Going with the flow – the appeal of the forward flow transaction in structured finance

What is a forward flow transaction?

A forward, or future, flow transaction is a financing arrangement whereby a corporate originator of receivables sells its beneficial interest in those receivables on an ongoing basis to a third party purchaser (the "Purchaser"), either immediately upon origination or periodically, and subject to pre-determined eligibility criteria.

Depending on the nature of the parties and their requirements, the Purchaser could be another corporate purchasing the receivables onto its balance sheet, a special purpose vehicle ("SPV") established by the Purchaser, a financial institution or fund which will provide funding by purchasing the assets itself, or in some structures the receivables will be sold or originated into an SPV (which may or may not be part of the corporate’s group and which obtains funding from the Purchaser with or without leverage).

Collections on the sold receivables are paid over to the Purchaser, to be either reinvested in additional receivables during a defined period, or retained by it or used in repayment of its debt facilities or otherwise extracted by its backers.

At its most basic, the forward flow can operate as a simple, bilateral receivables purchase facility; alternatively, it can take more complex and bespoke forms, structured as securitisations and serving the business objectives (as well as meeting the legal, regulatory and operational requirements) of three or more different commercial parties.

Why chose a forward flow structure?

Forward flow transactions are often seen as simpler and cheaper alternatives to traditional securitisation warehouse funding. The key difference with a forward flow is that the underlying receivable is usually fully funded by the Purchaser (albeit the Purchaser will, in many cases, obtain leverage), so the originator is not required to advance its own funds against the sold receivables, as would be the case on a warehouse financing. Given they are generally less complex, privately negotiated and unrated, they can also be quicker to complete.

Forward flow structures are appealing to corporates as they facilitate off-balance-sheet funding and provide liquidity for small and medium sized companies, or even microbusinesses, which may struggle to engage in more complex securitisation structures. They also allow corporates access to a wider range of funding sources and the ability to borrow against future income streams.

From the funder's perspective, forward flow structures are attractive to non-bank or specialist lenders wanting to diversify their investment strategies and gain exposure in new areas or where they may not have the necessary origination or servicing capability or regulatory permissions to lend directly to the underlying borrowers.

Investing via a forward flow also has the potential to provide funders with a higher return, not only because of the higher rates of interest that may be payable by borrowers on the underlying receivables (especially with unsecured consumer lending) but also because the forward flow Purchaser, though it may take the credit risk on the purchased receivables, will benefit from the full economic upside on those receivables (subject to payment of servicing and origination fees and, if commercially agreed, any share of that upside back to the originator).

Key structuring considerations

• Who are the parties to the transaction and are they authorised to perform their obligations?

As noted above, a forward flow transaction can take a number of different forms, depending upon the origination process and the Purchaser’s financing arrangements. A corporate may originate the receivables onto its on balance sheet and immediately sell them to the Purchaser (or typically an SPV established by the Purchaser) or the receivables may be originated by an SPV which is part of the corporate’s group. The Purchasers (or their sponsors) are often non-bank or specialist lenders, which have become increasingly active in the financing of small and medium sized enterprises and microbusinesses in recent years.

The Purchaser may take the risk of the full economic exposure to the receivables or may look to obtain senior leverage, in which case a securitisation structure may be required, bringing with it all of the usual additional parties and roles, including a security trustee, who will take security by way of a charge and assignment over all of the purchased receivables and other related or relevant assets and hold that security for the benefit of the Purchasers' various creditors and interested parties.

A servicer will be required to service the underlying receivables. This will often be the corporate itself, such that (as with a warehouse financing) there will be no change in the loan servicing arrangements from the underlying borrowers’ perspective (and the borrowers will not be notified of the sale of their receivables) unless certain agreed "perfection" events occur. A back-up servicer may be required as well.

It is particularly important to establish at the outset of structuring a transaction that the corporate or SPV seller of the beneficial interest in the underlying assets and any servicer has the necessary regulatory permissions and authorisations to perform their contractual obligations, as well has having appropriate systems and controls in place, as required for example under the Financial Services and Markets Act 2000, The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 and FCA Handbook. Use of an appointed representative arrangement may be something for the parties to consider when structuring a longer-term forward flow relationship in certain contexts.

• How does forward flow compare to a traditional warehouse securitisation?

