Securitisation: Back to the future

Securitisation is in recovery after its vilification as the ‘big bad wolf’ of the financial crisis. Evidence of this comes through a new partnership between UK marketplace lending platform, Funding Circle, and KLS Diversified, which is planning to repackage the originators’ assets into rated securities.

New York-based KLS Diversified Asset Management has agreed a £132 million ($207 million; €166 million) loan investment with UK-based Funding Circle. The hedge fund intends to package the loans the capital is deployed into as securitised bonds, KLS partner Gyan Sinha, explained to PDI.

Others have securitised marketplace loans before. For example, Eaglewood Capital has repackaged around $175 million of loans from US online lender LendingClub. However, the underlying assets were unrated – leaving the investor base much more limited.

OnDeck, the recently listed marketplace lender, has also recycled its own balance sheet loans into a rated securitisation programme. The difference between that and what KLS plans to do, explains Sinha, is that OnDeck’s loans are generally much shorter, with six-month tenors. 

The Funding Circle assets will average £60,000 ($91,000; €77,000) and have maturities of between six months and five years. Most are two- or five-year amortising loans. The structure is vanilla, without security, but the small business owners they are made to all provide personal guarantees, which are much more legally enforceable in the UK than the US.

WHY THE PARTNERSHIP?

KLS Diversified wanted to partner with Funding Circle for several reasons. 

That it is a business lending platform was important. KLS saw in UK small business finance an asset class with plenty of historical data and a creditor-friendly environment with enforceable personal guarantees.

Business loans were also more attractive than consumer loans because they offered more sophisticated borrowers and less regulatory issues than there are around a non-UK domiciled investor, explained Sinha.

“Our intent is to use this first deal almost as a pilot for a more programmatic approach,” Sinha said. “What we’d like to do is build a brand with Funding Circle where we’re coming [to market] on a regular basis and we develop a core group of investors that just understand the product.”

By partnering with the leading marketplace business lender in the UK, KLS has got ground-floor access to decent assets. Funding Circle has lent over £480 million to more than 7,000 businesses since its inception in 2010, of which over £250 million was lent in 2014. The typical turnover of their borrowers ranges between £600,000 and £700,000.

For Funding Circle the drivers behind the decision to team up with KLS were different as it was approached by a large number of potential investors seeking to structure similar deals, explained Sachin Patel, the firm’s head of UK capital markets. So the question was not ‘why’ but ‘who’?

The investment boosts the fire-power of Funding Circle and not just on a one-off basis – KLS will roll maturing assets back into the platform and hopes to establish a rolling securitisation programme.

Some larger institutional investors had also approached the platform, but they were turned down, Patel explained, because Funding Circle wanted to find a partner of the right size. An oversized investor would force it to ramp up lending too quickly to feed the new investment. 

“We choose to work with KLS because they’re great partners. They understand our vision and what we’re trying to achieve in building a better financial world,” said Patel.

That partnership extends to KLS helping Funding Circle bring its internal processes to institutional standards. 

For both sides, the joint-paper produced by the Bank of England and European Central Bank discussing the need for, and hurdles to, a better functioning securitisation market was significant. The paper explicitly refers to how a strong securitisation market can help non-bank financial institutions raise funds for lending to the real economy. 

“There are lots of very positive effects that the policy-makers are concentrating on. Hopefully this will feel less like a big, bad hedge fund trade and more like we’re actually trying to accomplish some good here,” added Sinha.

If the final structure meets the standards outlined by the central banks, the tie-up could certainly be the poster child for one form of securitisation the central bank paper outlined – feeding capital into the real economy via direct loans to business.

HOW WILL IT WORK?

Funding Circle will treat KLS’s investment – made via a special purpose vehicle (SPV) – as it would funds from any other passive investor, explained Patel. The funds are distributed to a cross-section of loans made via the platform and then held by KLS’s investment SPV which can recycle amortisation payments back into new loans.

Funding Circle services the loans – collecting interest and amortisation payments, monitoring for issues and eventually if needed, dealing with stressed or defaulting borrowers. It brought those activities in-house in 2013 because it found losses were reduced by managing stressed assets directly. 

For borrowers whose loans have been repackaged and sold as securitised bonds, it will be business as usual, added Patel. 

When the agreement was announced in December, KLS was in discussions with one credit rating agency about getting ratings for the underlying loans. Since then it has been in talks with several more agencies and is in the process of deciding which to go with, said Sinha.

The cost of the rating process will have a large impact on the viability of securitising the assets, he added.

The loans will be divided into rated tranches with KLS meeting retention requirements and reassuring investors that it has ‘skin in the game’ by holding the unrated piece. Timing is subject to how long the valuation process takes, but the firm hopes to price the first repackaged notes in late summer of this year, Sinha said.

SELLERS/BUYERS

The bonds that KLS plans to sell will not fall under the ECB’s ABS purchase programme, said Sinha, but all boats are carried by a rising tide. With the central bank buying up European securitised paper, higher yielding but similar assets are likely to attract more interest, he agreed.

The US fund has also been approached by interested buyers including European state-related institutions and investors keen on getting a slice of the mezzanine debt, Sinha added.

The tie-up, if KLS has a successful bond issue in 2015, could pave the way for a lot of similar deals. That Funding Circle had its pick of investors suggests that other marketplace lenders are probably having the same discussions right now. 

Funding Circle and KLS negotiated with HMRC, the UK tax authority, to formulate a scheme to have KLS’s investment exempted from withholding tax, explained Patel. It was a Funding Circle-specific exemption, but shows that a tax model for foreign investors exists.

VIRTUOUS CIRCLE – WHO ARE FUNDING CIRCLE?

The UK-based marketplace lender has moved well beyond the peer-to-peer origins of the industry. State-backed British Business Bank is the platform’s biggest lender and its expansion and decent returns on investments have attracted larger investors. 

Growing at a good clip since it was established in 2010, that growth has accelerated over the last few years. It has branched out into real estate lending and moved beyond the UK when it bought a US-based lender in October 2013.

But the firm expects to moderate that rapid growth over the next two years. “We’re very conscious that scaling from £3 million of lending per month to £35 million is one thing, but scaling from £35 million to £3 billion is a whole different kettle of fish and so we’re constantly implementing the right controls and managing our growth over the next two years,” said Patel.

The firm also has ambitions to establish a bench-mark credit rating system for small businesses. The tech-driven firm plugs directly into the same sources of credit information as bank lenders, but because its technology has been built from scratch, it doesn’t struggle with the same legacy issues as banks and can update its credit models every six months – much more regularly than traditional lenders which can take much longer to collate the information before they can start to update their models, explains Patel.

Funding Circle and the general marketplace lending industry is also a Downing Street darling. In his Autumn Statement, the UK chancellor put marketplace lenders on equal footing with banks by allowing investors to write off bad debts against income tax – an overnight boost of around 25 percent for average investor returns.