This helps Percent understand and, should we proceed with a transaction, convey to investors the risks posed by the originator and servicer as a counterparty to the contemplated transaction.

Below is a table featuring some of the dimensions of counterparty risk that we examine: 

Category Explanation
Financials Financial analysis includes analysis of an originator’s liquidity position, leverage, profitability, growth plans, capital raising potential with respect to both debt and equity, and company forecasts.
Operations Operations analysis focuses on originator operational strength, with a particular focus on management’s experience. For earlier stage originators, special attention would be given to “key person” risk and exposure to key clients and vendors. 
Technology Technology assessment focuses on the technology systems used in underwriting, servicing, and monitoring the asset portfolio. We also analyze the originator’s information security framework.
Internal Risk Internal risks encompass the remaining sources of counterparty risk that are endogenous to the company. We analyze compliance and fraud risks and their associated controls and conduct headline searches and background checks of the prospective originator’s CEO and the company itself. 
External Risk External risks focus on risks that are exogenous to the company. These include the risks to an originator posed by competition, cyclicality (both with respect to origination volumes and performance), regulatory and policy risks, litigation and legal risks, and external technology risks such as the failure of outside systems and the risk of technological disintermediation.

The above is a high-level summary of our underwriting process when it comes to measuring counterparty risk. As was the case with materials requested, the extent of the analysis may vary based on the peculiarities of a prospective originator. As an example, for originators operating in foreign jurisdictions, currency risk, hedging risk, and country risk would also form part of our external risk analysis.

A prospective originator will only rarely have a perfect score in each area of our analysis. Let us return to our hypothetical originator, ProLoan. Suppose that the company is currently at an early stage in its life and as a result is unprofitable. Also suppose it also has not raised new equity capital in over a year. While this increases the financial risk of the originator, the risk can be partially mitigated if the company is close to achieving profitability or is in the midst of raising new capital. If the firm has well known and committed equity investors, all of this helps reduce the likelihood that the company will not be able to continue operations in the near future. 

Asset Performance Risk

Once we have gauged the originator’s counterparty risk, we focus on the particular deal opportunity at hand. Key here is understanding the risk profile of the underlying assets, how they combine into a portfolio, and how that portfolio is structured into a note offering. 

Level of Analysis Considerations
Structural-Level Considerations include cash control arrangements, bankruptcy remoteness of the structure, performance reporting frequency, and the transaction leverage (e.g. the ratio of assets to equity capital).
Portfolio-Level Considerations include portfolio diversification with respect to obligor concentration, industry and geographic concentration, and customer sourcing channels.
Asset-Level Considerations include historical asset performance with respect to delinquency and default rates, amortization profile, and the nature of any collateral in the case of secured underlying assets (e.g. collateral value, liquidity, ease and cost of sale, etc.).

Besides the above levels of analysis, Percent also considers relationship risks. These are the risks that a transaction underperforms because of a deterioration in the relationship of two or more transaction parties or other entities. Drivers of relationship risks include active lawsuits, key client or vendor risk, and other relationships such as the length of the partnership between an originator and its portfolio servicer (in cases where the originator outsources its servicing function). 

Suppose our prospective originator ProLoan sources all of its customers through a partnership with a single online platform commonly used by freelancers and contractors, a platform akin to Fiverr, TaskRabbit, or HomeAdvisor. Suppose it also uses data from this platform to underwrite its loans and monitor its borrowers. For the sake of example, let’s say that, in the past, some customers have complained to the platform about certain deceptive marketing practices employed by ProLoan. The platform is currently investigating the matter and may limit access to ProLoan following its review. Either its reliance on this platform partner or the complaints could be a source of relationship risk, but together they are more meaningful as ProLoan relies on a continued partnership with this platform to source customers and adequately underwrite and monitor borrowers. 