In a traditional warehouse transaction, a lender will enter into an asset-backed lending arrangement enabling a borrower/issuer vehicle to purchase assets from a corporate who (as originator) will retain the junior risk in the transaction, typically by way of a subordinated note or loan. In contrast, in a forward flow transaction there is usually no such retained interest, and so there is a transfer of the entire economic interest in the underlying assets to the forward flow Purchaser. Credit risk then lies with the forward flow Purchaser and the corporate which originated the loan no longer has any economic or beneficial interest in the receivables.

If the forward flow transaction involves tranching at the Purchaser level, it is possible that the arrangement could fall within scope of Regulation (EU) 2017/2402 (together with the onshored version in the United Kingdom, the "Securitisation Regulation"). This will be the case whether or not the receivables are originated by the corporate and then transferred into an SPV or whether they are originated directly into the SPV.

If the forward flow transaction is a securitisation, it is likely that the Purchaser (or the junior funder into an SPV purchaser or the originator) will need to qualify as an "originator" of the receivables for the purposes of the Securitisation Regulation in order to retain the 5% material net economic interest in the transaction mandated by the Regulation's risk retention requirements.

The Purchaser/relevant funder would need to be able to satisfy itself that it would qualify as an originator, either because (for example) the loan was originated into an SPV owned by it or because, in accordance with limb (a) of the Securitisation Regulation definition of originator, it was involved directly or indirectly in the original agreement which created the obligations of the debtor. The latter may be easier to demonstrate where the origination processes and lending criteria have been designed specifically with the Purchaser's forward flow transaction in mind.

Contrast this with a typical warehouse transaction, where the seller of the receivables will usually have been the original lender under the agreements with underlying borrowers and will more easily fit within several of the permitted categories of risk retainer under the Securitisation Regulation.

Other applicable provisions of the Securitisation Regulation, including requirements relating to due diligence, reporting and transparency, will also need to be catered for, just as they would on a warehouse transaction. The difference on a forward flow will be that regulatory responsibilities will be borne by the Purchaser, who will need to understand those responsibilities and seek appropriate supporting undertakings from the entity with actual knowledge of the portfolio and its ongoing performance (usually the servicer) to put it in a position to comply with those responsibilities.

If a forward flow transaction qualifies as a securitisation, this can result in an operationally burdensome outcome for smaller companies which are not set up to manage securitisation due diligence. Where the Purchaser does not have a funding arrangement, it may be desirable for the transaction to be structured so as not to come within the purview of the Securitisation Regulation (in a way that would not be possible on a warehouse financing). Maintaining single tranche lending will be one way of doing that. Alternatively, forward flow transactions can also be structured such that the corporate takes a subordinated loan or note in the new structure, enabling it to act as risk retainer alongside the Purchaser and senior funder.

A Purchaser may also negotiate the right to exit from the forward flow by way of a public ABS take-out (or some alternative form of refinancing). This would have an impact on contractual provisions in the forward flow documentation, such as representations and covenants from the originator (and more specifically, the asset warranties), taking into account that the Purchaser may not have been involved in the writing of the underlying receivables or have any direct access to portfolio performance data. Consideration will need to be given, possibly at term sheet stage, to what the Purchaser's intended exit strategy is (if any), who will be responsible for providing the asset warranties to the securitisation issuer and what role the originator will play and what assistance they will provide in relation to any ABS or other refinancing. 

• Exclusivity and allocation volumes

Whether or not the corporate has already entered into financings with other lenders, Purchasers, in order to receive comfort as to origination volumes, are likely to look to entrench rights to receive a given volume of originations by the corporate (possibly based on a percentage of monthly originations, an absolute minimum monthly amount, or some more nuanced formulation). They may also look for exclusivity as to the funding of any new or competing products originated by the corporate.

Such rights will help Purchasers mitigate against the risk that a corporate with multiple funding arrangements will simply prefer the most economically attractive structure (best purchase price, in the case of a forward flow, or lowest funding cost, in the case of a warehouse) when selecting which facility to sell a new batch of originations to.

• Due diligence and documentation

Inevitably forward flow transactions necessitate enhanced scrutiny by the Purchaser of the origination policies and credit servicing, given the sensitivities to portfolio performance and reflecting the fact that these transactions involve transfer of the entire economic interest in the receivables, and not just a secured lending arrangement with residual risk on the portfolio retained by the originator.

