Fortunafi: External Audit Report, by Luca Prosperi

This document reflects solely the author’s opinions and is provided for informational purposes only. The content of this document should not in any way be relied upon as legal, business, investment, financial or tax advice. Although the document has been prepared based upon information shared by some of the parties mentioned, the quality and completeness of such information has not been independently verified and this document makes no representations about neither its accuracy nor appropriateness.

1. Scope of Work

This document intends to offer the outside-in perspective of an experienced structured credit investor with regards to the onboarding of the FFT1-DROP token as a new RWA vault type. The onboarding followed the MIP6 application dated 11th of January 2021, the approval of the related executive proposal on the 4th of August 2021, and the consequent execution on the 6th of August 2021. The document will touch, although briefly, several aspects of the matter, including:

  • Commentaries on the underlying credit exposures
  • Key risks and mitigating actions
  • Notes on the underwriting process
  • Outside-in perspective on MakerDAO’s unique characteristics

The document has been independently completed by Luca Prosperi (@luca_pro, [email protected] – you can find a summary of Luca’s relevant experience at the bottom of the document). Any reaction and commentary from members of MakerDAO’s community will be most welcome.

2. Commentaries on the Underlying Credit Exposures

Fortunafi is a financial intermediary (the intermediary) that partnered with Centrifuge (the structurer) to launch a financing pool with the technical abilities to attract on-chain funding from partners such as MakerDAO (the senior investor). The financing pool behind FFT1-DROP would focus on revenue-based financing (RBF) as underlying credit collateral. In accordance with Centrifuge’s construct, the financing pool, tokenised through the Tinlake platform, has been subdivided into a TIN (junior) and a DROP (senior) tranche. DROP will be the collateral deposited in the MakerDAO’s vault.

As mentioned, Fortunafi acts only as an intermediary by (i) identifying and partnering with credit originators, (ii) sponsoring the structuring of the exposure, (iii) retaining part of the exposure, and ultimately (iv) marketing the remainder to third parties. At the time of the MIP6 application, Corl was the only asset originator constituting the financing pool. Since then, a new arrangement with Pipe, another originator, has been reached. Pipe is now expected to originate the vast majority of the financing pool. Both those originators, however, are not the ultimate borrower of the credit issued, acting themselves as tech-enabled intermediaries.

Although facilitating diversification and scalability, the long value chain borrower → asset originator → intermediary → structurer → senior investor presents several risks that should be carefully addressed in the due diligence phase and, especially, through the definition of the underwriting criteria and structure. We will touch on all those points below.

2.1. Nature of the Underlying Credit Exposure

The underlying exposure of the FFT1-DROP is expected to be entirely constituted by RBF.

In RBF, investors inject capital in a business in return for a percentage of originated revenues, with either definite or indefinite maturity, with the possibility for the business to terminate the arrangement by buying out the outstanding loan at a pre-agreed multiple. The credit investors might in addition ask for the issuance of equity warrants, not to improve the underlying credit risk but rather to further enhance returns. Based on the information provided, underlying borrowers may or may not offer personal or hard asset guarantees on the credit; given the start-up nature of the ultimate borrowers, the presence of those guarantees does not constitute a game-changer for credit robustness.

The loan, de facto, is sustained only by the future cash flows (both operating and investing) of the business and has a risk profile similar to that of preferred equity – given the existence of contractual interest payments senior to dividends and other distributions to shareholders. In practice, this type of financing has been used by founders to bridge their needs between venture financing rounds, making it a specific type of venture financing. The business and equity investors are incentivised to buy the loan out using fresh funds gathered in each round – typically when revenues are expected to improve significantly. RBF is therefore inherently pro-cyclical and might not offer beneficial dynamics to investors: in best case scenarios of solid revenue growth and available financing borrowers are incentivised to pre-pay the loans and consequently reduce the effective time to generate interest, while in phases of stagnant growth and lacking venture funding credit performance will be impacted. This pro-cyclicality also suggests the risk of high correlation among individual exposures, making tranching less effective.

In their Collateral Onboarding Risk Evaluation, the RWF CU anchored expected probabilities of default in the range of 1-4%. This estimate seems extremely optimistic based on observed performance – information protected by NDA. Given the nature of the credit, and the potentially sudden effect of macroeconomic dynamics on the credit quality, any covenant package might have limited effect in protecting MakerDAO. Although this type of risk-return profile might still be attractive for venture funds and similar investors, it might not have the same level of attractiveness for lenders like MakerDAO, focused on providing a positive return but with the preservation and expansion of the DAI as the core ambition.

