How family offices are achieving alpha, with financial warehouse facilities
Financial warehouse facilities are big business, and the demand for financial warehouses is rapidly growing with the explosion of asset backed private credit. Traditionally these were provided by banks and investment banks. However, we are now seeing the rise of family offices and specialised investment funds entering the space.
In this article we go into the details about what a financial warehouse is, how the market opened for family offices investments into warehouse facilties and how they are achieving alpha returns.
What is a financial warehouse facility?
A financial warehouse is where a wholesale investor (family office, bank, investment bank, specialised investment fund) provides a line of credit to a lending company. Think of it as a lender-to-lender facility.
For the provision of this line of credit, the wholesale investor takes the lenders loan book and the underlying security of the loan book as security for the facility being provided. These facilities can be tied to existing loan books, or to new loan books.
The lender taking the funds can be a bank, a non-bank lender or private lender.
Key benefits for the provider of the warehouse facility are:
- They do not have to engage in individual loans.
- They do not need to manage individual loans
- They do not need to originate loans.
- They do not need to manage the default process.
- They do not have high deal concentration risk, as their capital is spread across multiple deals.
- They can gain an alpha return.
- The role of the warehouse provider is to ensure the lending criteria of the warehouse facility is met by the lender.
Security ranking of the warehouse facility
The capital of the warehouse facility can be secured in several ways.
- It can be the senior lender, with its own loan book.
- It can be second ranked, in other words its capital ranks behind other capital in the capital stack of the lender originating the loans.
- Warehouse facilities can even take the assets of an existing loan book as security, which improves the overall total security pool for the warehouse provider.
- First loss provisions can be structured, so the originating lender puts their capital at risk first on each deal before the warehouse loses any of its capital.
What security does the underlying warehouse facility have?
Warehouse facilities can be secured by various types of loan books including;
- Consumer home loans
- First mortgage private loans
- Second mortgages
- Equipment finance
- Cashflow loans
Pricing is a subject to ranking of the warehouse facility, the risk of the underlying asset class used for the loan book, and the risk of the end borrower.
Warehouse facilities are not a one size fits all product, and the market highly rewards tailored products.
How the borrowing lender of the warehouse facility makes money?
The lender makes money typically off the spread, between their cost of capital for the warehouse facility and the interest rate that is paid by the end borrower, plus the lenders application fees etc.
How the market opened for family offices?
Conventional warehouse facilities provided by traditional banks and investment banks, have stringent criteria for borrowers to be eligible. This has given way for new entrants like family offices and specialised investment funds to enter the market, offering far easier terms than conventional players.
Typically warehouse criteria for banks and investment banks has included.
- A minimum facility size of $50M.
- Require a proven track record of 3 years.
- First loss provisions, that can’t be met by newer lenders.
- Credit score requirements of end borrowers or some type of severability check.
- Funding of certain asset classes within limiting LVRs.
Not all lenders can meet these requirements, and more importantly some of these requirements can impede a lender from growing or offering certain products. This stringent criteria has now allowed family offices the opportunity to fill the market gap between when a private lender starts and when they become eligible to eventually get a traditional warehouse facility.
What is an alpha return?
In the simplest terms, an alpha return is where an investor can make a higher return in one investment, compared with another investment of similar risk. In other words, the investor did not need to take on more risk to generate the higher return. So an alpha return, is produced when there is an asymmetric return to risk ratio.
How to achieve an alpha return?
An alpha return can be achieved in one of three ways.
1. Risk is reduced whilst maintaining the same level of return with a comparable investment.
2. A higher return is achieved, whilst maintaining the same level of risk with a comparable investment.
3. When it comes to warehouse facilities or certain private credit investments. The parties providing the capital have the ability to do something unique. They at times can ask for equity in the core business they are providing funds to, which increases yield and or capital growth, without added risk (we cover more on this below).
How family offices are generating alpha returns with warehouse facilities?
Family offices typically gain an alpha return through unique deal structuring, and by providing urgent liquidity to lenders, that lenders are happy to pay a premium for. This has been at the heart of our work.
First loss provision and reduced deal concentration risk
Base case
A family office can write 80% LVR loans, against metro assets that they manage, for 11% p.a.
How alpha is gained
By providing a warehouse facility to a private lender doing similar loans, in need of urgent capital. They can request an 11% return but ask that there is a first loss provision of 5% to 10% on each deal.
The family office has now reduced risk in two ways. First deal concentration risk is reduced, as funds are spread across multiple loans. Secondly, the lender is now providing first loss capital of 5% to 10% for each loan (further reducing risk), whilst maintaining the same level of return.
Taking a fund as security for a facility
Family offices can loan money to private lenders and take the lenders loan book / fund as security.
Base case
A family office typically does loans at 65% LVR at 9% p.a.
How alpha is gained
In this scenario a private lender has urgent need for capital, with a loan book that consists of loans priced at 9% p.a., at 65% LVR, with a book size of $65m against assets of $100M. Let’s also assume that $65M of deployed funds was from investors that the private lender had.
The family office could provide a $50M loan to the private lender, but also ask to take the existing loan book as security. With them ranking as first or second (subject to negotiated terms) to the existing fund.
Scenario A (senior position)
In the scenario where the family has the senior debt position on the existing fund, plus their own new book of $50M. The total deployed loans would be $115M (the existing loan book at $65M plus borrowed funds of $50M), against assets of $177M ($100M of assets from the original loan book, plus $77M of assets from the new funds).
The family office would then have the same level of return at 9% for their $50M, but actually their overall LVR position would be significantly less. As they would now have a loan book with total assets of $177M as security, versus them just doing $50M against $77M.
Scenario B (their capital ranks first, plus secondary position on the existing fund)
Even if the family office ranked behind the liabilities of the fund (to pay investors their capital back), it still has extra equity available to it of $35M from the original loan book ($100M in assets, less $65M in investor capital =$35M). This $35M would be on top of first ranking $50M warehouse facility and their $77M in assets as security.
In either scenario the family office has reduced deal concentration, more security, and have achieved the same level of return with less risk.
Capital growth through warehouse facilities
Family offices that are working with new private lenders, can also achieve capital growth on top of their yield.
Base case
The family office only earns their risk adjusted return on their warehouse facility or provides a warehouse facility to a lender.
How alpha is gained
Deal terms are everything, especially with new lenders or lenders desperate for capital. A key term that can be negotiated for family offices, is that a percentage of equity in the new lending business is provided to the family office providing the capital.
This does a few things, firstly it increases yield on any warehouse facility provided. Not only is the family office making its interest return on loaned funds. It now takes a percentage of profit of what the lending business itself makes, from app fees and the spread between interest rates (cost of the warehouse and the price capital is sold for).
Secondly, its provides capital growth via equity ownership in the lending business.
Whilst some would argue, that providing a warehouse facility to a new or younger lender carries more risk. The inherent loan types, LVRs and terms are still controlled by the family office providing the facility, just the same as it would be for a mature lender.
If you’d like to explore this further, for a confidential discussion you can contact us here.
