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Old Hill Partners March 2018 Commentary: Not All Sub-Prime is Created Equal

In previous commentaries, we have examined a number of market sectors and terms that are often misunderstood relative to the private credit space – marketplace lending, for instance, or leveraged loans. As questions about the late stage of the credit cycle abound and concerns grow about the health of the consumer, we decided to delve a little deeper this month into the non-prime auto lending portion of Old Hill’s business and explain why we view it as a place where such misunderstanding can actually be a source of additional risk-adjusted return.

Non-prime borrowers are often lumped together with sub-prime, the infamous bogeymen of the 2008 financial crisis universally blamed for nearly bringing the world economy to a halt. But this is a simplistic approach – the “everything but prime” definition actually encompasses several distinct portions of the market. For instance, it includes not only those with poor credit but also borrowers with little credit history, students, or those recovering from an adverse life event. Some are admittedly damaged credits, but some are reasonable credit risks - for example, those with a steady income and an ultimately rising credit score. There are also vast differences within the sub-prime sleeve itself, such as mortgage loans versus auto loans, despite being painted with the same brush. The notional market for the former is much larger than the latter, for example, and in many respects sub-prime mortgage debt was what sent the financial world spiraling a decade ago.

In recent years, PE money has poured into the non-prime auto loan market and massive dry powder on the sidelines led to a non-prime market characterized by poor decision making and insufficient risk analyses. In response, Old Hill largely backed away from financing sub-prime auto transactions. However, we think a silver lining exists as these recent entrants retreat from the market. Coupled with our traditional due diligence discipline and structuring experience, the wholesale side of the sub-prime auto lending market offers a great opportunity to generate attractive risk adjusted returns.

What do we mean by wholesale? In a wholesale finance transaction, we’re financing the lenders who extend the loans to the consumers – we do not lend directly to the consumer. And we concentrate on lenders financing used cars, not new ones, because as the prices of new cars have risen faster than incomes (meaning that the customers cannot afford higher monthly payments), loan terms had to get longer, in turn causing the loans to amortize slower than the pace at which new vehicles end up depreciating. This ultimately results in lower recovery rates on defaulted contracts (i.e., what the repossessed car sells for relative to what the loan amount is at that time). While loan terms for used cars have also marginally increased, the velocity of price depreciation versus amortization has remained much more stable and thus represent a better segment of the auto lending market.

A number of other factors round out our approach. In addition to stringent due diligence on the borrower and a deep analysis of the performance history of the loans made, we add in an extra cushion for our capital through a conservative advance rate (how much we advance relative to the unpaid principal balance of the underlying loans) determined by a combination of our crisis-era experience, some extra margin for unforeseen events, and a discount to the purchase price (many subprime auto loans are purchased by our clients from the originating dealers at a discount to their unpaid principal balance). Together, these then add to the substantial cushion the financing company itself had already laid onto the loans, essentially adding another whole tier of protection – we learned a long time ago that those who charge more than the market and advance less than the market can do well regardless of cycle position. Finally, we collateralize the capital we advance with the loans themselves, which are in turn secured by the vehicles and highlights the asset-based nature of what we do.

As per the above, our transactions are structured so that the financing company, which is generally smaller and not sponsored by a private equity investor, has skin in the game. This aligns our interest in the underlying loans with those of the company actually making them. Aside from the obvious benefit, a sort of adverse selection occurs that improves the risk profile of the loan portfolio we’re financing. In a typical case, the sub-prime lender might occasionally look at its portfolio of loans and sell the weakest to an outside 3rd party because the lender may want to keep the best for itself. In our case, the alignment of interest we achieve when the financing company has significant skin in the game ensures they are incentivized to include the best credits into the collateralized portfolio we are financing. This results in a higher overall quality, and lower risk of defaults, down the road.

As with our other asset-based lending activities, we approach the non-prime portion of our business with a quantitative, data-driven analysis of performance specific to the company we are financing and try to predict what’s going to happen to it under a number of different scenarios. We scrutinize delinquencies, defaults, prepayments, fraud, etc. so we thoroughly understand the portfolio and the lending philosophy that creates it. Only then do we move forward with a transaction

The result is a non-prime lending portion of our business that looks very different from the image conjured up by the “sub-prime” moniker and what may be occurring in the public securitization market. Not only are attractive, risk-adjusted returns possible from the rigorous approach we take to this fundamentally higher-yielding market, but we are able to mitigate default risk to acceptable levels through due diligence, aligned interests and collateral protection. From our perspective, the non-prime auto industry is frequently misunderstood by many investors, and fear of this segment can translate into several hundred basis points of additional return for lenders who understand how to properly and prudently structure such transactions.

We’d be happy to explain this approach in greater detail or answer any questions you have. Please contact info@oldhill.com for additional information.