At Percent, we pride ourselves on our transparency and providing investors complete visibility of the deals on our platform. This is why we developed our thorough due diligence process. We assess the risks and stability of each prospective originator partner that comes through our pipeline to offer investors highly scrutinized and transparent investments.
Before an originator launches their first note on Percent, we perform thorough due diligence by assessing the company as well as their asset portfolios. This team focuses on numerous factors, datapoints, documents, and other sources to primarily assess two broad types of risk: counterparty risks and asset performance risks.
Counterparty risk is the risk posed by shortcomings on the part of a transaction party, typically due to a financial, technological, operational, or other failure. Asset performance risk deals with all 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. Should originators show significant risks or red flags, their deals will not appear on Percent.
Understanding Percent’s Due Diligence
To aid in the understanding of our due diligence process, we will 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. 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 requires 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. Some of the principal inputs used in Percent’s due diligence process include:
- Corporate Structure
- Sample underlying loan agreements
- Originator financial statements
- Portfolio data tapes showing assets and payments
- Underwriting manuals
- Agreements with other capital providers
These are just the most critical diligence inputs. Percent would also typically receive other documentation from a prospective originator as well, including everything from insurance policies, business continuity plans, formation documents, management biographies, and further supporting documentation. Percent would also conduct an on-site or virtual (via video call) operations review.
Depending on the nature of an originator’s business, Percent may request additional information. For example, say ProLoan, the hypothetical lender we introduced, lends to sole proprietors for business purposes.t 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.
With Percent as underwriter, we analyze the materials we receive 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:
|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.|
This is a high-level summary of our underwriting process when it comes to measuring counterparty risk. 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. Suppose the originator is an early stage company 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 gauge 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 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|
|Available to Note||77,600||97,000||77,600|
|Ending Note Balance||731,183||642,211||571,662|
Processes After Percent’s Due Diligence
Once all the diligence materials have been received from an originator, the internal scorecards and models have been completed, and the 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 Percent reviews each transaction.
Percent may approve or reject a transaction, or provide conditional approval. With conditional approval, Percent identified areas for improvement and have opted to make their approval contingent on these modifications being implemented. Sometimes, these conditions are quantitative, such as requiring overcollateralization by increasing the ratio of collateral relative to the note amount. Conditions may also be 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, 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.
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 once a deal closes. Originator partners are subjected to ongoing diligence. They must provide notification to Percent in the event of certain material events while also complying 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.
Due diligence is a dynamic and ongoing process, one Percent takes seriously for the benefit of all investors. With better due diligence comes better understanding of risks, and thus the ability to make more sound, informed investments.
This post was updated on April 8, 2022.