What is forward flow?
A forward flow arrangement is when an investor agrees to buy a set of loans originated by another party. In a forward flow arrangement, the investor and originator agree on the price and eligibility criteria of the loans in advance. While forward flows aren't specific to fintech platforms, we'll focus on fintech platforms as a case study here.
Forward flow arrangements are becoming more popular with fintechs because they allow fintechs to access debt capital even as they're building out their underwriting and servicing capabilities. Otherwise, fintechs might have to lend off of their balance sheet, which would lead to dilution.
What's in it for the investors or capital providers, which are also the purchasers of the originations in this case? Forward flow arrangements allow financial institutions to own loans and interest payments (also called the beneficial or economic interest) of the loans they buy. This allows investors to obtain a higher yield and put capital to work without having to have origination and underwriting expertise in-house.
What's the difference between a forward flow agreement and warehouse financing?
New fintech platforms often go to market by adopting new underwriting models or techniques. It can be hard to know how those techniques will perform long-term, which makes it particularly important for investors looking into forward flow arrangements to do their due diligence. In contrast to asset-backed lending, where debt capital investment is backed by receivables, investors in forward flow agreements carry more credit risk. Not surprisingly, only a fraction of proposed forward flow arrangements make it to the finish line.
In particular, some investors worry that the transfer of loans from the fintech platform to the investor might create a conflict of interest. Theoretically, a fintech platform could begin to originate loans that are of lower quality over time, as the fintech plaform is no longer the party that suffers if repayment rates go down. At the same time, forward flow agreements can include protections to make sure that a funder can manage their credit risk (i.e., include some cushion for delinquency, non-performance, etc.). At a high level, funders in a forward flow arrangement are trading the security they might have with a warehouse financing for higher yield.
In a warehouse financing, both a capital provider and fintech platform hold on to the risk of origination non-performance. In a forward flow arrangement, the credit risk sits primarily with the funder. That makes the eligibility criteria of the originations a common diligence and/or negotiation point between fintech platforms and debt investors. Investors don't want to buy loans without being confident about how those loans will perform.
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Want to learn more?
After businesses close a forward flow arrangement, their challenge shifts from closing their debt investment to making sure they can use technology to streamline eligibility reporting. If you're interested in learning more about software that can help you scale your capital markets function, just schedule a demo of Finley here.
