[After spending a couple of hours watching the movie The Big Short, this all seems pretty normal banking practice, but involving a small island sort of elevates it to a higher plane. Pun intended. bp]
Why this subprime lender funds loans through the Cayman Islands
by Kadhim Shubber
Jan 19 10:18
Elevate Credit calls its customers in the US and the UK the “New Middle Class”, selling them loans in the latter at a representative APR of 1295 per cent. It is gearing up to float in New York this week and, if successful, the Texas-based business will be the “first tech IPO of 2016”.
The company claims that unlike payday lenders, it has transparent fees “in order to help our customers facing financial hardships”. But while its front-end might be simple, the funding for one of its loans is a complex web of financial engineering involving a Chicago-based private-equity firm and a special purpose vehicle in an offshore tax haven.
The documents filed for Elevate’s IPO not only show a company trying to raise “as much as $80 million while admitting it may not be completely legal”, as MarketWatch put it last week, they also provide an insight into the mechanics of modern finance, describing a flow of money from stressed borrowers* in the US to the Cayman Islands and then seemingly back again.
It’s a demonstration of how “fintech” companies are more financial wizardry than technological innovation.
Elevate has three products, all with happy sounding names that disguise the fact that they are high interest loans for people with few other options. “Rise” and “Elastic” in the US, and “Sunny” in the UK. The company itself used to go by a different name. In 2014, it was spun out of Think Finance, itself a sky high-interest lender that changed its name from ThinkCash in 2010. Its chairman and chief executive Ken Rees was previously the chief executive of Think Finance and the company is 27 per cent owned by Sequoia Capital.
The source of capital for two of its loans, Rise and Sunny, is Victory Park Capital, a Chicago-based private-equity fund and one of the most active buyers of high interest, online-originated loans. Victory Park gives an Elevate subsidiary access to up $335m in funds and the subsidiary uses that money to lend to its customers. Pretty straightforward.
But the third product, Elastic, technically a line of credit, is funded in a more complicated manner. Here’s how it works.
Instead of having a direct agreement with Victory Park, this time it is a bank in Kentucky that does the lending and a company thousands of miles away in the Cayman Islands through which funding for the loans flows. It’s called “Elastic SPV” and is a special purpose vehicle named after the product.
Republic Bank and Trust Company, the Kentucky bank, lends to the public and pays Elevate a fee for its underwriting and branding. These partnerships are not uncommon for the simple reason that while nonbank lenders have to obey state usury laws in the US, banks are granted the right to avoid local interest rate caps and instead abide by the rules of their home state. The average APR for Elastic loans is 88 per cent, meaning Elevate would struggle to make the loan itself in many states.
The Cayman Islands SPV then has the right, but not the obligation, to buy a 90 per cent “participation interest” in those loans, paying a premium on the loan and a fee to the bank. The bank retains the loan documents and the relationship with the borrower, while the majority of the interest payments flow offshore to the Cayman Islands and into the SPV.
So where does the SPV get the money to buy the participations? It has funding from Victory Park, the aforementioned Chicago-based fund. When the SPV was created in July last year, Victory Park agreed to lend it up to $50m, later upped to $100m. For the first $50m Victory Park charges a base rate of 3-month LIBOR or 1 per cent, which ever is higher, plus 13 per cent. For the next $50m, it charges the same base rate plus 12 per cent. Elevate’s assets are pledged as collateral for the facility.
The reason that’s important is the margin. Victory Park is charging around 14 per cent and the Elastic loans pay an average APR of 88 per cent. The difference between those two numbers, when you account for loan losses, is effectively profit that is collecting offshore. “Essentially, the margin earned by that SPV would escape US taxation,” said Andrey Krahmal, a US tax lawyer at Temple Tax Chambers, via email.
