Questions is our Q&A series featuring key decision-makers in the corporate credit markets.
Post-transaction management is the less glamorous counterpart of asset origination, though recently it has gotten a lot more attention than it once did. The blowup of Market Financial Solutions and the now head-spinning £1.8bn total claims against the company highlight the need for diligence once the deal has been signed and the champagne has been drunk.
Enter Steve White, co-founder of Five Sigma Finance. Five Sigma provides tech-driven strategic buy-side and sell-side advisory services to clients across public and private assets, with a particular focus on asset-backed finance.
9fin sat down with White to talk about post-execution transaction management, the lessons of recent high-profile frauds, and the critical role rigorous monitoring plays in keeping assets and investors secure.
1. In granular terms, what does post-transaction management actually mean?
Post-transaction management is where the hard work begins. Anybody you call will tell you they do the validation, monitoring and reconciliation required to keep a deal airtight. And in many cases, they do. But the question is: To what extent? How thoroughly? How systematically?
What we have found consistently is that explosive growth in this ABF sector has led firms to prioritise deal origination. The monitoring function on a relative basis gets smaller than it needs to be. The infrastructure, which is difficult and costly to build and maintain, does not get built.
What we have created at Five Sigma is technology to operate at scale providing leverage to our extensive financial expertise. We built a data pipeline engine that ingests data however it arrives then validates and reconciles it against previous periods, and flags errors in a matter of seconds.
All data and reconciliation errors are identified, down to the single loan level and all relevant users receive a data quality email report before the person who uploaded it has had time to get up and make a coffee. The data uploader can then examine those data issues, fix them, re-upload, and if there are still errors, the process repeats.
Over time, this process creates a feedback loop that makes data progressively cleaner. When we see something that cannot be explained by what we believe is an honest error, we start asking hard questions. These errors can include simple things like a borrower's age dropping by five years between reporting periods, a property postcode or some lien detail changing or a loan marked 60 days past due with no delinquent balance.
Whatever it is, we call it out and get to the bottom of it.
2. If I’ve underwritten an asset well, aren’t I covered?
Yes and no. Underwriting is critical and most investors are very good at it. They spend enormous amounts of time screening deals, analysing data, and drafting documents to optimise returns.
What is less appreciated is that even great transactions can fail to achieve their potential due to a lack of monitoring and asset management that is reactive, quietly turning these deals into mediocre performers.
Remember that a transaction is underwritten at a single point in time; it is a map of the investment territory. The transaction itself and the returns typically accrue over three to five years, during which time many things can and will change. An effective asset manager has to actively navigate that territory throughout.
You have to think of post-transaction management in two distinct phases. The first is onboarding: reconstructing the transaction from the document level, mapping key data against structural features, and using technology to establish access to data tapes, account banks, servicing reports, and similar. The outputs of this onboarding process include a full analytics suite and asset and liability models, all hosted on our proprietary platform, Abide.
The second phase is proactive, ongoing management: frequent communication with all transaction counterparties, challenging unexpected cash movements or asset performance, monitoring performance trends, and conducting regular account reconciliation and audits to maintain a clear picture of cash and collateral position and minimise error and fraud risk.
Together, these two phases are the core of what we do.
3. Market Financial Solutions is a big topic right now, alongside other post-transaction blowups. Generally speaking, what aspect of management was missing in these cases?
From the outside, nobody can know the full picture. However, we talk to funds regularly and what we find frequently is that the monitoring function is under-resourced relative to the scale of what it is being asked to do.
People are still stitching together Excel spreadsheets month to month, manually, painstakingly, trying to track cashflows across a portfolio of transactions of meaningful size. That is both slow and fragile.
The other issue is talent. That middle-office role is not glamorous but it is critical. It requires someone who is numerate, can work across complex models, can manage relationships with multiple counterparties, and can do it consistently over a long period.
Good, ambitious people tend not to stay in that role, they want to become portfolio managers. So you end up with an essential function that is chronically understaffed and chronically under-retained, running on infrastructure that is not adequate or scalable enough.
In that environment, early warning signals get missed or are never generated in the first place.
4. How do you think the industry is set for the next MFS? Are there changes needed?
These things go in cycles; as an industry, we are always fighting the last war. Right now we are seeing a reaction where policing is tightening, data quality, policies and procedures are being scrutinised and investors are asking considerably more questions than they were twelve months ago.
What I would also point to as a structural change, is the shift in investor behaviour around audit rights. Historically, you might see a right to audit once a year in documentation. That is no longer considered adequate. Investors are now pushing for quarterly audits, and where they have a bank leverage facility, the banks themselves are saying they want to go in and audit too.
The dynamic has shifted: where previously only one in three investors might insist on heavy audit rights, it is now closer to three in three. Originators who previously could push back on that stance can no longer do so. Those clauses are being inserted and they are not being negotiated away.
That is a meaningful change and, in my view, a healthy one. Together, we think these changes will make the next MFS harder to pull off and easier to catch early. But I would be naive to say it eliminates the risk.
5. How is the market reacting to these high-profile incidents of fraud?
The pool of active investors has narrowed as a result of recent events, with some shifting focus to their existing portfolios or rotating strategy entirely. That has strengthened the hand of the investors who remain active. They are no longer competing on speed and ease of due diligence and are finding that they can insist on stronger conditions. And they are insisting.
