Raising debt still remains elusive. A common question is how much data is needed to raise a facility. I break down what debt investors are looking for and how you can raise your first facility.
Most founders know how to raise equity. But raising the first debt facility remains a mystery. Founders try to sell the long term vision before selling the existing performance data. Because that’s what they are used to selling to equity investors.
However, the conversations with debt investors are structured differently. Debt investors prefer familiarity over future grand visions.
Note: I’m talking about asset-backed debt facilities (generally raised by fintech companies).
Understand the debt investor’s mindset
Before we talk about the data that debt investors need, we need to understand their mindset. For an equity investor, a successful outcome could be 100x. For debt investors, the best outcome is the interest rate earned on the facility.
Imagine investing in startups and being capped by only a 10%-15% interest rate. Limited upside but significant downside. The differences in the expected outcomes change the conversation dynamic and the pitch is not the same.
Debt investors need more proof (of credit performance) compared to business proof asked by equity investors. Debt investors try to protect the downside as much as possible while equity investors look for the maximum upside.
Similar to equity investors, debt investors have to write long memos. All deals have to go through an independent committee. That committee is going to ask questions to make sure the debt investor doesn’t lose money.
The 3 main things debt investors look for are:
Sometimes I say that debt facility pricing is somewhere between a pawn shop and a stock market. Without data, it’s more like a pawn shop, with data it gets closer to a stock market.
The good thing is that once you develop portfolio performance, you will get a lot of options. And it only gets better with time (assuming performance holds). The cost of capital will go down and the facility size will go up.
A few things to keep in mind:
All debt facilities are raised in the context of the product. The terms and parameters of the debt facility will look very different if you are raising for a mortgage product vs. a BNPL product.
Debt investors will try to benchmark your product and potential performance with similar products in the market. There’s a balance of using new and unproven variables and traditional metrics in underwriting. For debt investors, unproven data sources mean risk (stability, scalability, compliance, credit, etc).
There’s a clear tradeoff for debt investors to earn a certain risk-adjusted return, so your product needs to meet that or offer a higher return.
It will feel like debt investors are asking for the sun, the moon, and the stars. But they do it to protect their downside given their upside is limited. Get comfortable with the asks.
With that, let’s talk about some common questions and metrics you should have before you raise your debt facility.
Cumulative default rate
Do you have any static pool analysis?
For all close-ended credit portfolios, you can easily draw a cumulative default rate (or cumulative delinquency curve). Almost all default curves start to flatten at some point in their maturity. The flattening of the curve is a sign that new defaults as a percentage of the outstanding portfolio are going down. Said another way, if customers have paid most of their way through the loan, they are likely to pay the last few installments.
For open ended portfolios showing consistent delinquencies and default ratios as a percentage of outstanding balance by cohort is useful for showing consistent performance. Investors will also want to understand how you manage line sizes for this type of product.
Here’s a sample static pool analysis:
How quickly does your principal pay down?
The risk goes down as your principal is paid down. In the context of similar products in the market, your principal should be paid down at a similar rate.
Debt investors generally want to see how long it takes to pay down 50% of the principal amount.
This, obviously, is different for revolving credit products (like credit cards) and long duration close ended products (like mortgages).
How many loans have you originated in the credit box for which you’ll use the debt facility?
All (well most) debt investors know that the borrower risk scales exponentially as you scale the portfolio. They would want to understand if your borrowers in the near future will be similar to the portfolio you have originated until now.
Irrespective of what you say, they know that the risk will increase. They expect that diversification amongst the large number of loans will lower this risk.
Higher risk as you grow is dependent on your acquisition channels, which brings me to the next point.
What acquisition channels are you going to use to originate loans?
In most credit businesses, different acquisition channels have significantly different risk characteristics. e.g. if you have a consumer credit product, paid search channels like Google will be riskier (on average) compared to direct mail. It’s not just about CAC, it’s also about the implicit credit risk of the borrower.