2.2. Key Stakeholders

Fortunafi is a fund manager focused on alternative credit, represented in forums by its CEO, Nick Garcia (@_nick, [email protected]). The firm is focused in generating yield from tokenising real-world cash-flowing assets, and it was founded in 2020. Based on the original MIP6 application, Fortunafi was created specifically to partner with Centrifuge & Corl and launch an on-chain credit fund. At the same time, following the partnership with Corl and now Pipe, Fortunafi intends to expand the roaster of originating partners and become one of the key players in connecting real-world borrowers and DeFi liquidity providers. Centrifuge has built a tech solution to tokenise collateral assets and be utilisable on-chain. Through their on-chain securitisation platform, Tinlake, Centrifuge has currently c. USD 32m of total value locked. Based on the conversations had with Fortunafi, the firm expects to fully finance the TIN junior tranche of the financing pool – more on structuring below.

Corl serves as an onboarding platform for businesses seeking funding. Businesses can apply for financing through Corl’s web infrastructure that acts at the same as a financing platform and a business dashboard with access to the underlying payment, banking, and customer data. Based on the documents provided, Corl does not participate in the financing of the businesses originated and scored through their platform, acting as a pure distribution channel for credit investors. Fortunafi’s stresses Corl’s ability to leverage new alternative data sources and machine learning techniques to assess credit quality; based on the author’s experience, and on analysis performed by credit risk specialists like Oliver Wyman, the ability of those techniques to enhance human credit underwriting is yet to be proven.

Pipe is the next originator that is supposed to constitute underlying exposure of the vault. Based on the limited information accessed, the credit originated by the firm is supposed to be significantly lower risk compared to Corl’s, with a focus on 12-month term loans for large SaaS providers with at least USD 5m revenues. Pipe is expected to represent 90-95% of the pool, making the initial due diligence performed with a focus on Corl largely redundant. Although understandable in such early stages of development, Fortunafi’s shift of focus in the very initial stages is a cause of concern that should be monitored.

At the time of writing, no DAI has been minted through the FFT1-DROP vault. However, based on the conversations had with the parties involved, it is not clear what proportion of the DROP tranche will ultimately be allocated to MakerDAO, and who would be the other DROP co-investors. This information will be crucial to both provide a proof of concept and to offer operating leverage to take remedial actions in case of need, given the peculiar nature of MakerDAO as non-legal entity.

Fortunafi has shared with MakerDAO the most updated (end of July 2021) dashboard of the underlying pool composition – composed only by loans originated by Corl at the time of writing. A high-level analysis of the loan development provides a mixed view:

  • Small size compared to debt ceiling, with levels of collateralisation in check
  • Size (by annualised revenues) and growth trajectory of the financed business is below target
  • Although single investees don’t represent a significant portion of the debt ceiling, the outstanding loans seem quite concentrated (40% represented by one borrower); this seems physiological in ramp up

Interestingly, the dashboard developed by the RWF CU doesn’t seem to include a satisfactory view of credit quality development. This could be due to the nature of RBF – and this brings us back to the point that it is quite difficult to preside over credit quality in such asset class. Based on the author’s understanding, it is Fortunafi’s responsibility to provide an updated Net Asset Value (NAV) of all credit positions – given the early days of the partnership, this methodology hasn’t been investigated, but the RWF CU should monitor it alongside observable events.

2.3. Structuring Concerns

Fortunafi acquires RBF assets from the originators via a bankruptcy-remote SPV. The SPV, via Centrifuge’s Tinlake infrastructure, will tokenize the title of each underlying asset into NFTs that will BE added in Tinlake as collateral. Those tokens will be utilised to issue FFT1-DROP (representing 90% of the pool, pledged into MakerDAO’s vault) and FFT1-TIN (representing the remaining 10%, fully purchased by Fortunafi). In customary manner, the SPV will have authority over the underlying collaterals. The investor will be represented by an independent director within the SPV, but MarkerDAO won’t have authority over the underlying collateral in case of adverse events – given its non-legal nature. Based on the information shared, there is no contractual obligation on the participation of Fortunafi and other co-investors into the DROP and TIN tranches. The same applies to a randomised vertical participation, typical of off-chain collateralisation deals.

Based on the FFT1-DROP parameters, MakerDAO will have an additional margin of safety. With a minimum vault underlying collateralisation ratio of 116.6%, MarkerDAO will mint DAI representing only c. 86% (i.e. 1 / 116.6%) of the underlying collateral, meaning that the implicit attachment point of the senior tranche would be c. 12% rather than 10%. Based on the conversations held with Fortunafi, it is understood that the SPV presents an excess spread between the contractual interest payments from the borrowers and the interest paid – this excess spread will function as a tool to replenish the junior tranche in cases of losses; it is our understanding that the full residual value of the structure will be of benefit of the junior investors – this is not uncommon in the market. The documentation of the underlying SPV hasn’t been provided, but it is expected that the junior investors will be obliged to always maintain the minimum junior tranche requirements also per SPV terms, with the ability to distribute at least part of the residual value before the end of the vehicle.

