When it comes to portfolio performance covenants in loan agreements, there is an important distinction between ongoing and cohort covenants. Ongoing covenants are those that change with time and must be continually monitored and updated throughout the loan agreement, whereas cohort covenants are those that are specific to assets disbursed in a specific period.  In this blog post, we will discuss the differences between ongoing and cohort portfolio performance covenants and their implications for lenders and borrowers.

Ongoing Portfolio Performance Covenant

‍Ongoing portfolio performance covenants are the most common type of portfolio performance covenants we see at Cascade. An example of an ongoing performance covenant is a delinquency test where the investor wants to ensure the portfolio does not go above a specific portfolio at risk (PAR) value. As the covenant uses the outstanding portfolio balance net of write-offs as the denominator, as long as the borrower keeps originating faster than defaults, the covenant will not be breached.  However, if origination slows down the covenant can be breached.  The main thing is the covenant calculation is constantly changing and does not settle until all loans are fully repaid or written off.

Cohort Portfolio Performance Covenant

‍Instead of using an ongoing delinquency test, the investor might choose a cohort delinquency test whereby the denominator is fixed with only the original principal balance of loans disbursed in a given period (1 month, 1 quarter, etc).  If the period is greater than 1 month, a common age definition might be included so that the delinquency rate is based on assets based on the maximum number of months all assets have on book - this is just a technique to normalize the data to a specific snapshot in time.

Key Differences

‍The critical difference between the two different covenants is the time period of the test.  Both covenants in the above example are focused on delinquency and trying to ensure the overall delinquency rate of the portfolio doesn't breach a specific trigger.  The ongoing test takes all loans that are outstanding into consideration, while the cohort covenant is just focused on loans disbursed in a particular period, such as a month.  The other major difference is that written-off loans are typically excluded from the numerator in the ongoing calculation, whereas they remain in the calculation for the cohort test.

Pros and Cons

‍There are pros and cons for both types of covenants - here are the main things to consider:

1. Ability to cure - if a covenant is breached, being able to cure the covenant might be critical for the survival of the loan, otherwise an event of default could be called, which increases interest rates and harms future debt raises.
   • Ongoing Covenants - These can be cured as the calculation can change daily. In the above example, by increasing originations the delinquency ratio can be lowered just by expanding the denominator. It can also be cured by improving collection processes on future delinquent loans.
   ‍• Cohort Covenants - It's much harder to cure a cohort covenant as you can only cure it by collecting on loans from that specific period that are already delinquent.
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2. False Conclusions - the goal of portfolio performance covenants are to determine if underwriting is deteriorating. If a covenant is tripped because of a non-underwriting-related issue it could create false conclusions.
   ‍• Ongoing Covenants - as discussed above, an ongoing covenant could be breached by disbursements decreasing. Perhaps due to a cyclical event or the originator tightening up underwriting criteria. In this case, the denominator decreases as good loans pay off and only bad loans remain outstanding causing a breach.
   ‍• Cohort Covenants - these covenants are designed to prevent false flags by keeping the numerator and denominator proportional. So when disbursements decrease, causing the denominator to decrease the numerator should also decrease proportionally as well. The one concern here is the law of small numbers tripping a trigger. If only two loans are disbursed and one becomes delinquent that creates a 50% cohort delinquency ratio.
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3. Complexity - as investors and borrowers create more complex covenants, asset-back lending facilities are becoming more complicated. While this suits some investors/borrowers it doesn't work for everyone. Often times keeping things simple allows the facility to be operationalized and in doing so limits other forms of risk.
   • Ongoing Covenants - having one ratio for the covenant is the simplest thing to do. It's well understood by both parties and can be easy to back test. It limits the number of waivers/amendments needed or advance calculations. These ratios are often tried and true calculations that have been used on multiple other investments.
   • Cohort Covenants - creating the right cohort size, dealing with common age issues, and adjusting bad definitions based on months on book, all create a lot of complexity. Building cohort covenants requires both parties to thoroughly understand what the covenant is doing and back testing. If the covenant is not designed right there will be a lot of breaches that require waivers/amendments.

How can Cascade help

‍At Cascade, we offer a comprehensive suite of portfolio performance covenant data management tools designed to borrowers and lenders keep track of their portfolio performance covenants. As data agents we continuously monitor the performance of your assets, ensuring that any potential risks or issues are identified and addressed quickly. Our tools allow users to back-test covenants so they can be refined to ensure they achieve their intended goal without causing unnecessary burden of requiring unnecessary waivers.  Our powerful analytics platform also provides deep insights into your portfolio's performance, helping you make informed decisions when there is a breach. By leveraging Cascade as a data agent and our proprietary analytics platform, you can have peace of mind knowing that your portfolio is being monitored for performance and risk. Whether you’re using a cohort or ongoing covenant strategy, our team of experts is here to ensure that you have the data and insights necessary to make informed decisions.

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