What happens when your debt facility is in default
You've raised a facility, everything was going great, but then it didn't. No one told you what happens when your facility is in default and how to navigate it. This post will give you an overview.
We’ve all read a lot about raising and running a debt facility. We know about preparing materials, running a process, negotiating terms, and operating a facility.
After you raise a facility, unfortunately, things always don’t go well.
In some cases, the facility may end up in default.
Generally, in fintech, most founders don’t understand the consequences when things don’t go right.
We have all seen an example of this with BaaS providers like Synapse. Building a fintech company is tough, but working through the wind down is even tougher when things don't go right.
Most founders don’t know what happens if a warehouse facility goes into default.
They are surprised by the actions of lenders. The friendliness disappears and everything is “commercial.”
This post, hopefully, helps you understand the consequences when a facility is in default and the process followed by lenders. The details of the remedies a leader may exercise depending on the reasons for default and your options once the lender takes steps towards that.
What does it mean to be in default?
Before we go into the details, know that lenders are not your friends.
They are supportive, but not your friends.
They are, by definition, lenders. They will do whatever it takes to get paid. And paid in full.
Debt investors are extremely perverse to downside risk - which is understandable. Unlike equity investors, their expectation is always to get paid in full.
Now, the meaning of default is obvious.
But let’s understand it in the context of a facility.
A facility is considered in default if one of the pre-defined conditions (or requirements) in the facility documents is tripped or not followed. Depending on the condition you violated, you may have a cure period (2 days to 30 days), but if you can’t cure it your facility will be considered in default. In some cases, you don’t even have the option to cure.
Curing a tripped condition means correcting it. e.g. if it’s a financial shortfall by depositing additional funds, you can cure it.
Once a facility is in default after the cure period has passed, generally it cannot be made current again.
A few examples:
Company’s cash balance or Tangible Net Worth falls below a certain amount
Any of the default metrics of the loan portfolio are higher than expected
Credit criteria are not followed accurately at the time of origination
Loans that don’t meet the credit criteria are sold to the lender
Any balance shortfall is not fulfilled
Tripping a covenant
Misrepresentation of a warranty
Default conditions are divided across different areas depending on how the default could occur and the severity.
Defaults could be related to a few areas:
Portfolio Performance
If the portfolio hits triggers and is not cured within the specified time period.
Regulatory events
Due to regulatory events that may or may not be in company’s control e.g. lending without a license or entering into a judgement with a government authority
Misrepresentation
Falsifying any warranty or misrepresenting any material information about the company, portfolio, or related items.
Change of Control
If a fundraise or sale of the company results in a change of control.
Servicer Default
Not performing servicing duties as contracted or expected.
Below are a few more reasons (by no means they are exhaustive):
Indebtedness - taking on more debt without informing the lender or their approval.
Borrowing Base Deficiency - failing to maintain borrowing base thresholds.
ERISA Events - any ERISA event that results in large liabilities.
Court Orders - any court orders that prevent the company from lending.
Backup Servicer - fails to maintain the backup servicer as agreed.
What happens if a facility is in default is described in the rights and remedies section of the legal agreement. These rights and remedies dictate what actions lender can take.
What happens once you are in default?
The lender’s goal is to get paid from the portfolio including outstanding interest, legal fees, admin fees, and all other associated fees (which could be high).
Depending on the type of default, the lender may enforce different remedies to get paid.
In portfolio performance related defaults, the lender has limited remedies aside from taking control of the portfolio.
Once the portfolio is in default, lenders can also add a default premium to their interest rate. It is typically 1%-3% on top of the normal interest rate.
The lenders are most afraid of losing their principal, that’s why they add cushion for protection in different ways.
Depending on the type of default, a few things may happen:
Lender stops all more funding requests i.e. terminate revolving period immediately
Lender can substitute the servicer (from your company to the backup servicer or choose a new servicer)
Lender notifies the borrowers about the change of servicer
Lender takes over the receivable account and make the payments to themselves
Lender gets the right to sell the collateral to pay themselves
Lender asks you to immediately prepay the facility
These are the most common things a lender can do once the facility is in default.
The lender gets a unilateral right to the underlying portfolio in case of an event of default.
If the default was due to reasons other than portfolio performance, the lender may demand getting paid in full immediately.
Depending on the lender, they can be aggressive about this. More aggressive lenders can cost your company a lot of money and wasted resources.
This doesn’t mean that the parent entity is liable to pay, it just means that the lender may sell the portfolio immediately to pay themselves wiping out your equity/first loss position and demanding any limited guarantee from the parent*.
The parent company’s liability is limited in all cases (except fraud).
*parent = your C-corp; with facilities, you create a new entity that becomes the borrower; lenders generally don’t lend to the C-corp directly
Hope this overview helps you negotiate better and trip covenants by mistake.
If you are going through the process of getting out of a defaulted facility, feel free to reach out for help.