The RWF CU has proposed a set of soft (i.e. non-enforceable) covenants, mainly covering:

  • Allowed underlying investments
  • Investment concentration
  • Fortunafi junior participation – minimum 60% or USD 1m
  • Senior co-investment – minimum 25% or USD 1m, and 10 co-investors
  • Monitoring guidelines

However, it is our understanding that, given the non-legal nature of MakerDAO, the ability to take remedial actions in case of unsatisfactory performance of the underlying collateral or business partners might be extremely limited. The co-investment requirements, in this context, become of extreme importance.

In case of insufficient junior collateralisation (due, also but not only, to unsatisfactory performance), the liquidation mechanism will follow Centrifuge’s model, as per the MIP22. Interestingly, the MIP22 analysed states that the liquidation mechanism would work well for loans “[…] of very short maturity and waiting for loan maturity is economically viable” or “[…] The loans can be sold off (refinanced) by the issuer off chain and there is a process in place for the liquidation of the pool in case any DROP token holder (such as Maker)”. The type of engagement behind FFT1-DROP doesn’t seem compatible with those requirements. The diagram below represents the liquidation mechanism when triggered.

3. Key Risks and Mitigating Actions

  • Underlying pro-cyclicality and correlation of RBF
    • Commentary: RBF is a specific type of venture financing with inherent pro-cyclicality and correlation, impacting the effectiveness of tranching in adverse phases of the credit cycle; based on the author experience, this type of financing is sub-optimal for MakerDAO’s risk-return profile
    • Available mitigating actions: increase collateral requirements, introduce mezzanine financing, maintain/ reduce debt ceiling, avoid RBF for future exposures
  • Fortunafi’s focus seems shifting from the original intentions stated in the MIP6 application
    • Commentary: the FFT1-DROP vault would have been constituted initially to provide on-chain financing to the credit originated by Corl only; with time, also given an apparently unsatisfactory performance of the originator, another originator, Pipe, has been added to the pool – this changes of focus, happening in the early days of the proposed partnership, should be monitored
    • Available mitigating actions: although not much can be done to mitigate this risk now, the need for an approval by MakerDAO (governance or RWF CU) to add new originators with the impact of changing the risk profile of the financing pool is expected to be a soft covenants
  • Separation of origination, risk underwriting, and financing
    • Commentary: this separation, typical of a pure originate and distribute model, and the consequent misalignment of interests (with the originator incentivised to intermediate more and more volumes, and the financier focused on net yield and credit quality) could have negative effects on credit performance during the adverse phases of the credit cycle – this is particularly important given the nature of the underlying exposure
    • Available mitigating actions: originators should be required to retain a super-junior exposure on the originated credit, throughout the life of the loan; best practices would require the originator to offer a buyback guarantee of non-performing loans – e.g. following 60 days of delinquency
  • The implied IRR of the investment, and of the junior tranche especially, might not be consistent with MakerDAO’s conservative nature and mandate to preserve the DAI
    • Commentary: based on the estimates provided by the underwriting partners, the internal rate of return (IRR) achievable by RBF-types of exposure is extremely high, in the 20-40% range, similar to that of venture investing; this IRR could be significantly enhanced for the junior tranche investors – currently, FFT1-DROP Stability Fee stands at 4.5% for an implied attachment point of c. 12%; given the nature of MakerDAO’s interests the risk-profile could be enhanced via more prudent structuring or higher stability fee
    • Available mitigating actions: increase stability fee, increase collateral requirements, introduce mezzanine financing
  • Given the nature of the underlying credit and the allowed concentration, the senior attachment point seems aggressive
    • Commentary: FFT1-DROP has an implied attachment point of 12%, meaning that following defaults constituting 12% of the pool the vault would start suffering losses – this seems aggressive considering the risk profile of RBF; in addition, with the maximum allowed concentration as per the soft covenants at 30% of the debt ceiling, the default of one single borrower (with recovery rate expected to be very low considering the nature of RBF) would wipe out 20% of the vault, i.e. > 4 years of stability fee for the whole pool
    • Available mitigating actions: reduce maximum exposure concentration limits, increase collateral requirements, introduce mezzanine financing
  • Given the limited ability of MakerDAO to enforce remedial actions, the co-investment requirements might be insufficient
    • Commentary: it is understood that MakerDAO does not have contractual obligations in place with the SPV nor any other party, and this could dramatically impact its ability to act in remedy of unsatisfactory performance of the underlying credit or partners; in this construct, the existence of large and reputable senior co-investors becomes key
    • Available mitigating actions: increase the soft covenant requirements for the presence of senior co-investors, ideally transforming MakerDAO into a minority senior investor; those co-investors, if institutional, would themselves require enhanced representation and control
  • The liquidation mechanism might not be compatible with the underlying nature of the credit
    • Commentary: the liquidation mechanism within the Centrifuge construct might not be compatible with the bulky, asset-light, low-churning, nature of the underlying credit – this could expose MakerDAO to losses due to the expected low recovery rate of non-performing loans
    • Available mitigating actions: although not much can be done to mitigate this risk now, increasing the seniority of MakerDAO’s exposure might be a partial solution

