...and why the market needs to be revolutionised to capture its full potential
This is the second part of a three-part series about what’s wrong with the Fintech lending value chain as we know it and why we believe it needs to be revolutionised for it to truly prosper and grow into what it can be. Enjoy!
Let’s pick up where we left it at the end of Part 1 of the series, the cost structure of typical facilities offered to Fintech lenders. As there is less to say about the interest cost specifically, we’ll leave that aside for now and focus on the other three layers of fees.
Set-up costs
Remember the round peg into a square hole? This is it. More or less all private credit professionals will want to protect their downside in all possible scenarios, however unlikely they may be. The result being a few hundred pages of loan documentation and a legal fee of a couple of hundred thousand Euros.
Don’t get me wrong, legal advisors are very much necessary for this type of deal, but if you’re a small lender with a single credit product targeting borrowers in one or a few jurisdictions you could standardise 90-95% of it. Additionally, you can keep it relatively simple while maintaining flexibility, but only if you really want to do so. That’s why our legal fees are capped at a 10th of what is typically seen in the market.
IRR enhancing fees
Let me quickly explain what these fees might be, from most common to least common;
Commitment fee – 0.5-2.0% on the amount committed by the debt investor, to be paid immediately (or at best as you draw down on the facility),
Unused fee – 0.5-2.0% paid on the unused portion of the committed amount (i.e. committed amount minus loan book - the money you are not even using),
Penalty fee – 1.0-3.0% of extra interest during the time you are in breach of any trigger or covenant,
Amortisation fee – 1.0-3.0% of extra interest when the facility term has ended (unless someone else has bought over the outstanding loans) and you’re forced to do a portfolio runoff,
Exit fee – 0.5-2.0% on the committed amount to be paid immediately at the end of the facility (similar to commitment fee but at the end of the facility term),
Management fee – 0.5-2.0% paid annually on drawn amounts directly to the debt investor to manage the facility/relationship with the lender, and
Origination/Drawdown fee – 0.5-2.0% to be paid at every drawdown i.e. every time a lender needs more money
So if a debt investor sets an interest rate to 9.25%, that’s not what they expect in terms of return from the debt facility – it’s actually way more. The interest rate is just the minimum return they need to achieve, whereas the additional fees are what pay their bonuses (it's a joke, but it's more or less true).
These are costs that are relatively difficult to quantify if you’re a new player, but debt investors are really good at it since they’ve seen hundreds of your peers and know what journey lies ahead of you. How strange it may seem, they sometimes know more about lenders’ growth trajectory than the founders know themselves, i.e. an information asymmetry.
When a founder has a really strong conviction that they can build a €25m loan book in one year, they don’t think so much about a 1.50% unused fee. But if that loan book only averages out at €5m during the first year, the Fintech has then paid an unused fee corresponding to an additional interest rate of 6.00%. That’s more than enough to have substantial negative unit economics. So, what happens? The lender didn’t have any net revenue that year and now needs to raise additional capital. But who’s going to invest in such a business case?
Imagine raising your first equity round and half of it is spent on the first day, ouch...
Correspondingly, the commitment fee (especially together with the set-up costs) can easily eat up a pre-seed round. Consider the same €25m debt facility with a Commitment fee of 1.00% and legal costs of €150k, that’s €400k out the door day 1, even before you’ve started to lend out a single Euro. Imagine raising your first equity round and half of it is spent on the first day, ouch...
What I’m trying to say is that it’s at least €400k more expensive to start a Fintech lender compared to a B2B SaaS company, and who are the ones paying for it? VCs. Who’s benefiting? Debt investors.
As you probably understand by now, the IRR improving fees are great for the debt investor, but can be disadvantageous for the Fintech lender, especially if things don’t go according to the plan (spoiler alert: they rarely do). Most start-up founders already know this, but growing a business is not a straight line, there will be ups and there will be downs, that much we know.
Warrants
So, you’re a founder of a Fintech lender, you’ve secured a term sheet with a favourable interest rate, manageable set-up costs and acceptable IRR enhancing fees. Now what?
You have to give away a part of your business to the debt investor. After already diluting yourself to your equity investors, you now also need to dilute yourself and your equity investors to bring in a debt investor. Another big difference compared to a “traditional” B2B SaaS start-up. Additional dilution.
The reasoning is that the debt investor by providing a debt facility will increase the value of the start-up, and that’s most probably true. They want to take part of the upside they contribute to. Nothing wrong in that.
But it’s like giving Amazon warrants in your business because you’re using AWS. Cloud services can probably be argued to be as essential for a Fintech lender as a debt facility. And it’s not like the debt investor has given a discount on the interest rate and fees that they’ve exchanged for a piece of the pie and additional up-side, right?
It’s not a small piece of the pie either, it’s substantial. On average you probably see debt investors receiving warrants corresponding to 3-7% of the cap table. However, I often see the likes of up to 10%, with the absolute highest being 20%. Imagine giving away 20% of the company for free?
And how do these warrants work? Usually, the strike price is your latest valuation or if you’re raising debt in conjunction with equity, your upcoming valuation. In some cases, the debt investor wants penny warrants, meaning that they can buy the shares at nominal value, so basically no equity capital coming into the business once the warrants are exercised.
But wait, it gets worse. These warrants can be structured in a way that they don’t need to be exercised until 10 years later, long after the debt facility has been terminated and the start-up is now a profitable business without the need for equity injections. Your old debt investor will be waiting outside your cap table until an exit, and in the worst case, together with other debt investors you’ve worked with along the way.
It is clear that debt investors have created one of the greatest financial products out there. As discussed in this blog post, more or less all of the credit risk, i.e. the downside, lies with the Fintech lender and its equity investors. The debt investors effectively always get their money back plus interest. But here’s the thing, they can also get Unicorn returns due to the warrants.
Debt investors get solid and stable returns in a downside scenario, but Unicorn returns in an upside scenario.
Compare this to VCs who are losing money on 7 out of 10 investments just to get that one investment with outlier returns to pay for all of the “bad investments”. Debt investors are actually earning high risk adjusted returns on all investments, while still reaping the benefits of the outliers. In short, they get solid and stable returns in a downside scenario, but Unicorn returns in an upside scenario.
Too good to be true? Unfortunately not. A Fintech VC investor I spoke with recently told me they were seriously considering investing part of their fund in a private credit fund to improve their risk adjusted returns...
This concludes the second part of the Series. Next time, I’ll be elaborating on what I think needs to be changed to truly maximise the potential of Fintech lenders and target the market opportunity up for grabs.