What we are also seeing is that originators are becoming more conscious of the quality of the data they are providing. You might be surprised at how many originators, particularly younger, less established ones, do not actually know whether the data they are sending to investors is structured appropriately. They have developed their technology to make the borrower's journey easy, but they have not built the infrastructure to make the investor's journey easy.
6. How effective can diligence really be when somebody is motivated to deceive you?
According to experts, most fraud does not begin with an intent to commit fraud. It often starts with a mistake: something is misallocated or goes slightly wrong, money is borrowed from one pot with every intention of paying it back. It then spirals out of control.
So, the direct answer is that our goal is to identify and examine all of the incoming information and any reporting inconsistencies. In this way, we can identify unusual or suspicious behaviour in the very early stages making the fraud significantly less likely or minimising any impact.
The way we do that, through our technology platform and what we call Transaction Lifecycle Advisory (TLA), is to be a persistent and constructive presence in a transaction. We reconcile all the data and all the cashflows. We probe and question anything that looks out of order. We organise periodic audits.
Critically, we make it visible to all the counterparties that we are questioning everything. In doing so, we are trying to discourage potential bad actors before they act. Think of it as the house on the street with visible cameras. A would-be fraudster cases the neighbourhood and looks for the house without them first.
7. You’re involved in some complex asset-heavy deals with post-transaction needs, what are the opportunities you see there?
Two good examples of our work here are in Spanish re-performing mortgages and UK equity release mortgages. The first of these follows a familiar story: after the global financial and sovereign debt crises, Spain in particular saw a significant stock of mortgages that defaulted, were restructured to allow the borrower to re-perform, and which the Bank of Spain has since required banks to hold additional capital against.
That has driven Spanish banks to sell those portfolios, often blended with performing collateral to improve overall execution. The challenge for investors is that these are genuinely tricky mortgages to evaluate. You do not know how long they will continue to perform, whether they will fall back into delinquency, for how long, and at what severity.
There are also significant issues on the data quality of both loans and security collateral. That makes understanding and modelling the portfolio a complex problem, and we have helped a number of investors analyse, model, structure and acquire those portfolios including going through the rating agency process.
UK equity release mortgages are in some ways the opposite end of the spectrum in terms of asset quality, but the analytical challenge is similar. You have a set of co-dependent variables including interest rates, house price appreciation, mortality, morbidity, moves into long-term care, and prepayments from downsizing that all have to be modelled simultaneously, particularly when the goal is to create matching adjustment eligible notes for insurance companies.
That is a heavy lift. You need deep expertise in building those models and it is not something most market participants have the capacity to do well.
8. What does good management look like in those markets, and where are they headed?
In the re-performing mortgage market, good management means doing exactly what we do elsewhere, at the loan level, and with a higher degree of complexity.
As an example, for one of our clients, we onboarded multiple portfolios onto Abide, and then we run monthly reconciliation from the servicers’ data, tracking principal receipts, interest, delinquency transitions, and recovery rates on a loan-by-loan basis.
We have also built a customised feature to estimate the current value of individual properties using comparable transactions in the same geographic area, which removes the need to commission a local valuation for every asset in the book. Is it as precise as a physical inspection? Perhaps not in every case. But it is dramatically more efficient and continuously updated.
As for where these markets are headed, both are, to a degree, supply-constrained in the current environment. Equity release origination volumes are materially below their peak, although if interest rates fall, that should change.
In Spain, improving economic conditions mean the stock of re-performing mortgages is gradually shrinking as borrowers transition back to performing status and stay there. Banks have also generally tightened their lending criteria, which should reduce the pace of future NPL accumulation, absent another severe economic shock.
If that shock arrives, the dynamic could reverse sharply. What I would say is that irrespective of where volumes go, the monitoring function in both of these markets is non-trivial, and investors who underestimate that are taking on more risk than they realise.
9. You moved from working for Morgan Stanley to a fintech, what has that been like? And what is one piece of advice you would give to others?
Yes, and I am still looking for my business class airline tickets and my five-star hotel reservation. They must be with my PA…
On a more serious note, it is hard to describe how exciting it is to be part of a dynamic, growing fintech. But thinking about my transition from Morgan Stanley, the following comes to mind: the power of the franchise is extraordinary. The people you are surrounded by are first class. The training one receives is second to none. The flood of information from every corner is remarkable.
In the transition to a boutique, that infrastructure falls away. Yes, in a fintech there are no politics, no bureaucracy, you can make decisions quickly, be nimble, which is great and one reason that many make the move.
On the other hand, those decisions are made from imperfect information. All of the information that just flows into the larger institution has to be instead gleaned from separate, diverse sources or created on your own. It is exhilarating and eye-opening.
No matter how good one is at building a business within a large organisation, it is very easy to underestimate the power of the brand behind you. Doors open. Calls and meetings are taken. You have access to a multitude of clients, due at least in part, to the franchise.
In a fintech, trust has to be earned bilaterally, one piece of work at a time; it no longer flows from the institution. It is on you, no one else. It is not for the faint-of-heart but boy, it is an incredible journey, incredibly gratifying.
