At Cadence, we prioritize managing risk and commit to being transparent about those encountered in private credit investing. On our deal pages and in posts like this one, we continue to be upfront about the risks faced by investors on our platform. We are encouraged when investors consider this information and inquire about how Cadence mitigates these risks. These types of questions have motivated us to write up a detailed outline of our risk mitigation strategy.
Components of Risk
We believe that risk must be understood on a holistic basis, taking into account all factors affecting investment performance across an entire portfolio. However, for the purpose of explaining our risk mitigation procedures, it’s easier to group risks for the sake of illustration.
As we have outlined in a previous post, we usually divide risk into two categories, asset performance risk and counterparty risk. The former relates to when the underlying assets contributing to the repayment of an obligation do not perform as expected. The latter deals with the risk that the performance of a note becomes de-linked from the underlying assets due to the actions (or inactions) of a transaction party. Whichever category of risk we are referring to, and though the details may change deal-by-deal, the approach to risk management usually changes little.
Asset Performance Risk
For most investors, asset performance risk is the easier category to grasp and measure. When buying a piece of real estate, for example, most people intuitively understand that their return depends on the ability of that property to generate cash flows, generally from rent or sale proceeds. Similarly, an asset-backed bond depends on its collateral pool to generate returns.
The notes offered on Cadence’s platform are collateralized by portfolios of private credit assets. These could include loans, leases, cash advances, receivables, royalties, and more. These assets generate cash flows that can be predicted with some level of accuracy but not with certainty.
Nonetheless, the first step to mitigating asset performance risk is examining the payoff characteristics of the underlying assets. Relevant questions include:
- How frequently the underlying assets pay?
- Whether the assets amortize or do they generate cash flows only at maturity?
- How long are repayment periods?
- What proportion of the assets will likely experience collection issues?
- What measures can an originator or servicer take to mitigate losses on a defaulted asset?
Cadence reviews prospective originator partners’ loan books to answer those questions. Should we proceed, Cadence also strives to make that information available to investors. For some originators, Cadence receives and posts real-time asset performance data, a feature we expect to roll out to more notes in time.
Despite best efforts to project asset performance, there will inevitably be some variability. Because investors in Cadence notes only have recourse to the underlying assets, should cash flows from those assets come in lighter than expected, interest and principal repayment to investors could be impaired.
To mitigate this risk, Cadence usually requires that originators absorb losses on the collateral up to a predetermined point. This provides a cushion called a “first loss cushion” or “first loss provision.” Historically, this first loss cushion has varied between 5% and 25% of notes’ principal and interest amount.
Cadence arrives at an appropriate first loss cushion based on the term of the note and the projected default rate of the underlying assets. Other factors, including delinquency rates and recovery rates on defaulted assets, are also considered. We aim to have a first loss cushion that is some multiple of the projected default rate over the term of the note.
To illustrate the protection provided by this cushion, suppose a 3-month note is collateralized by assets with an 8% historical annual default rate. If future defaults are expected to match the rate of historical losses, then the projected 3-month default rate would be 2%. If that note has a 15% first loss cushion, the protection would amount to 7.5 times the projected default rate. In this example, even if defaults were to come in at twice their historical level, there would still be ample cushion.
The kind of first loss cushion just described is a form of”credit enhancement,” so-named because it improves the credit quality of a bond. Other forms of credit enhancement may include cash reserves and insurance. Any credit enhancements present in an investment offering are crucial factors in understanding its risk and, as a result, they are mentioned on our deal pages for investors’ benefit.
However, there are other credit enhancements common to Cadence notes that are easily overlooked. As an example, in general, the underlying assets collateralizing the notes yield a return higher than what is due to the noteholders, this difference is called “excess spread” and provides yet another cushion to absorb losses.
For example, imagine two Cadence notes yielding 10%, one collateralized by assets earning 12% and another by assets yielding 22%. The excess spread is 2% and 12% for each note respectively, and in either case that excess can be used to make up for losses from defaults.
However, the support provided in the second note is far greater than in the first note. Excess spread is especially crucial for high-yielding asset classes like emerging market consumer credit, factored invoices, and merchant cash advances.
While asset performance risk is the more obvious of the two groups of risks we outlined earlier, counterparty risk shouldn’t be ignored. Counterparty risk refers to the risk of an entity involved in a financial contract not honoring its obligations. This could be due to the bankruptcy of that entity, but counterparty risk could also arise from operational failures.
Counterparty risk is especially relevant in private credit because the sector is more opaque. Whereas most public market transactions are executed through well-known, highly-regulated exchanges and clearinghouses, this is not so in private credit. In private markets, transactions are executed directly between two or more parties. This means the financial health and operational strength of counterparties matters a great deal more than in public market transactions.
The two most important counterparties involved in the notes offered on the Cadence platform are our originator partners and Cadence itself.