Further, the same external risks that Percent examined for measuring originator country risk need to be reassessed in light of a specific transaction since the resulting conclusion may differ. As an example, suppose an originator makes loans in foreign currencies and only hedges that currency risk if required to by its funding partners. In this case, an originator may have substantial unhedged foreign exchange risk. Yet if Percent requires its portfolio be hedged, then the risk to our specific transaction may be less. 

Cash Flow Modeling

Besides the more qualitative deal risks, an analysis of quantitative risks is required. The chief risk here is that the proceeds from the underlying assets are unable to cover interest and/or principal payments on the note during the life of the transaction. This may arise because of a shortfall in portfolio proceeds caused by increased defaults or delinquencies, or reduced recoveries on defaulted loans. As part of its cash flow modeling, Percent attempts to predict the behavior of future cash flows from the pool of collateral that will collateralize the notes. 

First, a “base case” forecast is generated. This is usually constructed using the historical performance of either the originator’s overall originations or a particular subgroup, but may be adjusted to account for any factors that would be expected to cause future performance to differ from the historical experience. In the event that historical performance from the originating company is limited, a proxy analysis using originators of the same asset class may be considered. This forecast is then stress tested to ensure that even in a period of higher default rates, the portfolio would still perform well enough to repay investors in a timely manner. 

Sample Cash Flow Model

Scenario: $800,000 Note Issued at a 14.0% APY

Month 1 Month 2 Month 3
Portfolio Collections 80,000 100,000 80,000 
Servicing Fees/Costs (2,400) (3,000) (2,400)
Available to Note 77,600 97,000 77,600
Interest Due 8,783 8,028 7,051
Interest Paid 8,783 8,028 7,051
Principal Paid 68,817 88,972 70,549 
Ending Note Balance 731,183 642,211 571,662 

 

Post-Diligence

Once all the diligence materials have been received from an originator, the internal scorecards and models have been completed, and both parties still believe a note program remains attractive, the transaction goes through an internal committee process. A memo is prepared to compile all of the relevant information on the intended offering, and several team members review each transaction. 

The committee may approve or reject a transaction, but another typical outcome is a conditional approval. In this scenario, the committee members identified areas for improvement and have opted to make their approval contingent on these modifications being implemented. Sometimes, these conditions are quantitative in nature, such as requiring more overcollateralization by increasing the ratio of collateral relative to the note amount. Other times, the conditions could be more qualitative, such as requiring the prospective originator to complete its onboarding of a critical new hire before launching an offering. 

In the case of our ProLoan example, a couple issues were raised in our due diligence process. To mitigate risk, the committee may choose to make approval contingent on the successful completion of the company’s ongoing equity fundraising round or favorably resolving the issues with its platform partner or adding a couple new partners. 

Post-Approval

When a deal is approved, work begins on preparing transaction documentation and implementing the intended structure. Percent also begins preparing information that will be available for investors to review when making their investment decision.

The diligence process does not end, even once a deal closes. Originator partners are subjected to ongoing diligence requirements. Not only are originators required to provide notification to Percent in the event of certain material events but originators must also comply with other ongoing requirements. Typically, originator partners must provide Percent with portfolio performance reports on either a daily, weekly, or monthly basis. The originator must also complete regular compliance certificates and provide updates upon refinancings, which are used by Percent to stay informed of the most critical aspects of an originator’s business. Originator partners are also subjected to annual reviews where certain internal scores and models are updated, often from scratch. This is especially important since our due diligence process is constantly evolving. 

Conclusion

In its capacity as an underwriter, Percent closely diligences investment opportunities to ensure only attractive offerings are permitted and that the risks are understood, mitigated, and adequately disclosed to investors. This diligence process spans asset performance and counterparty risks, and leverages the perspective and judgement of numerous internal experts at Percent. It is also an ongoing process that hardly ends upon the closing of a particular transaction that Percent structured and introduced to investors. Due diligence is a dynamic and ongoing process, not a singular, static event in the process of bringing a deal to the market.

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