In asset-backed securitization and warehouse lending arrangements, the deferred purchase price (DPP) refers to a portion of the purchase price that is held back from the seller and paid out over time. The DPP provides protection for the asset buyer in case the underlying assets underperform.
In a forward flow arrangement, the asset buyer (usually an investment fund or warehouse facility) agrees to purchase assets such as consumer loans, auto loans, or other receivables from an originator on an ongoing basis. The buyer pays an initial purchase price equal to a percentage of the asset value. The DPP represents the balance owed to the seller, which gets paid on the back end assuming the assets meet certain performance thresholds.
How Does Deferred Purchase Price Work?
When assets are sold into a warehouse facility or fund, the total purchase price has two components:
- Initial Purchase Price: A percentage paid upfront, typically around 98-100% of asset value
- Deferred Purchase Price: The balance, usually 2-5% of asset value
For example, on a pool of $10 million loans, the terms might be:
- Initial Purchase Price: $9.8 million (98% of total)
- Deferred Purchase Price: $200,000 (2% holdback)
The DPP functions as a risk retention mechanism that aligns incentives between the buyer and seller of the assets. The buyer does not have to pay full price upfront, guarding against adverse selection where the seller offloads lower-quality assets. The DPP also compensates the buyer for taking on credit and prepayment risk associated with the collateral pool.
Seller’s Perspective
From the seller’s (platform or originator) perspective, the DPP represents a receivable they’ve booked but can’t fully collect yet. It provides an incentive to maintain origination discipline and prevent their underwriting guidelines from slipping over the facility term, which would lead to worse performance. Having skin in the game ensures the seller’s interests are tied to the assets’ performance.
On each payment date, the fund manager verifies that the collateral pool has not breached any representations & warranties or fallen below designated thresholds for delinquencies, defaults, prepayments etc. If everything checks out, a portion of the DPP is released to the seller as a form of deferred compensation.
Buyer’s Perspective
For the buyer, retaining a piece of the purchase price allows them to price risk into the acquisition cost of the assets. It also serves as first-loss protection against deteriorating collateral performance. If thresholds are violated, the DPP gives holders of senior fund notes or warehouse lenders added assurance via overcollateralization.
In practice, most buyers or lenders only call a DPP holdback in extreme scenarios. Their incentive is keeping the facility economics on track so the arrangement can be sustained and expanded gradually over time. But having that backstop enhances ratings on bond deals and lowers advance rates for warehouses.
DPP Across Asset Classes
While exact terms vary, the concept of deferred purchase price holds fairly consistent across auto loans/leases, marketplace lending, credit cards, or student loan ABS. A sample DPP structure is outlined below based on different asset types:
Auto Loans & Leases
Profile: Prime to subprime auto loans or leases from banks, captive lenders & independent finance companies.
DPP Levels: Historically 2-3%, widened to 4-5%+ for subprime drivers during COVID uncertainty.
Payout Terms: 50% after 12 months if no threshold triggers hit. Remaining 50% after 18-24 months assuming continued compliance.
Threshold Triggers: Cumulative net losses on auto pool exceed projected levels based on credit model inputs. Breaches of representation around loan data, compliance violations.
Marketplace Loans
Profile: Unsecured consumer or small business installment loans from FinTech lenders. Much shorter history than auto, credit cards.
DPP Levels: 4-7%+ given limited data history and potential credit model risk.
Payout Terms: 20-25% after 6 months, another 25% at 12 months. Remaining 50% in 25% chunks at 18 and 24 months.
Threshold Triggers: Vintage-based cumulative charge-off rates, delinquency rate levels by product. Breaches around loan metadata or regulatory compliance. Portfolio triggers around yield, prepay speeds etc.
Credit Card Receivables
Profile: Pooled seasoned credit card or charge card balances from large banks.
DPP Levels: 1-4% on prime receivables. Much higher for subprime obligors.
Payout Terms: 25-50% at 12 months, remainder at 24 months.
Triggers: Portfolio triggers around yield compression, payment rates, gross charge-offs. Vintage triggers based on projected loss curves. Breaches of eligibility criteria or representations.
Student Loans
Profile: Private student loan collateral, much riskier than government program SLABS.
DPP Levels: 5-8%+ given navigating unknowns around income-based repayment plans, various modification programs offered.
Payout Terms: 25% at 12 and 18 months. Remaining 50% at 36 months.
Triggers: Vintage thresholds around deferment/forbearance levels. Breaches on binding arbitration clause representations. Portfolio triggers on realized yield.
In each market vertical, the deferred purchase price schedule aligns risk between the buyer and seller. It also reflects asset duration, the quantity of historical data, product diversity and other structural nuances inherent across consumer finance sectors.
