The Rise and Rise of Loan Origination Funds

By Alan Smith | 13 November 2015

Overview

The growth of non-bank lending continues to proliferate. This has been given a boost in the aftermath of the financial crisis when many banks, stung by poorly performing loans, scaled back their lending to small to medium sized enterprises (SMEs). 

This has provided an opening for non-bank financials, ranging from fund managers to insurance companies, to start originating loans. “Fund managers, which have historically invested into securitised products such as Collateralised Loan Obligations (CLOs), Mortgage Backed Securities (MBS) and Commercial Mortgage Backed Securities (CMBS), are increasingly issuing securitisations on their own, often through special purpose vehicles (SPVs). A number of fund managers such as alternative credit funds are also exploring whether they can undertake loan-origination, whereby they provide financing to capital hungry SMEs. This is providing end investors with decent yields in what is a low yield market environment more broadly,” said Alan Smith, senior vice president at SS&C.  

The bulk of this activity occurs in the US, where 80% of corporate lending is derived from capital markets. While bank lending still dominates in Europe, this appears to be changing. A paper by the Alternative Investment Management Association (AIMA) – “Financing the Real Economy” – estimated SME funding from the private debt industry could reach 15% to 20% within five years in the EU, up from 6%. “US corporates have a longer track record of securing financing from capital markets,” said Smith. 

Regulatory Drivers

Regulatory change is also a major factor behind the growth in non-bank lending. “Regulation is playing a major component in banks’ retreat from lending. Basel III capital requirements will force banks to hold more capital against riskier loans, forcing many to scale back their lending activities. Meanwhile, the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve issued guidance in 2013 – “Interagency Guidance on Leveraged Lending” – which sought to ensure financial institutions conducted leveraged lending activities in a manner that was safer. This has facilitated a further retreat by some banks from SME lending,” said Smith. It should also be noted that EU regulators are seeking to encourage non-bank lending, and easing the provisions around securitisations through the Capital Markets Union (CMU) project currently underway.

What are fund managers doing?

Fund managers have built up systems and processes in order to cater for this new asset class. “Many have hired credit relationship managers and individuals well versed in the credit review processes. Loans can be exceptionally complex, and it is critical managers hire people who have a solid understanding of loan contracts and the operational processes that go with them. The maintenance of these loans and their waterfalls in the vehicles is a very complex process and requires highly trained operations teams for each type of loan,” continued Smith.

Loan origination funds incur the same risks as the banks that originated these loans before them. It is critical managers have systems in place where they can undertake rigorous Know-Your-Client (KYC) checks verifying clients meet the relevant credit criteria to receive the loan. Most importantly, managers need to understand how to deal with non-performing loans.  Loan origination carries with it a number of compliance obligations, including governance issues, capital adequacy rules and adherence to Generally Accepted Accounting Practices (GAAP) provisions. “Operations - if kept manual -carry major risks and it is becoming critical for fund managers to automate them. As data flows from very different sources, managers need to aggregate, measure their risk accurately and present a GAAP compatible balance sheet,” said Smith.

Unlike publicly listed companies where there is a considerable amount of information sources around financials, it is harder to obtain up-to-date information on SMEs. As such, firms must ensure they understand the SMEs’ business structures before they originate any loans. “Information on the underlying debtor is far less accurate or less readily available than a publicly traded company and requires a deep knowledge of the credit world and loan management,” said Smith.

“SS&C recognises that loan originations can be a highly complex process. Our long-standing expertise with complex asset classes and our ability to provide industry experts well-versed in each of the many different facets of the industry puts us as a service provider in a strong position. Managers should look for a platform built on best of breed technology that can process and aggregate the data from origination to investor reporting. SS&C with its proven track record on each of the underlying asset classes and processing of all the different fund structures in an STP environment enables the fund manager to focus on managing risk, and finding investment opportunities while keeping cost down and relying on a vendor that will help guide them through the ever greater regulatory requirements,” said Smith.

This is evident in how SS&C has developed its product offering to tailor for this evolving asset class.  “We can help loan origination managers perform accurate valuation of their Net Asset Values (NAVs). We have built the systems and infrastructure to streamline the loan origination process and the administration that goes with it. However, we moving beyond simply cutting a NAV but helping our fund manager clients ensure compliance with the governance provisions and we are in the process of moving towards more of a CMBS and MBS loan origination support service. We are helping firms with their operational requirements to help them run their loan book in a manner not too dissimilar to how a bank would,” highlighted Smith.

Firms must also ensure they adopt best of breed technology when undertaking loan originations. The processes around loan originations have historically been quite manual, although Smith advised managers to embrace automation. 

“Our technology enables managers to digitise the loan origination process thereby reducing the need for human intervention, and allowing managers to reap cost savings. Loan origination – when carried out manually – will often have to be done across multiple spreadsheets and databases. By using SS&C’s systems, managers running loan origination funds can implement efficiencies in the loan origination process from initial request through initial funding,” said Smith.

Conclusion

Regulators are attempting to reduce the real economy’s reliance on bank lending, and as such funds offering loan origination are going to increase in importance going forward. “Building the infrastructure is crucial for these managers to thrive. However, this infrastructure is often complex and operationally challenging, and managers would be advised to look towards outsourced providers such as SS&C to assist them,” said Smith.

For more information please visit our website, read our press release, or contact Alan Smith here.

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