“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” – Albert Einstein

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The best way to build wealth—aside from inheriting it—is by harnessing the power of compounding over time. Consider this: Over 99% of Warren Buffett’s current wealth was generated after he turned 50.

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However, the power of compounding can be a double-edged sword. Just as positive returns multiply, so do negative ones. For instance, it takes just three and a half years to recover from a 25% loss (assuming an 8% annual after-tax return). But a 50% loss requires nine years to recoup, and a 75% loss takes 18 years. This underscores the importance of generating solid returns while avoiding significant losses for effective wealth creation.

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When it comes to consistency and low correlation with public market instruments, asset-based lending stands out. Within this sector, one of the most compelling asset classes, in our opinion, is loan warehousing.

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What Is Loan Warehousing?

Loan warehousing is not to be confused with real estate lending backed by warehouse properties. Instead, it refers to financing provided to originators of various financial products, such as mortgage loans, auto leases, and other consumer assets. These financings are structured similarly to public securitizations.

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Loan warehousing is particularly attractive to smaller or start-up originators looking for flexible funding solutions to grow their businesses to a size large enough to access public markets. Providers of loan warehouses benefit from competitive pricing and numerous credit protections built into these structures.

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Typically, loan warehouses have a stated maturity of 2-3 years, as the assets are usually refinanced through public term deals, making them significantly shorter in duration than corporate loans.

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What Are Its Benefits?

1. Bankruptcy Protection: Loan warehouse funding is provided to a bankruptcy-remote special purpose vehicle (SPV) and secured by a portfolio of assets acquired by the SPV from the originator.
2. Aligned Interests: Lenders typically fund only the senior portion of the assets in the portfolio, with the originator funding the equity, aligning the interests of both parties.
3. Structural Protections: These structures include numerous safeguards, such as eligibility criteria for new assets, trigger events, and controls over the originator's credit and collection policies, to prevent a drift toward riskier lending practices.
4. Default Protection: To safeguard the financing from any default or insolvency by the originator, servicer, or cash manager, a backup servicer is employed.

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Why Aren’t More Managers Doing It?

Despite the clear benefits of loan warehousing, several barriers to entry exist for those looking to participate in this sector:

1. Access: Sourcing these loans requires an extensive network.
2. Expertise: These loans demand deep due diligence, including portfolio underwriting and servicing, as well as structural, quantitative, and legal analysis.
3. Loan Size: These loans typically start small (under €5 million) and grow over time to €20-30 million. Smaller lenders may be unable to participate because the loans will eventually exceed concentration limits. Conversely, larger fund managers may find the loan sizes too small to meet their minimum investment thresholds of €100 million or more.

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Conclusion

In conclusion, loan warehousing offers a unique and compelling opportunity within the asset-based lending sector, particularly for those seeking consistent returns with lower correlation to public markets. While the barriers to entry—such as access, expertise, and loan size—may deter some managers, those who can navigate these challenges stand to benefit from a well-structured, secure investment vehicle. As with any investment strategy, success hinges on diligent risk management and a deep understanding of the underlying assets, making loan warehousing an attractive, yet specialized, approach to wealth creation.