July/August 2014 – Issue 4

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Secure(itized) Future

By: Autumn Cafiero Giusti

Securitization

Investors pour $175 million into OnDeck following an investment-grade rating

Now that OnDeck Capital has begun packaging up its business loans and selling them off to investors, alternative business lenders have high hopes that a larger segment of the investment community will start pouring money into their industry. Financial experts expect to see more investor interest in this type of lending, not to mention more activity of this kind from competing lenders.

On April 30, New York-based OnDeck announced its inaugural securitization transaction of $175 million. In a coup for the lending company, OnDeck’s Class A notes received a BBB rating from ratings agency DBRS Inc. The Class B notes received a BB rating.

Wall StreetThe BBB rating is significant because it gives OnDeck’s notes investment-grade status, signaling to other small-business funding companies that they belong to a breed of assets that Wall Street investors are starting to take seriously. That translates to less expensive capital for these lenders and greater interest from investors, who are warming up to alternative business loans as a legitimate form of lending.

For a long time, investors shunned companies like OnDeck on the belief that alternative business loans were a highly risky form of lending. The OnDeck transaction and BBB rating is evidence that investor confidence is shifting in the industry’s favor.

“We got rated despite the fact that we were a new lending company in this market and a new asset class,” says OnDeck CEO Noah Breslow.

OnDeck says the securitization is the first in the non-SBA direct business lending industry and described the transaction as “significantly oversubscribed.” The $175 million fixed-rate notes are backed by OnDeck’s loan assets.

Noah Breslow, OnDeck CapitalFor the past seven years, OnDeck has focused on small business lending opportunities for businesses with less than $5 million in annual revenue. This transaction marks the latest move by OnDeck toward widespread acceptance in the investment community. In 2012, OnDeck secured $100 million in debt commitments, including an $80 million credit facility led by Goldman Sachs and Fortress Credit Corp. in 2012.

jeremy brown rapidadvanceJeremy Brown, CEO of RapidAdvance in Bethesda, Md., says the OnDeck announcement is an important development for the industry because it indicates there will be more involvement from investors.

“I think it shows the continued development and acceptance of what we do becoming more and more mainstream, as opposed to five years ago when we were considered this fringe, odd industry,” he says.

New asset class evolves
From the point of view of the alternative lending industry, the OnDeck announcement marks the evolution of a relatively new asset class into the capital markets, says Tom McGovern, vice president at Cypress Associates, a New York-based investment banking firm.

“It’s showing that they can exhibit statistically predictable cash flow and credit performance in such a way that a rating agency will put a rating on it, and an investor can have some confidence as to what they’re going to get in terms of credit performance,” he says.

Tom McGovern  Cypress AssociatesMcGovern is also seeing a shift in attitudes among those who lend to the merchant cash advance industry. For a long time on the senior debt side, there’s been a divide between traditional factoring receivables and merchant cash advance receivables.

“They don’t see merchant cash advance receivables as equal quality to a traditional factoring receivable. This development will serve to shrink that distinction,” McGovern says.

The announcement also serves to help lower the cost of capital for funding companies.

Having another big player in the space with securitized notes could help merchant cash advance providers obtain lending facilities at better rates, and with decent terms.

“It definitely should help facilitate the process of getting credit to make merchant cash advances,” McGovern says.

Rohit Arora Biz2CreditThere is cautious optimism among some funders, though, given the fact that securitized lending in the mortgage industry helped fuel the housing market collapse in 2008. Rohit Arora, co-founder and CEO of online credit broker Biz2Credit, contends that the alternative lending industry needs to proceed with caution. If the demand grows for securitized loans, the temptation is to lower underwriting standards in order to originate more loans.

“That’s what created the whole mortgage bubble. And then it burst,” Arora says.

OnDeck’s scoring model
In an effort to keep underwriting standards high, OnDeck started developing its own credit scoring system when it came on the scene in 2007. Breslow explains that at the onset of the company, there were two primary forms of lending on the market. One was a traditional bank loan, which could be a lengthy process for businesses wanting to borrow only $40,000 or $50,000, and businesses would get declined three out of four times. On the other end of the spectrum was merchant cash advance, which was much more expensive than a bank loan, and it took a couple of weeks for a business to get its money.

OnDeck’s strategy was to split the difference between the two loan types, and the company came up with a system to automate the funding process.

Unlike merchant cash advance, OnDeck’s funding isn’t tied into the business’ credit card processing. OnDeck draws a fixed amount out of the customer’s bank account each business day. As long as the customer has a separate bank account, he or she can take out a loan from OnDeck.

OnDeck makes all of its loan decisions through a credit rating system it calls the OnDeck Score. Breslow says that the OnDeck Score is to businesses what the FICO score is to individuals.

The OnDeck Score relies on various data sources to create a snapshot of a business’ credit. For every applicant, the score takes into account more than 2,000 data points indicative of the small business’ performance. Whereas FICO looks at negative lending information such as missed payments, OnDeck looks at positive information, such as what types of credit the business already has, and whether the business owner is good at managing cash flow, Breslow says. Other factors include the type of business, where it is located and public records data.

