The emperor's new clothes or a viable alternative to traditional securitisation structures?
Forward flow transactions have come to prominence over the last five years as a simpler alternative to established warehousing/securitisation structures, particularly in certain asset classes, such as SME lending. Here we consider some of the key issues for both funders and originators.
What is it?
A contractual pre-funding of asset originations (typically loans or receivables) based on set eligibility criteria, volumes and concentration limits. From the perspective of an asset originator, it is a pre-funded origination mechanic (forward flow) as opposed to a post origination transaction in balance sheet management (securitisation).
Commercial rationale
Crucially, the title to the originated assets is allocated to the balance sheet owner at the point of origination rather than sold or transferred post origination, as may be the case with a typical warehouse or securitisation structure.
This allows market participants to originate in greater volumes, while utilising the balance sheet of their relationship investors. Such transactions have, in our experience, been particularly prevalent in the start-up/fintech community and for platform lenders.
In particular, forward flow:
- allows greater market participation by investors who wish to increase their market share in highly competitive asset classes, for example, SME lending.
- avoids the need for complex regulatory compliance, rating agency criteria and more complex documentation.
- allows for the funding of 100% of the target portfolio for funders and off-balance sheet treatment for originators (where the originator elects not to participate).
- allows originators the certainty of funding during high volume origination periods.
Key features and structures
On/off balance sheet
One of the key drivers behind the use of forward flow arrangements is the positive balance sheet treatment for originators. While dependent on the specific structure employed, which can vary, in our experience, such structures can be arranged to be largely 'off balance sheet' for the originator. While originators may take a vertical slice of a single tranche transaction (perhaps as skin in the game as discussed below), they typically do not take the originated assets on balance sheet at any time, resulting in beneficial accounting or, where relevant, regulatory capital treatment. This is a key differentiator from traditional securitisation, where assets are taken on the balance sheet and then sold (legally or beneficially) to an SPV/trust vehicle. Consequently, forward flow transactions allow for an originator to access a funder's balance sheet without the need to raise its own funds (which is particularly relevant for start-up originators or platform lenders (in the widest possible sense)).
Origination
Origination operates to a set of eligibility criteria agreed among the parties, where the originator will have access to funds via a distribution/pre-funding account (typically funded on a periodic basis eg monthly). Originators may advance funds through the structure with the corresponding asset documentation being entered into directly with a funder SPV.
Under a forward flow structure a funder typically (but certainly not always) funds 100% of the portfolio assets. As a consequence it is the funder that has the economic risk and reward of the portfolio but origination control sits with the originator. Funders will therefore seek fetters of that originator discretion through certain contractual and structural controls. These are typically bespoke to a transaction and are heavily negotiated. Examples may include:
- Restrictions on volumes
- Ring-fenced concentration limits
- Establishment of a trust or security over the pre-funding account
- Stop funding events eg insolvency, unremedied material breach, regulatory breach
- Skin in the game – to ensure quality control on origination
- Repurchase options
- Amendments to standard documents
- Amendments to originator underwriting policies and procedures
Given the heavy exposure to originator behaviour, funders will seek warranties as to the eligibility criteria on origination, though these are often accompanied by M&A style limitations on liability. Again, this is a heavily negotiated part of a forward flow transaction.
Credit risk allocation
Credit risk in a forward flow transaction typically sits with the funder who may fund up to 100% of the portfolio. This is in contrast to warehousing or securitisation transactions where an originator may be required to hold a proportion of risk to satisfy regulatory requirements under the EU/UK Securitisation Regulation. It should also be noted that the originator does not take a junior credit position and the structure is not tranched thereby removing forward flow from the reach of the EU Securitisation Regulation and/or the UK Securitisation Regulation.
That being said, in our experience, originators may take a pari passu participation in individual assets comprising the overall portfolio as 'skin in the game', in order to provide comfort to funders (in addition to contractual protections) ensuring high quality, complaint originations and to ensure that commercial interests remain somewhat aligned.
Economics
While the funder vehicle will be allocated assets at par, collections will be often distributed according to a waterfall of payments agreed between the parties, with servicing and collections fees, perhaps among other items, being deducted from total collections. Of course, the precise economics of each deal will be structured on a case by case basis, but in our experience a typical ABS style waterfall will be put in place.
Other items may include origination fees or deferred consideration and profit-sharing arrangements depended on overall portfolio performance. It is, however, unusual for the originator to be exposed to the same level of downside risk as the funder (which is consistent with credit risk allocation described above).
Typical key documentation
- Framework Agreement/Master Definitions.
- Servicing Agreement.
- Origination Agreement.
- Documentation relevant to SPV/or trust structures.
- Security documentation (where relevant/appropriate to the structure) eg trust declared over funding/distribution account.
Find out more
We are well placed to offer assistance in this growing market. If you are interested in discussing forward flow financing with us, please contact a member of our Banking and Finance team in London.
