Contrary to common belief, the financing round following a Series A financing need not be a Series B equity financing. In between one equity financing round and the other, it is often prudent for founders to explore other innovative strategies for raising capital. Three critical factors should be top of mind in this context. These are, cost of capital, the risk of dilution and the speed of executing the transaction. While venture debt is a popular alternative to equity financing because it is non-dilutive, securitizations standout as a more compelling proposition. In addition to being non-dilutive, startups raising capital using a securitisation strategy do not need to put up a collateral or debenture as is often the case with venture debt.
How Do Securitizations work?
A securitisation is a process of financial engineering by which the cash flows from a portfolio of income-generating assets are packaged together and refinanced by the issue of newly created debt securities. In a simple tech-sector securitization transaction:
(a) a technology startup (the “Originator”) sells receivables which are due or will become due to the Originator in the future, from its customers, to a newly incorporated Special Purpose Vehicle (the “SPV”). Within the tech sector, such receivables could be, subscription fees, tariffs, fares, commissions or repayment of interest & principal payments due to the Originator, on a loan provided to a customer.
(b) The SPV purchases the receivables using funds raised from a combination of senior (and sometimes, mezzanine) debt providers (the “SPV Investors”). In practice, the receivables purchased from the Originator are used as collateral to secure the SPV’s obligations to repay the principal and interest and any amounts due to SPV Investors.
(c)Since the investment returns earned by the SPV Investors depends on the complete payment due on the receivables by the Originator’s customers, the Originator does not just walk way after selling the receivables and would therefore still be responsible for servicing the receivables and ensuring full payment from customers.
Why Securitization?
A securitization transaction is particularly complex because the SPV as well as the sale of the receivables must be structured to meet certain accounting, legal and tax imperatives. An additional level of complexity may result from the number of jurisdictions which the transaction crosses, the number of SPV Investors and transaction parties, whether the securities of the SPV are sold in a public or private offering etc. However, a securitization transaction presents a number of strategic advantages for the Originator, which includes:
a) the prospect that the sale of receivables is generally done on a non-recourse or limited recourse basis, meaning that, absent a breach of the provisions in the Transaction Documents, the SPV only has recourse to the receivables in the event of a default by a customer or when receivables are insufficient to repay the SPV’s debt.
b) the prospect of achieving a lower cost of borrowing relative to other forms of financing. This may be the case where the isolated cash flow on the back of which the borrowing is repayable is of a better credit quality than that of the Originator.
c) the prospect of accelerating cash receipts from the receivables whilst removing the receivables from its balance sheet, thereby reducing originator’ gearing, with the effect that the Originator can borrow more, improve return on capital and strengthen their balance sheet.
d) the prospect of interest rate arbitrage, which would arise where a Fintech is able to secure funds from investors at a lower cost than the interest rates they charge borrowers, thereby boosting profitability.
e) the prospect of liquidity, which results from an immediate injection of cash from the conversion of their assets into securities. This liquidity can be used to fund new loans, service existing ones, or invest in technology and infrastructure.
f) the prospect of scalability, given that securitization is inherently scalable and can accommodate the increasing lending volume that comes with scale. Fintechs generally require scalable funding sources as they continue to grown and expand their origination activities.
Some Key Considerations for Fintechs in a Securitisation
(a) Private Securitizations or Public Securitizations?
Originators need to form a view early on, on the type of capital markets they wish to access. In the local fintech market, private market securitizations are common, with global fund/asset managers or local asset managers serving as SPV Investors. We have also seen transactions where local asset managers are the SPV Investors. However, Originators can also access the public markets locally but will have to comply with the relevant SEC Rules relating to securitizations.
(b) Subordinated Loans in Securitizations
SPV Investors will typically fund a proportion of the loans based on a borrowing base calculation, with the implication that the balance of the purchase price will have to be funded by the Originator via a subordinated loan or by a junior lender. This construct aims to achieve some degree of alignment and risk allocation between the Originator and SPV Investors.
(c) Due Diligence & Reporting in Securitizations
Originators should expect that SPV Investors would conduct extensive legal, commercial and operational due diligence. This is typically necessary in determining the nature and scope of the representations and warranties to be given by the Originator. SPV Investors will generally be interested in ongoing updates on the performance of the receivables, organisational processes and key business functions. For this reason, transaction documents would typically place considerable reporting obligations on the Originator.
(d) Eligibility Requirements in Securitizations
SPV Investors would expect that the receivables meet certain eligibility requirements which are usually tested on the purchase date. Broadly speaking, eligibility requirements are the set of standards which provide assurance to the SPV Investors that the receivables would be fully recoverable and that the underlying contracts will be enforceable. Such eligibility criteria may be performance-related, such as having one or more instalment payments made, or ensuring proper hedging of receivables.Regulatory compliance may also dictate eligibility criteria, ensuring that receivables are consistent with relevant laws and remain free of fraudulent activity, legal disputes or encumbrances.
(e) Hedging FX Risk in Securitizations
Where the SPV Investors are foreign investors, it is often the case that the securities are denominated in a currency which differs from the currency of the receivables. Such transactions will therefore be exposed to currency risk fluctuations. Timing mismatches in receipts and payment obligations can also arise. It is often prudent to enter into derivative contracts to manage these risks.
(e) True Sale of Receivables in Securitizations
SPV Investors would want to be sure that the sale of the receivables to the SPV meets the legal requirements for a sale. Typically, when a sale of receivables is properly executed, it means that the receivables no longer belong to the Originator once the transaction is completed. However, if the sale fails to meet the legal requirements for a valid sale, there exists a risk that the transaction may be reclassified as a loan from the Originator to the SPV, with the transfer of the receivables being considered a security assignment instead. Should such a reclassification occur, the receivables would still be owned by the Originator and could become part of the Originator’s insolvency estate.
Final Analysis
Each organization may find it necessary to tailor its corporate financing strategy based on industry-specific factors or to its unique circumstances. While securitization offers certain benefits in contrast to conventional debt financing methods, it is prudent for entrepreneurs seeking funding to carefully evaluate the advantages and disadvantages of various corporate finance strategies with the guidance of experts.
Balogun Harold provides this information as a service to clients and other friends for educational purposes only. The foregoing information should not be construed or relied on as legal advice or to create a lawyer-client relationship. Readers should not act upon this information without seeking advice from professional advisers. Kindly seek professional advice specific to your situation. You may also reach out to your usual Balogun Harold contact or via support@balogunharold.com for support.