A funder will also expect comfort, supported by representations, warranties, indemnities and audit rights, that the servicing of the underlying agreements will be carried out in accordance with all legal and regulatory requirements, including the FCA’s rules and all applicable consumer protection and data protection law. This may be important to protect a funder in respect of its own legal and regulatory obligations (for example compliance with the FCA’s systems and controls requirements in the FCA Handbook).

Agreement will need to be reached between the parties as to applicable underwriting guidelines, servicing policies and standards and standard documentation and what will be required in order to change any of these. Given the credit risk assumed by the Purchaser, these are matters of much greater focus on a forward flow transaction and a robust, arm's length servicing agreement between Purchaser and servicer will be required.

• Eligibility of receivables and recourse to originator

Given that the Purchaser will effectively be committing to purchase receivables originated by a third party, strict eligibility criteria and possibly concentration limits will be required to govern which receivables will be eligible.

There is often a degree of tension around whether and to what extent the corporate should be required to repurchase or indemnify the Purchaser where it transpires that purchased receivables did not satisfy the eligibility criteria (resulting in a breach of warranty), given the corporate may be thinly capitalised and operating on the basis it will not hold any receivables on its own balance sheet. Liability caps and/or "sunset" clauses may be requested by the originator for these reasons, although will also need to be acceptable to any senior lender providing leverage to the Purchaser.

Where the forward flow transaction will involve the Purchaser acquiring all of the receivables originated by the corporate, the Purchaser may have a hand in designing the corporate's lending criteria and a consent right in respect of any changes (indeed this may form part of the risk retention analysis), such that the lending criteria and the eligibility criteria for the transaction are aligned and a breach of warranty is far less likely.

More commonly, however, the forward flow transaction will need to contemplate the possibility or existence of other financings entered into by the corporate, including warehouses and possibly public ABS deals where the originator has an established funding base. In that more normal scenario, the corporate will decide its lending criteria autonomously, although it is likely to have the eligibility criteria across its various financings in mind.

• Security over bank accounts

Normally forward flow transactions will include a "pre-funding" account, which is an account held with the originator of the receivables in which funds provided by the Purchaser or drawn from its lenders can be held pending their application by the originator towards the purchase of additional receivables during the agreed revolving period. This feature will be especially important on transactions where the originator is effectively writing receivables in real time with funds provided by the Purchaser.

No different to a warehouse transaction, funders will typically want any cash belonging to their transaction, and which is passing through the hands of the originator, to be held in a trust account or subject to an appropriate security arrangement, to protect against possible originator insolvency. The approach to that will need to be considered.

For forward flows involving a peer-to-peer lender, the parties may be able to rely on the statutory trust in accordance with the rules of the Financial Conduct  Authority (“FCA”) under Chapter 5 of its Client Assets sourcebook (“CASS”). The corporate must agree to maintain and operate such account at all times in compliance with the agreed terms and conditions, the CASS rules and any applicable laws and regulations.

• Other issues to consider

The economics of a forward flow transaction are key and need to work for all of the principal parties. Where the Purchaser will raise senior finance, there will generally be three such parties: the corporate/seller, the Purchaser and the senior funder. The interests of these parties will align and conflict on various different times.

Issues to consider may include: allocation volumes/exclusivity; purchase price; entitlement to excess spread/profit share; servicing and origination fees; allocation of costs and expenses; funding of reserves; hedging; which entity will act as risk retainer and provide the credit enhancement required by any senior lender; triggers for stop purchase, turbo amortisation and perfection; call rights; and allocation of risk and liability and indemnities generally. A comprehensive term sheet covering these and the other usual points of contention is advisable.

Conclusion

Given the current economic climate, non-bank and specialist lenders may continue to play a crucial role in the financing of the economy. A forward flow transaction can be structured to allow such lenders to provide relatively simple and quick financing to companies which might not otherwise want, or be able, to tap into the traditional securitisation market, while at the same time offering institutional lenders the opportunity to provide leverage and increased capacity as lending volumes grow.

This note is for guidance only and should not be relied on as legal advice in relation to a particular transaction or situation. Please contact your normal contact at Hogan Lovells if you require assistance or advice in connection with any of the above.

Authored by David Palmer, Aarti Rao, Stephen Bate, and Jane Griffiths.