Under-Appreciated Differences Between Forward Flows and Credit Facilities

Balance sheet-intensive originators often encounter a decision regarding how to finance their originations: whether to opt for a forward purchase agreement (“Forward Flow”) or to utilize a credit facility. Alex W. Wu, Ph.D. , Head of Risk at Coromandel Capital , provides an overview of the two and why Coromandel prefers the latter.

There are differences in structure and repayment (among others), which are laid out at the end of this article, but let’s first discuss a key difference in economics. You can expect to get a taste of the power of compounding as Warren Buffett of Berkshire Hathaway once famously said.

Using a $100 consumer loan as an example. Under a Forward Flow, the originator, as the ultimate selling entity (“Seller”), initially funds the loan with its own $100, and then sells it at the par value of $100 (plus any accrued interest) to the purchasing entity (“Purchaser”) who in turn receives all future loan repayments (principal and interest or a lack thereof if defaults occur). Unless originators can sell at a premium above par, their source of economics is limited to the origination fee, which let’s assume is 1% of the $100 or $1. In essence, the originator recycles its own capital of $100 to make $1. For the sake of simplicity, let’s assume the originator does $100 of loan origination per week and sells it at par for a return of 1% per week. Over a year (or 52 weeks), the originator generates a return of 68% ???more than 52% due to weekly compounding. How fast the originator can recycle capital matters tremendously to the return due to the time horizon of the return-generating process and the power of compounding. If the loan sale can only be done monthly instead of weekly, the originator’s return is reduced to 13%.

A credit facility is a loan to the originator where the originator (as Borrower) only pays the Lender (e.g. banks, credit funds, etc.) interest on the outstanding loan balance. The facility has a commitment with a maturity date, but before then, the capital remains outstanding and continually works for the originator. For comparison, let’s look at a credit facility backed by the same consumer loan as in the previous example under the Forward Flow. The Lender of the facility may require a 20% equity contribution from the originator (i.e., for incentive alignment, absorption of potential underperformance, etc.), so assuming the same $100 of the originator it can now support $400 in borrowed funds from the credit facility to originate $500 in loans (5x as much!). At a 1% origination fee, the originator can make $5 in fees. These loans charge an interest rate (“APR”) and may experience a credit loss due to default. The economics of the loans, namely origination fees and interest, need to cover both credit losses and servicing as well as the facility interest Lender charges on the $400 borrowed fund, which essentially represents a Net Interest Margin (NIM). Let’s assume that the loans have a standard monthly payment frequency and a NIM of 1% per month. Each month, the originator can reinvest the residual cash flow from the NIM to originate additional loans. Over a year, the loans generate a return of 13%???slightly higher than 12% due to monthly compounding, which may seem mediocre. But it is noteworthy that the originator has only invested $100 of their own fund. As a result, the originator’s return on equity is significantly higher at 63%, five times greater! If the loan product were to have a higher, weekly payment frequency with a NIM of 0.25% (1%/4) per week, the originator’s return on equity would increase to 69%.

In summary, when comparing a Forward Flow with a credit facility, the key difference lies in how the originator can utilize its capital. In a Forward Flow, the originator recycles its own capital, while in a credit facility, the originator can lever up its own capital to recycle both its own and the Lender’s capital. When making economic considerations, originators should assess the cash flow velocity of their products and the potential NIM under a credit facility. A credit facility is typically more beneficial when a product demonstrates a high cash flow velocity.

Typical Differences between Forward Flows and Credit Facilities:

1. Structure and Timing: A Forward Flow involves a transfer of a specified volume or type of loan from a Seller to a Purchaser. The transfer is prearranged and occurs (typically at regular intervals) over a defined period. In contrast, a credit facility provides ongoing access to a line of credit or a specific amount of funds that can be borrowed and repaid as needed (subject to borrowing base calculations and availability).
2. Transactional Nature: A Forward Flow is a transaction where the Seller sells a bundle of loans upfront and receives a lump sum payment. The Purchaser assumes ownership of the loans and the associated future repayments (or lack thereof if there are defaults). A credit facility, on the other hand, is a borrowing arrangement between a Lender and a Borrower, where the Borrower (i.e., originator) can draw funds as needed within the predetermined credit limit.
3. Purpose and Flexibility: A Forward Flow is often used by originators to generate liquidity, derive premiums to support a credit facility in lieu of raising dilutive equity (e.g. venture capital, private equity, etc.), prove out the concept by accumulating vintage performance data, manage risk, or free up capital for other purposes. A credit facility, on the other hand, provides borrowers with flexibility and ongoing access to funds that can be used as needed for various financing requirements.
4. Commitment: A Forward Flow provides the Purchaser with minimal notification periods and maximum flexibility to stop purchases, which conversely is to the detriment of the Seller by limiting its ability to reliably plan. A credit facility, however, affords the borrower committed capital (so long as covenants are compliant).
5. Incentive Alignment: A Forward Flow generates upfront revenue based on an originate-to-distribute model, which may reduce the originators incentive to comparatively promote healthier loans. A credit facility, however, aligns incentives better as the originator is the borrower and directly derives its revenue from the net interest income after loan losses generated over a longer timeframe and is rewarded substantially for doing so.

It's important to note that these differences are general in nature, and the specific terms and conditions can vary based on the agreement between the parties involved in the Forward Flow or credit facility. While Coromandel Capital prefers credit facilities, it recognizes that Forward Flows also have a place in the capital structure and that a mix of the two options (in varying degrees) also allow the originator to optimize their balance sheet and prevent dilution.

Coromandel Capital is always interested in educating both investors and originators on these options and other intricacies of the Private Credit market.

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