4. Notes on the Underwriting Process

Given the indirect nature of the credit origination flow (borrower → asset originator → intermediary → structurer → senior investor), it becomes clear that MakerDAO’s due diligence and underwriting should focus on the direct contact point – in this case Fortunafi; of its history, capabilities, shareholding, financial structure, and incentives. MakerDAO seems to have had extensive conversations with Fortunafi in order to understand their modus operandi. Based on the materials reviewed, however, the analysis of the underlying credit scoring ability of the originators, and of the asset classes to be underwritten, seems unsatisfactory on MakerDAO’s side. Fortunafi’s analysis of the platform’s credit underwriting ability doesn’t seem profound enough, and the same applies to the monitoring of credit quality. Based on the author’s experience, one credit risk analysist should be entirely dedicated to shadow rate the portfolio of the originators based on the data tapes provided – usually one analyst can cover 2-3 originators and c. USD 100m of outstanding loans, and it isn’t clear whether Fortunafi has currently those skills in house.

Where structuring is concerned, an aspect of paramount importance in structured credit, MakerDAO’s accepted terms and soft covenants do not seem to be fully aligned with the conservative nature of MakerDAO’s mandate. The agreed implied attachment point, the maximum concentration limits, and the co-investors requirements do not seem fully aligned with MakerDAO’s main priority, that it is in my understanding a scalable yet sustainable growth of the DAI footprint. At the same time, alternative legal constructs should be investigated – e.g. providing delegation to director(s) acting in representation of MakerDAO, informal yet transparent agreements with back-up servicers, forward flow agreements with non-performing credit investors, etc. All those aspects seemed absent in the negotiated package.

In addition, the liquidation mechanism applicable within the Centrifuge construct does not seem compatible with the type of underlying exposure. In a standardised, off-chain, loan agreement, such a circumstance would have been mitigated by a pledge of assets by the direct intermediary (in this case Fortunafi), beyond the intermediary’s junior exposure within the SPV. Although this cross-collateralisation might be an effective mitigant in TradFi, it is my understanding that MakerDAO wouldn’t be able to independently enforce such remedial action if negotiated. This is another reason the presence of a large, institutional, co-investor would be extremely beneficial for MakerDAO. The bankruptcy remoteness of the SPV vehicle, as well as the presence of an independent director, acts only as a partial mitigating factor.

5. Outside-In Perspective on MakerDAO’s Unique Characteristics

Providing financing to real-world assets via MakerDAO’s DAI is an ambitious, yet extremely challenging, task. On-chain securitisation and pseudo-securitisation has a series of challenges that go beyond traditional structured credit. In addition, the extremely low cost of capital of institutional investors these days doesn’t reduce the adverse selection issue of originators seeking financing on-chain – adverse selection that wouldn’t translate only in a low quality of credit, but also in an extremely short corporate history of the intermediaries. The difficulty of the challenge the RWF CU has tackled shouldn’t be underestimated.

At the same time, even in a bootstrapped start-up setting, sufficiently solid governance, structuring, and underwriting practices should be implemented. This in order to preserve the DAI, as well as to build the foundation of an increasingly ambitious real-world financing plan.

Defining the role of MakerDAO regarding financing projects in the real world goes way beyond the scope of work of this audit report. However, a few high-level suggestions already emerge. MakerDAO might benefit, for example, from a more passive position in relation to the underwritten credit. This would translate, in practice, into:

  • Clearer underwriting criteria published ex ante in MakerDAO’s forum for potential counterparties to measure themselves against
  • More robust structuring requirements, potentially discussed and agreed with Centrifuge and other similar service providers, also published ex ante in MakerDAO’s forum
  • More stringent co-investment requirements, both in terms of quantum, relative exposure, and nature of the co-investors to partner with
  • Clearer internal governance rules, in order to create effective multiple lines of defence that go through RWF CU, independent risk management, and ultimately governacne and the larger community
  • A replication of the centres of excellence within MakerDAO that currently deal with real-world assets, in order to avoid the existence of a single point of failure and further protect the DAI

Those suggestions need to be considered only as indicative. It is the opinion of the author that a more extensive and deeper effort to clearly define MakerDAO’s role in the real world of credit should be considered.

