The typical note structures used on Cadence’s investment platform bring various benefits for investors. Most programs provide exposure to a diversified pool of assets and benefit from some form of credit enhancement. The exact degree of these enhancements can be checked on a transaction’s deal page.
In securitizations of private credit assets, credit enhancement refers to any of a number of features designed to make the notes even more creditworthy than the underlying assets themselves. Perhaps the most common form of credit enhancement is overcollateralization, or “OC.” When the outstanding amount of the note is less than the notional value of the loans or other assets in the collateral, the difference is the OC. The higher the level of OC, the more protection there is against defaults and losses in the underlying portfolio.
A slightly less typical form of credit enhancement in Cadence notes is a cash reserve account. A cash reserve supports a deal by providing further protection against losses, but also by providing liquidity that can be used to meet note interest or principal payments if proceeds from the underlying assets come in lighter than expected.
Cadence note programs have utilized both of these common forms of credit enhancement in the past. We often combined the OC and the cash reserve (if any are available) into a single number called “first loss cushion.” In larger institutional securitizations on public markets, this is usually referred to as “total hard credit enhancement.” This may include the credit enhancement provided by more subordinated notes, but Cadence programs usually consist of a single tranche.
Cadence sees value in providing more detail on credit enhancement to investors, and to this end will separately disclose the level of overcollateralization and cash reserve. Note that these might not add precisely to the “first loss cushion.” In the world of esoteric asset-backed securities, OC is frequently expressed as a percentage of the portfolio amount rather than the note amount. Given the overcollateralization, the portfolio amount —the total asset value collateralizing the note sold to investors — would be larger than the note amount. As a result, the level of OC depends on how you characterize it. Given these ambiguous and potentially confusing industry conventions, it is all the more important to provide clear and detailed information about transaction structures.
Also, Cadence is rolling out a new structural feature to the note programs on the platform. These are note performance tests that check for sufficient collateral on an ongoing basis. At the close of each note, Cadence confirms that the collateral supporting any deal is sufficient to cover both the note amount and any OC required.
The introduction of an OC test would essentially ensure collateral continues to stay above some minimum threshold on an ongoing basis. If the collateral balance falls below this threshold, then reinvestment of proceeds from the underlying assets by the originator is typically either restricted or suspended entirely, with cash proceeds accumulated to pay down the note either in a lump sum or a series of amortization payments. As of December 2020, programs for PULSE Medical Finance and The Smarter Merchant include such a deal feature, and we intend to make this common across offerings in the future.
Typically, in calculating the collateral amount, assets beyond a certain level of delinquency are “haircut” — that is to say they are counted for less than their full value (usually $0 for defaulted assets). Similarly, assets with payments beyond the Cadence note maturity could also be haircut. In this way, an overcollateralization test ensures that even after deducting for defaulted, delinquent, or “long-dated” assets, there is still ample collateral. The test attempts to limit deterioration in the note’s credit enhancement.
An overcollateralization test was first introduced in the Cadence note program with PULSE Medical Finance, and was discussed in the “Risks And Mitigants” section of our deal page. The level of OC and any minimum threshold can be found in the Surveillance Reports for PULSE Medical Finance.
As a case study in the importance of note performance tests in esoteric securitizations, one can look to institutional transactions for which public information sheds some light on how structures held up through the Covid-19 recession earlier this year. An example was a $70 million deal for small business lender Fora Financial from late 2019. This transaction (Fora Financial Asset Securitization LLC, Series 2019-1) was backed by merchant cash advances and business loans. The transaction breached a test in April that triggered an early amortization of the notes. This ended a 3-year reinvestment period after just about 6 months as delinquency rates soared to 45%. Despite this, each of the classes of notes have paid back in full by November 2020.
Investors on the Cadence platform also had exposure to similar assets through note programs for originators such as Wall Street Funding, which was onboarded onto the platform in 2019. In the case of the Wall Street Funding program, the short duration of individual notes provided substantial protection by allowing program terms to evolve as the economic environment worsened. For example, the level of first loss cushion was increased from 15% to 25% as notes were refinanced, protecting against lower collection rates.
While short duration mitigates some risk posed by migration in the credit quality of underlying assets, investors increasingly value the protections offered by more dynamic structures. As such, notes that are both short dated and carry note performance tests will likely get more common, especially for programs that allow reinvestment of proceeds into new assets by the originator — actions that can cause credit quality to migrate. Cadence looks forward to communicating these structural nuances to investors to better illustrate how program structures are critical and can vary across offerings.
 Information from Kroll Bond Rating Agency “Fora Financial Asset Securitization LLC, Series 2019-1, Surveillance Report”, September 30, 2020
 Information from Kroll Bond Rating Agency “KBRA Withdraws Ratings on Class C Notes on Fora Financial Asset Securitization LLC, Series 2019-1”, November 16, 2020