Originator Counterparty Risk
The first step to mitigating counterparty risk is understanding the role of the counterparty and assessing the potential for their financial and operational failure. Our prospective originator partners go through an extensive due diligence process that assesses these risks.
Our due diligence process reviews prospective originators’ operational and financial health along with various external risks to their businesses. Our counterparty risk mitigation process also includes an on-site review of the originator. Once again, these initial steps are merely meant to understand the risk of working with a particular party.
In addition to our due diligence process, we put every originator partnership through an internal committee process where several experts in operations, finance, and business management share their thoughts on potential partnerships. We also leverage outside advisors to provide further perspectives on a particular counterparty. Whereas many credit committees focus overwhelmingly on financial health, we believe a broader scrutiny is particularly important in private credit.
Finally, our agreements with originators also provide various legal protections to investors. As an example, originators represent that they are in good legal standing and that our agreements with them are not in violation of other contracts or regulations that might encumber them. They also represent that they have proper title to the assets they are selling to collateralize the Cadence notes. Originator partners also attest that no other entities have a claim to such assets, except in the case of subordinated notes where a specific senior claim is identified and disclosed. Breach of these representations allows for the cancellation of a transaction by requiring that the originator repurchase the assets they sold. The proceeds from this repurchase would then be paid to noteholders.
If a counterparty risk were to materialize, either from an operational oversight or even an originator bankruptcy, it is worth noting that noteholders’ investment would still be collateralized by the underlying assets, be they receivables, term loans, cash advances, and so on. Cadence would manage the recovery process on behalf of investors in such an unforeseen scenario.
Cadence Counterparty Risk
Just as we thoroughly diligence any prospective partners, we perform a similar exercise on ourselves and in the process have developed a robust risk management framework to address potential issues.
As an example, not only do we use our committee process to scrutinize potential originators, we also use them as a forum to discuss potential operational issues that could arise on our end during the life of a transaction. This is especially pertinent to offerings with new deal features, like embedded call options, or transactions that involve a partner domiciled in a foreign country.
In the unforeseen event that Cadence ceases its operations, investors of our platform are protected. Investors’ uninvested funds are deposited in an FDIC insured bank account and are not commingled with Cadence’s operational bank accounts. The separation of these funds is reviewed by external accountants.
Investors’ funds invested in current opportunities, yet to mature at the time of a hypothetical insolvency, would also be protected. This is done through our use of industry standard special purposes vehicles (SPVs) that segregate the assets of the note issuer (the SPV) from any of Cadence’s assets and liabilities. Cadence also employs an independent director and backup manager for its SPVs, the latter of which commits to intervene in the unfortunate event Cadence were to cease operations. This backup manager would wind down the note programs then outstanding by remitting funds collected from the collateral to investors.
To be clear, when you purchase a note on the Cadence platform, you are not lending to Cadence, so we strive to make sure your investment is insulated from any counterparty risks arising from Cadence itself.
What are SPVs and How Do They Protect You?
In the previous section, we introduced SPVs. The role of SPVs in Cadence’s investment offerings are important enough to warrant some elaboration.
SPVs are separate legal entities, typically formed through limited partnerships (LPs) or limited liability corporations (LLCs), that are used to separate an entity’s assets and liabilities from those of other entities that might otherwise be related. SPVs create a ‘bankruptcy-remote’ entity whose creditors and other interested parties are substantially less exposed to the financial, operational and legal health of any other entity. For example, even if a parent company goes bankrupt, an SPV it owns equity in can continue to pay its creditors, provided proper precautions were taken to make it truly bankruptcy-remote.
The use of SPVs in structured finance and other financial market applications has been around for decades. This is because investors value the protection that they offer in preventing hidden risks from materializing because, for example, a creditor somewhere else in an organization was able to lay claim to collateral they thought was meant to secure their claim specifically.
Every investment offering Cadence makes available to investors on its platform is structured around a bankruptcy-remote SPV. These SPVs typically only have a single set of asset and liabilities. The assets are the invoices, royalty agreements, loans, and other financial assets that collateralize the notes. The liabilities are the Cadence notes issued to investors. We believe this structure is more investor-friendly than lending to the originator partners directly because it reduces dependence on the originator and the likelihood of the health of the entity deteriorating for some unforeseeable reason. We also believe that with scale, setting up SPVs can be done in a very cost-efficient manner, reducing costs that would otherwise be borne by the investor, originator, or Cadence.
Recall that we explained that counterparty risk could cause the performance of a note to become de-linked from the underlying assets due a transaction party not honoring a commitment, either out of intentional breach of contract or operational shortfall. We hope it is clear now why using an SPV helps reduce counterparty risk. This applies to the counterparty risk introduced by Cadence or our originator partners.
We hope this post laid out some of the risks involved in private credit investing as well as how Cadence mitigates those risks. Cadence believes that making private credit less opaque opens up the asset class to investors who would otherwise be unfamiliar or uncomfortable exploring this alternative asset class.