It’s understandable to not have tested credit performance across all your acquisition channels. However, have your acquisition story and respective credit risk implications clearly defined when going for your first facility.
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Does your portfolio have enough diversification?
There’s no exact answer but you know when you have too few loans. It shows up in the performance volatility. If you have enough loans in a cohort (monthly or quarterly), you can show limited volatility in performance.
A volatile cohort here and there doesn’t really matter. But broadly, cohorts should be stable. This is important for debt investors. Volatile performance = uncertainty and debt investors don’t like uncertainty at all.
Odd quarters with poor performance in a few quarters also show that you don’t have a grip on credit risk.
Servicing and Collections
How do you plan to service loans and manage delinquencies?
After originating the loans, they need to be serviced. Someone needs to call customers, collect payments, send reminders, send monthly statements, etc. This is a fairly complex and important function.
Investors will want to understand how you plan to do all this. Given servicing impacts the quality of payment collections, it is an important factor in raising a facility. Expect investors to ask for your “servicing and collections policy” and vet it thoroughly. They will look for details on payment options offered, delinquency management, collections setup, charge-off processes, etc.
Not having the basics in place or an understanding of what needs to be built is a red flag. In some instances, if investors like the credit but not the servicing, they will require the loans to be serviced by a third party servicer. If you are servicing, investors will require you to setup a backup servicer.
For open-ended revolving products, managing ongoing risk is also crucial. Risk management is done by the credit risk team but it’s impacted by the servicing team.
There are reporting requirements associated with servicing and investors will also want to understand that.
Are you compliant with all the regulations and are your loans legally enforceable?
No investor wants to take compliance risk. If your product doesn’t fit within clear regulatory boundaries, investors are unlikely to move forward (irrespective of the credit risk).
At the end of the day, the underlying asset (personal loan, credit card receivable, etc.) and its enforceability are the only backstops for investors. If the enforceability can be challenged, it would mean that the investor will not be able to legally collect.
Before going for a raise, make sure that legal and compliance are tight.
What is your equity fundraising plan?
This is straightforward. You need to show a tentative equity raise plan for growth and first loss position.
The quality of equity investors plays a role in raising the first facility. In some cases, debt investors will want to talk to investors for their view of the business.
What is your plan to grow origination volume?
Similar to equity fundraising, origination volume growth is important. It needs to be realistic enough because it’ll impact the terms of your facility. The growth should also support facility draws, acquisition, channel diversification, and prudent credit risk management.
Understand the implications of origination projections across the whole business.
Here’s the debt facility journey for Stilt:
$50k→$120k → $200k → $1M → $10M → $75M → $100M → $150M
We used our savings to originate the initial loans, then partially used the $120k equity raised from Y Combinator, and then used a part of the equity raised before getting our first $1M dedicated for loans. After we originated $1M+ in loans, we raised our first $10M facility.
Getting to the first $1M took us about a year. And the $10M facility was unlocked only after a $2.3M seed round.
The equity and debt fundraise usually go hand in hand.
Some conversations with debt investors will be like this:
Yes, you have some data but it’s not a large enough sample size
Yes, you have a large enough sample but it hasn’t gone through a complete payment cycle
Yes, your portfolio size is reasonable and has a couple of iterations but it hasn’t been tested in a macroeconomic cycle
Yes, your portfolio size is good, have performance data, ……
You get the idea.
There’s always something that will not be right. And that’s ok.
Debt investors are doing their job and have to be super diligent because they can lose money in many ways. The company may not work out, the product may not work, credit performance may be poor, the macroeconomic situation changes, negative compliance/regulatory developments, etc.
Raising your first facility may take time. It’s a different conversation than what founders are used to. Founders with a solid business model and quality equity investors are able to generate reasonable options for their first facility.
Hope this post provides helpful information for raising your first facility.
Feel free to reach out to me if you have any questions.
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