7. Notes on The Author

Luca Prosperi, MakerDAO believer and senior finance professional with 15 years of experience in banking and credit investments:

  • Publishing Dirt Roads, a Substack newsletter on the evolution of banking and DeFi
  • Originated and financed c. EUR 200m of credit through alternative lenders via both a banking platform (Citadele banka, ECB-regulated bank where Luca was Board Observer representing Ripplewood as the majority shareholder), and a credit fund (while at Partners Capital, a c. USD 40b AuM outsourced investment office)
  • Completed deals totalling > USD 5b USD throughout 5 years as a private equity (Ripplewood Advisors) and private credit (Partners Capital) investor, with focus on financial institutions and fintech companies
  • Advised on several high-profile transactions throughout 4 years as M&A banker in Morgan Stanley’s London FIG team
  • Advised financial institutions on the topics of risk management, strategy, and business growth for 5 years as strategy consultant at Oliver Wyman
  • Master in Business Administration at London Business School, MSc and BS in Mathematical Economics and Econometrics at Bocconi and Tel Aviv University
18 Likes

@luca_pro Thank you for your report, which I had the opportunity to read in detail. I believe it is sign of a maturing ecosystem to have both internal and external eyes looking into these credit structures. It is an initiative that is being boostrapped by the RWF team and should increasingly serve as a best practice moving forward across the DAO. For both RWA and Crypto-Native risk teams, by the way.

My first proposal to Maker 2 years back was a quantitative risk audit on the general model framework with an ex-banking colleague of mine which used to do internal model auditing at the bank we worked together. That proposal was not accepted as there was “no value” in auditing I was told at the time. I am happy to see we’re becoming a more mature project by having the opportunity of seeing this audit come to light.

In terms of the specific sets of risks and recommendations you outline in the report, we’ll be making sure to take your recommended mitigating actions a very close look. I believe there are some of them which might be more easily implemented than others. For example, reviewing the covenant rules, increasing collateral requirements and reducing individual borrowing exposures is relatively easily implementable. Implementing a “mezzanine” financing tranche in the structure as an additional capital buffer might be more technologically challenging. I’m also paying a close eye into the capacity of the intermediary (Fortunafi) to maintain a proper credit risk quality control and management framework in place. This is being very closely monitored from our side. Appreciate you bringing up the topic.

Onboarding is just the first step. Now comes the good part, risk management.

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To use an image of @williamr , RWA is moving step by step and there are no teleportation devices. External audits are a step. We know the final destination as defined in the RWA report (even if I take the right to change it along the journey):

(which could be challenged as well as @jameskmccall pointed out the flaws of the system generating the last financial crisis)

I started the journey one year ago and the biggest difference I see is that we are getting TradFi asset originators and profiles attracted by RWA at Maker. Yet the journey is still long. Getting those external audits is quite helpful at directing a new light at what we are doing and helps us (RWF + community) on what should be the next steps.

To me the most interesting part is the following:

This is something that we want to do but is quite hard and get lost in the zillions things we need to solve. It was too early before, but maybe that’s something we are at the right time now and should be given a greater focus.

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Great article @luca_pro. I definitely appreciate the time spent on this analysis for the benefit of the community. We are all learning a lot from you, so thank you. I also agree with @williamr that this is an iterative process and we can continually improve Maker’s lending mechanism.

I want to discuss the mezzanine idea. I really like the mezzanine financing tranche, especially for asset backed deals. The way to do it is to advance the loan for only a percentage of the asset, not 100%, and then split that loan into a senior and junior tranche. The only problem is that the equity tranche is off-chain.

New Silver is a good example. The real estate developers have historically put down 30% cash in New Silver deals to buy the home and then they take a loan for the remaining 70%, which is split between the senior and junior tranche (DROP and TIN), which are on-chain. Tinlake and Maker may look at that loan as a 83% DROP and 17% TIN split (look at New Silver’s pool on Tinlake). However, as a percentage of the total asset value, New Silver has a 30% equity tranche, a 12% “mezzanine” tranche (TIN), and a 58% senior tranche (DROP). In other words there is 42% downside protection (30%+12%) relative to the asset value for Maker as the DROP investor, not 17% as is seems on Tinlake.

