The advance rate is the output of a stress calculation, and the few points an originator negotiates off it decide what happens when the pool deteriorates.
An advance rate is set from the stress case, not from the market. On the worked equipment facility, base case cumulative net loss on the eligible pool is 2.4 per cent; a downside at 2.5 times base gives 6.0 per cent; 1.5 per cent for a servicing transition and data risk takes the requirement to 7.5 per cent. The rate is set at 88 per cent, leaving 12 per cent enhancement — a break-even loss multiple of 5.0 times base case. The originator had asked for 92 per cent.
The number is an output, not a negotiation
The advance rate is the proportion of the eligible borrowing base that may be borrowed. Its inverse is the credit enhancement: at an 85 per cent advance rate, 15 per cent of the pool absorbs loss before the lender is touched. Setting it properly means working from the stress analysis rather than from the market. Take the downside cumulative net loss, add a margin for the assets failing to be exactly as described, add the cost of a servicing transition, and set the enhancement above that.
The worked €200 million equipment facility shows the chain end to end. Diligence produced a base case cumulative net loss on the eligible pool of 2.4 per cent, allowing for the improved mix the eligibility criteria would force. The downside case, at 2.5 times base, is 6.0 per cent. A further 1.5 per cent covers a servicing transition and the risk that the data tape is not what it claims to be.
Step in the build-up
Per cent of the eligible pool
Base case cumulative net loss
2.4
Downside case, at 2.5 times base
6.0
Margin for servicing transition and data risk
1.5
Enhancement the analysis requires
7.5
Only after that arithmetic does the market enter. Where the market is more generous than the analysis supports, the analysis is the one to follow, and declining is a legitimate outcome.
What four points of advance rate buy
The facility was written at 88 per cent, leaving 12 per cent enhancement against a requirement of 7.5 per cent. The originator had asked for 92 per cent. Four points of advance rate is the whole of the difference between 12 per cent enhancement and 8 per cent.
The stressed case makes that difference concrete. The sponsor declines to inject equity, collections headcount falls by a fifth, delinquency reaches 4.1 per cent, the advance rate steps down, the liquidity covenant breaks and the revolving period ends. Cumulative net loss on the pool finishes at 5.4 per cent — comfortably inside the enhancement that was set, and not inside the one that was asked for.
Structure
Outcome in the stressed case
Advance rate, per cent
Enhancement, per cent
As documented
Repaid in full
88
12
As the originator asked
A loss
92
8
The advance rate is also the clearest measure of competitive pressure in a segment. When the same pool that supported 80 per cent two years ago supports 88 per cent today with no improvement in the data, the segment is being repriced by capital inflow rather than by credit improvement. Nothing in the loss curve has changed. Only the number of lenders bidding for it has.
Express the enhancement as a multiple
An absolute enhancement is not comparable across asset classes, because base case losses differ by a factor of several between segments. The comparable figure is the multiple: what cumulative net loss the enhancement absorbs, expressed as a multiple of the base case. Enhancement of 12 per cent against a base case of 2.4 per cent is a break-even loss multiple of 5.0 times. Below 2.0 times is aggressive in any segment. Above 4.0 times is conservative. Anything resting on data shorter than one full credit cycle belongs at the conservative end.
Two conditions make the multiple mean anything. The base case has to come from static pool cumulative loss curves by vintage, compared at the same age, rather than from portfolio-level ratios in a growing book. And the enhancement has to sit above an eligible pool that genuinely excludes assets. Applying the criteria and concentration limits to this originator's current book made 17 per cent of it ineligible — mostly catering equipment written without deposits, one named broker, and long-tenor contracts. Criteria that exclude nothing convert an advance rate into a number with no content.
What to do with it
The question to ask of any unfamiliar transaction is the first of the five structure review questions: what is the advance rate, and what cumulative net loss does the resulting enhancement absorb, as a multiple of the base case? That single number is comparable across segments, structures and managers, and it is the fastest way to see whether a transaction is conservative or aggressive.
Then check the three things standing behind it. The base case is a vintage curve, not a headline ratio. The downside multiple is stated rather than assumed. And the transition margin is funded money: on this facility, a €3.5 million servicing transition reserve paid at closing, and a warm backup servicer whose annual data load turned a four-month collections collapse into a five-week handover. The last check is amortisation speed. A weighted average remaining life of 31 months meant that once the revolving period ended, the facility repaid to roughly 60 per cent of peak within nine months.
The workbooks behind this article
Every figure above is a live formula in the free companion files for
The Asset-Based Finance Handbook. Each workbook ends with a Checks sheet
setting the printed figure beside the computed one. No account and no email address.
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