Financial markets continue to bank on the eventual success of President Trump’s regulatory reforms and tax plans, and almost universally expect the Federal Reserve to raise interest rates when the FOMC meets again later this month. Officials, including nearly every voting Fed governor, have taken pains in the last week to communicate an overall message that is both more hawkish and more coordinated that any in recent years, which suggests an overt shift in underlying monetary policy since the election. And if you’re looking for more signs that “animal spirits” are alive and well in the credit space, one of our associates returned from yesterday’s LendIt Conference at New York’s Javits Center to report a staggering 5,700 attendees. Only three years ago, the same gathering – which concentrates on trends in marketplace, peer-to-peer, direct and commercial lending – consisted of mere 200 people at the Times Square Marriot.

A common theme visible at this year’s LendIt was growing concern about impending default rates. Although not visible yet, the worry is that the rush of capital into the cash-flow and peer-to-peer lending segments of the industry over the past two years, largely in anticipation of the end of the Fed’s NIRP/ZIRP/QE experiment, will coincide with the Trump Administration’s goal of loosening the regulatory policies that have crimped bank lending since the financial crisis. Together, the stage could thus be set for a sizeable increase in default rates 18-24 months from now. Indeed, one of the most crowded panels our associate attended was one which explored the use of artificial intelligence to determine what businesses will become slow payers and which ones will turn into all-out defaults – an interesting theory, but one highly unlikely to replace the kind of old-fashioned granular due diligence undertaken by companies like us in advance of a transaction.

Accordingly, we decided to change our approach for this month’s commentary and look at the subject of defaults from our point of view as a lender in the small business space. To do so, we caught up with Peter Faigl, portfolio manager at Old Hill Partners and an expert in modeling, structuring and managing asset-backed lending investments, to get some insights about the topic.

What are the three most common mistakes you see in asset-backed direct lending transactions, and how can they be avoided? 

I think by far the number one mistake is having a weak or no alignment of interest between us, as the lender, and our client, as the borrower. This is usually achieved by having the borrower commit a meaningful amount of their personal capital to the transaction and subordinating it to us. Should the transition then run into trouble, they will be more incentivized to work with us on addressing the issues and/or minimizing the costs of resolving them.

A second common mistake is having an insufficient control over the cash generated by the underlying assets. If the lender does not have strong procedures in place on how the cash moves from the underlying obligors to the collection accounts, the lender is exposing itself to potential misuse or diversion of the funds by the borrower. This is a very common occurrence when the borrower becomes distressed.

Another mistake is lack of careful reconciliation of cash deposits received from the underlying obligors against reported payments on the data tape. One cannot just rely on information the borrower provides; it has to be reconciled on a periodic basis. Relying on an annual audit or field exam may or may not uncover any problems – from our experience, we frequently run into audit firms/field examiners that lack the proper knowhow, and as such, could be easily misled – and if they do uncover a problem, it may have progressed to the point where it now represents a much bigger issue.

What typically torpedoes these deals? And if you had to pick one thing that makes or breaks an asset based lending deal, what would it be?

Given the nature of the assets we finance, we need to have a strong understanding of performance of the underlying assets. This means that we need to obtain, process and analyze large volumes of data, and if the prospective borrower cannot provide that or if the data is inconsistent, we decline to pursue the transaction. Alternatively, if the borrower does not have sufficient capital to subordinate to us or is unwilling to provide bad acts guarantees, we will also pass. Alignment of interest is key – from having the data to understand the performance to the borrower having skin in the game.

How do you get early warning that a transaction is running into trouble, and what have you learned works best in salvaging it?

Most of our transactions have something called “performance triggers”. These are indications of performance of the assets in the portfolios backing our financing facilities – these could be measures of delinquencies, liquidations, collection rates, payment rates. We set these triggers so that if they are breached we can contractually redirect the cash flows to us to amortize our loan on an accelerated basis. As another warning sign, we monitor the timing of cash deposits into the collection account and monthly reconcile reported payments to the cash deposits as I eluded to earlier.

The best course of action is to work with the borrower on addressing the issue. In certain cases, the issue may resolve itself if given enough time (i.e., losses that may have breached the liquidation trigger will be pushed through). In others, we may reduce our advance rates or force early amortization or disposition of the financed assets. In the latter case, it is usually best to consider transferring the servicing of the underlying assets to a third party (if the portfolio is serviced by the borrower).

From your viewpoint, what are the three key characteristics of any successful workout?

First, make sure the borrower understands the consequences. It is very important to make sure the borrower understands the consequences of acting against our interests – greater loss of their subordinated investment and personal liability if their actions result in breach of any of the provisions in the bad acts guarantees we require of them.

Secondly, incentivize them. Frequently the borrower may not be eager to cooperate with us on resolving the situation. As such, we may offer them certain incentives that will economically benefit them – waive default interest, waive any minimum interest payments/non-use fees.

Finally, involve third parties. In the more severe cases, we would arrange for a transfer of servicing/custodial duties to an independent third party.

Peter Faigl is a Portfolio Manager for Old Hill with more than 15 years of experience analyzing credit based transactions and portfolio management for asset-backed lending investments. A CFA charterholder, he joined the firm in 2009 and is responsible for sourcing, analysis, asset-level modeling, structuring and management of Old Hill’s asset-backed investments.