The scoring system has helped OnDeck attract larger investors and lower-cost sources of funding over the years.

“When we started, we didn’t have any investors who believed in the OnDeck Score. Fast forward to today, we’ve loaned more than $1 billion to small businesses around the country,” he says.

About five years ago, most of OnDeck’s capital came from the hedge fund community. As of a year ago, most of that capital has been coming from banks. And now with securitized lending, OnDeck has expanded its investor base to take on more than 20 new investors, including mutual funds, asset managers, hedge funds and insurance companies – and at better terms than ever before.

Zhengyuan Lu OnDeck CapitalDiversification has helped OnDeck better serve its small business base, says Zhengyuan Lu, who facilitated the securitization deal and is head of capital markets for OnDeck.

“The more diversified your funding sources are, the stronger an institution you are,” he says.

Investment-grade rating validates industry

Obtaining a BBB rating is no small feat for any company, much less one in a fledgling asset group.

Charles Weilamann“It’s no easy bar to clear in terms of being able to package, put together and support an investment-grade security,” says Chuck Weilamann, senior vice president of DBRS.Breslow says bundling securities seemed like a natural progression for OnDeck. Last fall, the company received more than $130 million in credit facility commitments from participants including Deutsche Bank, Key Bank and Square 1 Bank. The shot of funding set the stage for OnDeck to pursue the securities market.

“We always thought securitization would be in our roadmap. And we just felt that when we closed our last credit facility with Deutsche Bank in September, that was a good step toward securitization,” Breslow says.

Deutsche Bank ended up serving in an advisory role as OnDeck’s banker for the securitization transaction and approached DBRS about getting a rating. OnDeck was a considerable departure from the types of companies DBRS typically handles.

“When we first met with the rating agency, they almost looked at us like we were from Mars, because it’s such a different process,” Breslow says.

Because OnDeck was different, Weilamann says DBRS took some of its existing rating tools and then augmented them to complete the process. OnDeck’s notes still had to meet several qualitative benchmarks such as asset characteristics, as well as qualitative benchmarks such as company management.

“We can’t require things as a ratings agency, but there are a lot of expectations that need to be met,” Weilamann says.

The BBB rating serves as an outside validation of OnDeck’s credit scoring model and servicing platform, particularly in a post-economic crisis market.

“It’s not like credit cards or mortgages that are well understood by the investor community. This is a new type of short-term business loan,” Breslow says.

The rating also gives OnDeck a credit opinion that’s highly visible to the investment community. “When you’re able to achieve an investment-grade certainty level, that attracts a fair number of investors. It opens up pools of capital,” Weilamann says.

Competitors follow suit
OnDeck’s leap into the securities market seems to have driven other funders to explore the option themselves. Industry observers believe many will try, but few will succeed.

Rohit Arora of Biz2Credit has been following the OnDeck developments and says his own company plans to securitize small business loans by the end of this year.

“What OnDeck has done with securitization is a good move. It helps the institutional investors to get a feel for a new product in a new asset class, which is always a good thing,” Arora says.

RapidAdvance has also considered the possibility of selling its loans to investors. Brown admits that the cash advance company has had conversations with a financial sponsor about securities, although he points out that the company has less of a need for securitization because it is institutionally owned. “But we’re certainly looking at it.” Brown also knows of at least one other company in the space that is reportedly getting ready to start selling off its loans.

DBRS has not yet rated any alternative business lending companies aside from OnDeck, but DBRS senior vice president Eric Rapp says they are in dialogue with other companies in the space.

That’s not to say that securitization transactions will start coming out of the woodwork. It’s likely that only the big names in the industry will have the resources to succeed in this area.

“There are a lot of guys in this space. I’m not sure that many have the financial wherewithal and experience as OnDeck. Definitely not the majority,” Rapp says.

Companies need to have the systems to organize the data so it can be presented to investors, and also be subject to all the scrutiny that a ratings agency requires. And putting together a prospectus like the one OnDeck completed takes months. Only larger, more sophisticated companies will be able to do this.

Brown believes only about six to 10 companies will be able to successfully access the securitization marketplace in the coming years. “You have to be a certain size for investors to be interested. It will mainly be just the larger funding companies,” he says.

McGovern points out that when he covered banks and thrifts as a research analyst on Wall Street earlier in his career, these types of securitizations were typically $1 billion transactions. “So it’s not going to be something that’s available to everybody,” he says.

Smaller players will still be able to benefit, though. McGovern believes that having more lenders move toward securitized loans should make the investor community more comfortable with this new type of asset.

Now that OnDeck has experienced its own success with locking down a securitization deal, Breslow says the company plans to focus again on its growth strategy. OnDeck grew its revenues by about 150 percent in 2013 and is on track for triple-digit growth again in 2014.

“We have a lot of capacity in our platform to lend and are focused on acquiring more borrowers,” he says.

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