According to Elevate’s prospectus, the SPV had $48m worth of loans receivables on its balance sheet as of September 30 last year. Assuming these are the Elastic loans at an average APR of 88 per cent, that suggests $42m of interest income a year. Elevate had net charge-offs, or unrecoverable debts, of about 50 per cent in 2014, so lets halve the $42m to $21m. At the time the Victory Park line of credit was just $50m, which would come at a cost of $6.5m a year. So that’s a yearly profit of about $14.5m as of September 2015, at which time the SPV had around $5m in cash on its books.
But at least some of that money comes back onshore, and here’s where it gets even more interesting. Elevate has not only pledged its assets as collateral for the Victory Park loan to the SPV, it also has a credit default swap agreement with the SPV, under which Elevate receives payments in return for promising to protect the SPV against loan losses from the Elastic product.
Elevate is acting as an insurer to the SPV, or in other words, Elevate is being paid to take the hit on the riskiest loans, while Victory Park is being paid a bit less, presumably, to fund the safer stuff.
Finance experts will have deduced by this point that the Elastic SPV looks like a securitisation vehicle. The SPV, which Elevate includes in its financials for accounting purposes but does not own, appears to be a way for Elevate and Victory Park to divide up, or tranche, the Elastic loans and receive a different return for taking on different risks.
So why do it in the Cayman Islands?
Well, one reason, and the reason why lots of securitisation vehicles are based there, is that the Cayman Islands has next to no taxes. Here’s an excerpt from a 2013 Conyers Dill & Perman document comparing the advantages and disadvantages of various small island groups for financiers wishing to do a securitisation (emphasis ours):
No taxes are imposed in the Cayman Islands upon an SPV or its shareholders. An SPV is entitled to receive an undertaking from the Cayman government such that no law enacted in Cayman imposing any tax to be levied on profits, gains or appreciation or which is in the nature of estate duty or inheritance tax shall apply to an exempted company, or its shares or by withholding for a period of up to twenty years, which is usually renewable for a further ten years upon expiry. Stamp duty applies in the Cayman Islands where original documents are brought to the jurisdiction although the liability of exempted companies is capped in most cases.
Not only is the Elastic SPV an ‘exempted company’, according to the IPO documents, its agreement with Republic Bank states that the loan documents are retained by the bank and not, you know, brought to the Cayman Islands.
The aim of all this engineering, says Jeremiah Wagner, a partner in the capital markets group at Cadwalader, Wickersham & Taft, appears to be to provide Elevate a lower cost of financing in the most tax efficient way possible. “You’re not changing the economics of the company, rather [you’re] giving it a better rate of financing, and then you need to structure it so you don’t trigger extra taxes,” he said via email.
A key question here is the size of the CDS payments from the SPV to Elevate. They may be large enough that the SPV is effectively routing interest payments back onshore to Elevate. Or they may be small, accumulating interest payments offshore. Another important question is the owner of the SPV, which is not public (it’s possible to have an ‘orphaned’ SPV, meaning it’s owned by a trustee). Andrew Dean of Maples Fiduciary, who is listed as the SPV’s director, declined to answer questions when contacted by phone. Victory Park Capital declined to comment, as did Elevate, which cited its “quiet period” ahead of the IPO. Republic Bank did not return a request for comment.
It’s also worth noting that Elevate is running at a loss ($4m in the nine months to September last year) and has deferred tax assets of $20m as of end of 2014.
If nothing else, it would be interesting if the income flowing into the Elastic SPV is securitised in the classic sense – divided up into a series of risk categories and then sold off to other investors in the form of bonds. Particularly in light of this line from the Elevate IPO documents.
“If Elevate products were required to receive and review additional documentation from consumers such as bank statements, photo identification or pay stubs, this added inconvenience may result in lower consumer applications and loans, which would adversely affect our growth.”
*Update: A previous version of this post described Elastic borrowers as “poor”. The average borrower salary is $60,000.
This entry was posted by Kadhim Shubber on Tuesday January 19th, 2016 10:18. Tagged with Elevate, Securitisations.