Right of first refusal (ROFR) is a contractual clause that gives a party the first option to purchase or finance an asset before the owner of that asset can sell or finance it to another party. In the context of a consumer loan warehouse facility, right of first refusal gives the facility provider the first option to purchase or finance the loans originated by the loan originator before those loans can be sold or financed elsewhere.
How a Consumer Loan Warehouse Facility Works
A consumer loan warehouse facility provides short-term financing to a loan originator to fund loans as they are originated. The loan originator closes and funds mortgage, auto, or personal loans to consumers using a credit line from the warehouse facility provider rather than its own cash. This arrangement benefits the loan originator by providing ready capital to close loans without tying up its own funds. It also generates fees and interest income for the warehouse provider.
Once the loan originator funds a consumer loan using the warehouse line, it has a short period of time, often 30-45 days, to either pay off the credit line by selling the loan to a third party investor or to another financial institution. The warehouse credit line is then replenished and available to fund new transactions. If the loan isn’t sold by the expiration date of the warehouse advance, the loan may go into default status requiring immediate repayment of the credit line.
A right of first refusal clause gives the warehouse line lender priority when the loan originator seeks to sell funded loans into the secondary market.
How a Right of First Refusal Works in a Warehouse Facility
A right of first refusal in a warehouse line agreement typically states that before selling a loan to another investor, the loan originator must first offer the loans to the warehouse lender itself. This allows the warehouse lender to cherry pick the most desirable loans to hold in its own portfolio rather than losing them to a third party.
The ROFR gives the warehouse lender time-limited exclusivity to purchase the loans. During the exclusivity window, often 24-48 hours, only the warehouse lender is permitted to make an offer and close on the loans. If the exclusivity period expires without an offer from the warehouse lender, the broker can then offer the loans more broadly and sell them to another investor.
Key clauses of a typical ROFR include:
Exclusivity Period:
The amount of time where the warehouse lender has an exclusive right to purchase loans before they can be offered externally. Often 24-48 hours.
Acceptance Process:
The method and timeline for the warehouse lender to accept the ROFR offer. Usually stipulated to be in writing within the exclusivity period.
Pricing Determination:
The mechanism for determining loan purchase price, often based on a pre-agreed upon index plus a spread.
Loan Delivery:
The timing and method for the loan originator to deliver loan documents and receive purchase funds after the offer is accepted. Typically 3-5 days after ROFR acceptance.
Remedies:
Recourse to the loan originator if loans are sold externally during exclusivity or terms of the ROFR aren’t followed. May include immediate repayment of facility.
Pros of an ROFR for a Warehouse Lender
From the perspective of the warehouse lender, requiring a right of first refusal in its lending agreements offers several benefits:
Access to High Quality Loans:
With first dibs on purchasing loans, the lender can select the “cherries” from each batch before losing them to competitors. This leads to stronger portfolio performance.
Low Cost of Funds:
Since the lender already finances the loans, no cash is required to purchase them. This is much cheaper than raising external capital to buy loans on the open market.
Generates Interest and Fee Income:
Bringing loans onto the balance sheet generates net interest income over the life of the loans. Purchase fees can also apply on loan acquisition.
Scalable Growth:
An ROFR makes it easy to rapidly scale loan portfolio growth funded solely from internal warehouse credit lines.
Flexibility:
If any loans are less desirable, the lender can waive ROFR and allow external sale. There is no mandate to purchase all loans.
Cons of an ROFR for a Warehouse Lender
Granting a blanket ROFR to lenders does limit flexibility for the loan originator. The lender should be aware of potential downsides as well.
Capacity Constraints:
The lender may lack enough balance sheet capacity to purchase all the loans it has a right to. This can lead to higher financing costs.
Increased Concentration Risk:
Exercising the ROFR may add concentration risk if it results in excessive exposure to a single loan originator partner.
Less Market Discipline:
Pricing loans via an ROFR rather than open market bids could result in overpaying. There is risk of adverse selection from the loan originator.
Requires Underwriting Capability:
To appropriately price loans and manage risk, the lender needs the infrastructure to efficiently underwrite consumer asset classes. This adds operational complexity.
Pros of an ROFR for a Loan Originator
For loans originators, right of first refusal clauses also offer some benefits:
Provides a Built-in Buyer:
Guarantees a buyer will purchase loans helping loan originators manage liquidity to fund new deals. Quality loan production gives lenders incentive to exercise the option.
May Result in Better Pricing:
By selling loans “off market”, an originator avoids transaction costs of wider bidding. Better pricing can be shared with its warehouse partner.
Reinforces Partnership:
Complying with the ROFR demonstrates good faith by allowing first dibs to a financing partner providing significant funding support.
Cons of an ROFR for a Loan Originator
However, there are also risks the originator takes on by granting its warehouse lender ROFR privileges:
Limits Market Options:
Particularly in a competitive market, the originator loses the ability to shop its loans for the best offer during the exclusivity window.
Weakens Negotiating Position:
Without price discovery from other buyers, it is harder to negotiate an optimized sales price. Could leave money on the table.
Adds Contingency Risk:
If the ROFR is waived or capacity limits are hit, the originator may have trouble finding an alternative investor in time to avoid defaulting on warehouse lines.
Requires Ongoing Appetite:
Originators must sell sufficient volumes of loan types the warehouse lender has ongoing demand for. If it primarily exercise ROFRs on specific products, the originator will be constrained to focus origination activity on those areas.
Tips for Negotiating an ROFR
Here are some tips for both loan originators and warehouse lenders to consider when negotiating an ROFR clause:
Start with Key Objectives:
Both parties should clarify priority goals for the clause related to risk appetite, return targets, portfolio composition, etc. This ensures proper alignment on interests and constraints.
Set Reasonable Time Windows:
Loan originators favor shorter exclusivity periods while warehouse lenders want more time. Typically 48 hours strikes the right balance for initial review and diligence.
Consider Partial Options:
Rather than “all or none” on entire pools, defining ROFR purchase options on a percentage of loans (e.g. facility lender gets right to 20%) is an option adding flexibility.
Price Transparently:
ROFR pricing methodology should be clearly defined based on observable benchmarks to ensure fair value and eliminate disputes. Both parties should have input.
Build in Volume Thresholds:
Requiring minimum monthly, quarterly or annual ROFR purchase volumes to maintain exclusivity rights promotes discipline on both sides to uphold their side of the bargain.
Analyze Portfolio Fit:
Originators can request clarity from warehouse lenders on types of loans, risk profiles, consumer credit segments, geographic locations, etc. they tend to exercise ROFR options on. This guides origination focus areas.
Model Scenarios:
Under various market conditions and capacity scenarios, both parties should financial model expected ROFR economics to size risk and optimize terms. Start with conservative assumptions.
Maintain Dialogue:
Ongoing open communication allows both sides to monitor market conditions and discuss adjustments if they are warranted to keep the arrangement mutually beneficial.
Exit Options:
Define terms for discontinuing or disengaging from the ROFR agreement if needed by either party while minimizing adverse impacts of any break in the relationship.
The right of first refusal is an important consideration for both lenders and originators in negotiating warehouse lines of credit agreements. Properly structuring the ROFR clause allows each party to optimize their position while still enticing their partner to uphold their side of the bargain through consistent loan production volumes on one side and active purchasing activity on the other side. Like any partnership agreement, clearly defining responsibilities, constraints, risk appetite and benefit expectations upfront smooths the process of bringing this clause to life in a growing lending relationship targeting the consumer market.