I would like to see Maker continue to push for lower advance rates (more safety for Maker) while using its unique strategic competitive advantage to lower the cost of capital for the senior tranche since Maker has the lowest cost of capital. I would rather see less co-investors in DROP (no one else can go as low as Maker) but rather have more investors take the equity and mezzanine tranches to protect Maker’s senior position.

In the case of FortunaFi, I think a mezzanine tranche would likely require a negotiation with Pipe to finance the equity tranche or for other off-chain fiat-based Pipe investors to finance the equity tranche. I don’t know Pipe’s business model well enough to know if this is possible but it seems like it is worth inquiring about.

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Thanks for your comment Will. I agree, it is a maturation process. We shouldn’t forget the merit of the visionaries who got us here, nor disregard the contributions that others can give us now.

I truly believe this is the right time to step up our efforts in RWF. I hope this audit was instrumental to this, and I hope to be able to help the community further.

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Thanks Jason, I totally agree with you. More specifically:

  • I think a mezz can be easily implemented with a contractual, off chain, equity tranche from the originator
  • I am firmly convinced that maker’s priority should be downside protection, think of it like pledging high quality collateral to a central bank; maker’s could have super senior position even if yields were lower, I am sure that given higher efficiency vs senior credit investors, lower costs of capital, and different target, we could achieve 2% rates which I would imagine are good enough, as for maker the secret is more operating leverage and size
  • I also think, based on my experience, that equity participation of the originator is key for ensuring credit quality and alignment of interest; some platforms might not have the equity to back it up, but nonetheless we could push, and/ or get different contractual guarantees like buyback guarantees (at par) for non performing loans

I’m looking forward to discuss more, even if I’m just a community member.

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@luca_pro 100%. To an extent, I am still sometimes amazed that what started as an “experiment” survived this long. There is an immense amount of resilience and drive in what we do, maybe that’s why. Or maybe, more importantly, the community really wants RWA to succeed. I’d like to hope so.

Rest assured this is a core piece of the puzzle in my view. My drive now is to get us moving from “this is a nice experiment” → “this is solid”. Auditing is a cornerstone of that building. Internal, external, on the counterparties and across several verticals (legal, credit risk, ops risk, accounting…). Right there straight out of the bat these all core and immensely valuable functions that need to be performed, at scale. If I had to define where we are, I’d say moving from phase 1. “Experimentation” to phase 2. “Capability building”.

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It is exciting. I’m not an auditor, I am a builder, and I hope that my knowledge will be instrumental to this.

I have worked in banking and alternative credit all my career, I am aware of the immense ocean of opportunities maker has - and the powerful storms of threats out there as well.

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Great job @luca_pro, real pro! :slight_smile: Love the suggestions for going forward, most certainly needed or at least to be strongly considered. Stay the course!

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@luca_pro 100% on this one. We’ll amend this appropriately. If the originator does not retain a first-loss capital piece in the “notes” their credit risk exposure is essentially null. At the moment, that credit risk exposure is transferred on one level up to the “intermediary” (FF) who holds the TIN. You’re right, this is not ideal for risk alignment. We need to find the sweet spot in terms of the ratio of SPV equity between them.

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Thank you, Luca, for this overview. Hopefully, we can provide some facts and additional clarity here.

Fortunafi’s RBF product currently provides capital to businesses for up to 24 months (not indefinite maturity), in turn being entitled to a percentage of the business’ revenues, or a stream of specific revenues. In terms of security, it can vary. From a security interest against all the businesses’ assets, or to obligations on the businesses to cover losses on contracts (in the case of Pipe, for example), as well as other ways to mitigate risk that we are considering with future originators currently in discussions with us. We focus deeply on risk mitigation when underwriting a new asset or originator and will continue to do so as we look to grow in a sustainable manner that doesn’t compromise performance. We also believe that exposure to our product is significantly different than preferred equity. First, the term on our RBF contracts is not indefinite like preferred shares tend to be (perpetual). Second, assets in our RBF product currently receive cashflows from overall business revenues and are senior to any new debt obligations of the underlying business, unlike preferred share subordination.

There also seems to be some confusion about the focus of the pool. The inclusion of Pipe as another originator was always contemplated and disclosed. It is in no way a shift in focus. Regarding correlation among exposures, we’d argue that having more than one originator reduces such correlations, when compared to traditional asset-backed securitizations (“ABS”) which often package assets originated by a single business (leasing ABS of a specific operator, solar ABS of a single originator, rental car ABS of a single car rental company, etc). The ability and flexibility of the structure to diversify originators is in our opinion a benefit to investors. Finally, we were confused by the assertion that RBF is pro-cyclical and thus without benefit to investors. Most financial assets are procyclical, benefiting from general economic growth and experiencing increased pricing and performance volatility during economic downturns.

