When One Bad Alternative Finance Transaction Blows up Your Portfolio

Investor interest (and when I say investor I mean Non Bank) in financing business credit (ie, shortening receivables or extending payables) is at all an all time high. But if I am managing funds for a family office funding a few middle market buyer’s and their suppliers via some platform, and one transaction goes bad, all the net discount revenue I earned goes out the window.

No investor likes to lose money. None. And in the world of business credit, transactions are PRIVATE. Information is public with retail credit, and all you need to make a credit decision is someone’s identifier like their SIN#, or Social Security # or some health identifier to retrieve lots of credit data. The equivalent is very hard in the commercial world, where data is not always available, or may be outdated, or even incorrect.

So how do investors go about controlling risks? There is no one answer. It depends. And what it depends on is the information, collateral and risk mitigation techniques that are developed. You see, an accounting firm like Deloitte or PwC can only go s o far in blessing a supplier network to say the data is what the vendor says it is. But what they cannot do is say the algorithm or underwriting model that is used for the data can be used as a predicator for credit decisions. Investors need to find the talent to do that and combine it with risk mitigation that the market will still accept, and at rates that are palatable to whatever supply chain you are financing. Hard right? You bet.

Given we are in an extremely benevolent credit cycle, many of these networks and peer to peer lending models have not been around long enough to provide loss experience through business cycles.

So for the entity that manufactures and looks to sell asset (ie, receivable or loan) what contingency protects you? As a friend of mine likes to say, information is asymmetric and credit decisions are binary – either you get Paid or you do NOT.

There are certainly other legal instruments besides receivables purchase. One could have receivables assigned to them, and the borrower retains ownership of the accounts, collecting payment and passing them to the financier. Or there could be a pledge of receivables, which involves more operational work.

Instruments such as estoppels can be used to control risk. There are numerous methods, but at the end of the day it comes down to investor risk versus reward, and if the borrower is willing to accept the terms and conditions.

So as you read about more investor interest in this space, bear in mind details matter.

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