Market Range of DPP Levels
While DPP arrangements share similarities in concept and utility, specifics often vary based on:
Type & Quality of Collateral
For largely “clean” prime quality loans, DPP might be 1-3% of assets. For B&C grade consumer, small business, specialty finance assets, DPP could be 5% or higher.
Data History
When expanding into newer lending niches with limited data, DPP is wider to account for projection uncertainty. As performance history builds, DPP gradually declines to equilibrium.
Macro Conditions
During periods of economic growth & low unemployment, DPP tends to tighten as credit conditions improve. In downturns or recessions, DPP widens to buffer against higher anticipated losses.
Investor Risk Appetite
When fixed income markets exhibit risk-on behavior, easier investor placements let managers reduce credit enhancement like DPP. The opposite happens when securitization markets face volatility.
Based on above factors, the deferred purchase price generally falls into these ranges by asset type:
Typical DPP Range
Prime Auto Loans & Leases
Near Prime Consumer Loans
Marketplace Loans
Subprime Auto / Credit Card / Installment Loans
Specialty Finance Receivables
2-4%
3-6%
5-8%
8-12%
10-15%+
So in liquid consumer finance sectors, DPP between 1-5% is common. For assets with more uncertainty, deferred purchase price frequently resides in the high single digits to low double digits.
DPP Mechanics in Warehouse Facilities
In a securitization context, deferred purchase price mechanics aim to distribute risk between senior bond investors and equity holders who retain the residual certificate. Warehouse line advance rates serve a similar risk balancing role between the lender and buyer.
Most credit facilities used to finance specialty finance assets have two key parameters that factor into sizing:
1) Advance Rate – The max % of collateral value the lender will fund against, currently ranging from 70-95%+ based on asset type & risk profile.
2) Eligible Asset Value – The value ascribed to the underlying receivables/loans when calculating the borrowing base availability. Generally a discount against gross receivables outstanding to account for dilution, losses, etc.
To illustrate using a hypothetical $100mm pool:
- Gross Receivables Balance: $100mm
- Eligible Asset Value: $90mm (90% of gross)
- Advance Rate: 80%
Borrowing Base = Eligible Assets x Advance Rate = $90mm x 80% = $72mm
The gap between the gross receivables and net loan availability provides a risk cushion protecting the warehouse lender.
This gap consists of two pieces:
1) Discount against gross assets – ($100mm – $90mm = $10mm)
2) Advance Rate haircut – ($90mm x (100% – 80%) = $18mm)
In total, there is $28mm or 28% credit enhancement on the hypothetical $100mm pool. The deferred purchase price can essentially be viewed as a component of this enhancement that sits subordinate to the warehouse lender’s drawn balance.
For example, if the DPP is 10% of advances, it would fund $7.2mm of the $28mm credit enhancement in above example ($72mm drawn x 10%). DPP assets sit below the warehouse lender & absorb first losses.
Tying this together in the balance sheet view:
$100mm Collateral Pool
- $72mm: Warehouse Line Advances
- $7mm: Deferred Purchase Price (10%)
- $21mm: Discount against Eligible Assets (10%) + Residual Advance Rate haircut (18mm)
The combined credit enhancement guards against potential collateral underperformance over the facility term. Advance rates & eligible asset value discounts provide first loss protection. DPP absorbs subsequent losses before impacting principal recovery on drawn warehouse balance.
Factors Impacting DPP in Warehouses
In warehouse lines, deferred purchase price often fluctuates over time based on:
Advance Rate
If a borrowing base is consistently over-collateralized, excess enhancement allows lower DPP. Many facilities start conservatively then gradually increase advance rates.
Excess Interest Spread
As receivables portfolios generate meaningful excess spread between interest income and funding costs, supplemental overcollateralization builds organically, enabling lower DPP.
Portfolio Seasoning
Early on as performance history develops, DPP wider protects against modeling error. As seasoning builds, risk clarity allows DPP reduction.
Macro Backdrop
Similar to bonds, warehouses see DPP widen amid volatile markets or downturn onset, tightening when outlooks improve.
Investor Feedback
Asset buyers & rating agencies critique deal structures. Feedback on credit enhancement levels, DPP mechanics, helps calibrate to optimal market clearing levels.
In warehouse lines or securitization vehicles, deferred purchase price protects against downside miscalculations. It represents one of the most adaptable forms of credit enhancement, typically ranging from 1-15%. DPP aligns incentives for sellers to uphold underwriting discipline, while compensating buyers for taking on uncertainty and risk. Though exact mechanisms vary, DPP remains a tried-and-true way to balance outcomes across financial transactions.