We should also address concerns regarding size, concentration, and growth trajectory of the pool. As Luca understands and recognizes, current size and concentrations are temporary predicaments of ramping up. The unexpected delays in onboarding Pipe had an impact here, but we expect that to be sorted over the next few weeks. No DAI has yet been minted, meaning that Maker is not currently exposed to this temporary concentration risk. Regarding growth trajectory, growth performance is never linear. The growth trajectory of the financed businesses are aligned with expectations. With this particular type of RBF asset, the bulk of the returns occur in months 12-24 due to increased revenues resulting from the financing and an increased probability of an early buyout. The current annualized return of the portfolio is more than sufficient to service the stability fee from Maker. We are also actively growing our team, to maintain underwriting quality and monitoring capabilities as we ramp up the pool.

A considerable portion of this review is dedicated to structuring concerns, many of which are borne out of Maker’s lack of legal entity. This reality is out of Fortunafi’s or any other partner’s control. It seems fitting that such concerns be addressed in a separate discussion specific to these challenges, not as an indictment on Fortunafi’s pool or Centrifuge’s capabilities. On our part, we strongly believe in being aligned with investors, doing so by having – and planning to continue to have – material skin in the game as holders of our pools’ TIN. That said, some of Luca’s structuring suggestions make sense (as we in fact discussed and suggested to him) and are issues that many of us in this ecosystem are aware of and are actively working to solve already. It must be said that what Centrifuge has implemented so far is extremely impressive, and that we know for a fact they are focused on continuing to refine the technology and the robustness of future structures.

On a more general note, most (all?) of the DeFi world is at a stage of rapid evolution and growth, including Maker’s ecosystem. We must be mindful of this when deciding what solutions make sense and how they are proposed. Growing from an emerging technology to an established financing ecosystem, that could one day rival traditional credit markets and attract traditional institutional capital, doesn’t happen over the course of a single deal or a few. It’ll take time, effort, creative iteration, and lots of collaboration between all parties involved.

As William stated in his reply above, thoughtful review and discussions surrounding structure and risk are a sign of a maturing ecosystem. Couldn’t agree more! We are optimistic and hopeful that this maturing process will include issuers/originators in the ongoing review process, to ensure accuracy and clarity in this effort to provide transparency and viable solutions to the community.

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Nick,

Thank you for your thorough reply on the report. Although, naturally, each party might have a different perspective on the most relevant topics, I believe this is in the nature of creating a constructive dialogue among parties in order to achieve the most beneficial outcome for all. I also second what @williamr said in relation of observing Maker maturing as a platform, and what you said about the whole sector as well. I believe we are in the early days of a new era in ‘real-world’ financing - it is my intention to contribute to that development helping to set solid pillars of prudence and risk management.

This is obviously an exercise of balance and compromise. In the case of the external report, I have tried to put myself in the position of primarily safeguarding Maker’s interest as senior lender, therefore maintaining a very conservative stand on several items.

Thank you for your comments on the RBF asset class. Although I find them valid, I would also like to stress that the risk profile of an investment does not depend necessarily on the strictly contractual aspects. Seniority and maturity of a loan, for example, should be seen in the context of the lifecycle of a business, its ‘runway’ in terms of expected life without additional funding, the solidity of its fixed and immaterial asset pool acting as collateral, etc. Nevertheless, thank you for clarifying.

Thank you also in clarifying that your focus hasn’t changed since the beginning of your engagement with Maker. I am sure this is the case, as it is you who have had all the conversations with the RWF team. My comments on this (non-vital, as I specified) aspect, were related to the fact that the initial MIP6 mentioned Corl as a core partner for the credit fund. Corl, in perspective, will represent only 5-10% of the pool.

On correlation, I agree with you in the fact that more originators will reduce correlation. My comment on it was related to the asset class in general, that in my opinion shows potentially high level of cross-exposure correlation: as you describe, most of the RBF loans are repaid via refinancing through venture funding, and the lack or abundance of systemic venture funding available would impact most exposures at the same time. Your intention to diversify the pool across multiple originators, and life stages of the companies, will definitely go in the direction of improving diversification and making the slicing of the pool in tranches more effective. Still, it is my belief that having stricter single-borrower concentration limits would be of paramount importance to protect Maker. The same comment applies to pro-cyclicality; in the report I didn’t obviously intend to say that this characteristic is inherently bad or good for investor, but simply that asset classes that have a very high sensitivity to economic or investing cycles might not be compatible with Maker positioning of conservative lender of last resort. The guidance on assets pledgeable at central banks in exchange for access to the central banking liquidity window could offer good guidance.

I do not have additional comments and, although as I said from a different perspective and with a different risk tolerance, I agree with most of the things you have said. This is a long journey and being part of this is exciting and energising for myself, as I am sure it is for most of the community. I firmly believe that having this type of conversations across the various phases - from proposal, to collateral approval, and ultimately monitoring, will be extremely beneficial both for Maker and for the counterparties that structure themselves to work alongside Maker and make the DAI a relevant source of liquidity in the modern lending space.

Regards, Luca

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Could we possibly work with a reputable mezzanine investor that takes portion of risk right below us?

We could get sophisticated private credit investors interested in this - as we would basically be levering their position. And they would certainly do alot of good credit, structuring and asset management work on investments.

We would not be perfectly aligned with them but reasonably aligned as they would take any losses before we would so they would focus on solid credit underwriting.

Private credit investors are generally looking for senior leverage for their existing (& new) investments and it juices their returns. If we are providing reasonable senior leverage, we could get such folks bringing their deals to us. We would also focus on private credit groups that do innovative financings in ESG areas… Names like Theorem Capital, Upper90, & i80 Group

Such a strategy would likely push us towards bigger investments which isnt necessarily a bad thing…

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Currently, the Tinlake smart contract doesn’t have the concept of a mezzanine tranche (there is one TIN and DROP). We could find someone that would buy DROP and refinance them at MakerDAO (managed by the CR), but we don’t have the smart contracts for that either (that would be on MakerDAO side, but unlikely to get prioritized as I don’t think it would scale well). I’m not sure we can find an off-chain solution, but, with a bit of creativity, everything is possible. Nevertheless, the whole point of on-chain securitization is to reduce the off-chain component.

With @williamr work on a branching model, we would be able to find the best spot in terms of CR to suit our risk appetite. Currently, all Centrifuge assets have a 105% CR (mainly technical). Maybe we could achieve 115% CR if we drop the SF to 3% (just guessing the numbers). That, with finding some reputable DROP investors, should achieve most of the goal.

Regarding FortunaFi, the most important point is for them to expand to Pipe and other asset originators to diversify the pool and improve the risk profile (as described in the risk assessment).

perhaps the private credit funds could do a TIN type investment? The more fintechy ones could be interested…

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Maybe there’s a way to simply have our DROP redeemed preferentially in the event of a redemption? Then that makes the existing DROP the mezzanine and could be a work around? Given that our DROP lives on Tinlake at the moment, some kind of FIFO rule for redemptions could be a quick solution.

Just a thought. Not sure if there are legal or technical impediments to that kind of approach. Nor have I thought closely about if that would screw up the economics.

I believe that only certain asset classes require the existence of a mezz tranche. In high-turnover / deep-collateral classe like invoice financing the existence of a mezz tranche is, for example, of no use.

In those classes where a mezz is beneficial - those for example that are exposed to senior losses in case of single adverse events (like RBF), this can be implemented in several ways. The most simple is actually not having a mezz tranche but actually a thicker junior/ TIN, and have the TIN provider diversify by splitting their tranche as they want on the back end. The second degree of complexity is having a junior tranche off-chain, ideally funded by the originator, then a TIN (de facto becoming mezz) and then a DROP. The most difficult version is by asking Centrifuge or other counterparties develop multi-trenching.

@PaperImperium ‘s suggestion of a ‘super-DROP’ is only partially a solution I think, because seniority is not only characterised by preferential redemption/ liquidation.

It is very personal opinion that Maker should act as super senior lender, highly secured, in its exposure. Obviously the risk mitigation will depend on the type of credit arena the DAO decides to get involved in.

As I mention in my audit, I believe that a standardised set of requirement to be advertised to potential partners could be a good step forward, but maybe a deeper review of the credit policy would be even more beneficial.

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As we set up to be a diversified fund, it is important for the fund to hold senior tranches in multiple asset originators’ pools. To this end, we have built a smart contract that enables a pool to invest in senior tranches of other pools.

As each pool can have both senior and junior tranches, it is possible to construct mezzanine tranches on chain, the way @Jason described. In fact, is it possible to structure (super)^n senior @PaperImperium if that is what investors want.

A structure needs to be appropriate for the risk profile of the asset class in question as @luca_pro pointed out. And generally the simpler the better, especially when working with asset originators/institutional investors who are new to this space. However, if a more complex structure is required i.e. Super Super Senior, then investors can at least rest assured that the token can trace back to the underlying pool of assets that ultimately backs it up. This feature is not lost on regulators such as FCA in the UK (they told us in the sandbox), so not to induce another 2008.