What is a backup servicer?
A backup servicer is a company that takes over the servicing duties (i.e., the collection and recording of loan and interest payments) for a portfolio of assets or receivables when a primary servicer can't perform its duties. Backup servicers usually step in for servicers when trigger events (usually defined in credit agreements for debt capital deals) happen. A key example of a trigger event is the insolvency of a servicer.
What is the role of the loan servicer in fintech?
The loan servicer is the party that manages all the day-to-day operations of a portfolio of loans, including sending out communications to borrowers, receiving and recording payments, and tracking all borrower loan statuses over time.
The reason servicers and backup servicers matter for fintechs is that many fintechs are directly or indirectly part of the $1 trillion lending industry, which has a large ecosystem of vendors that help fintechs acquire, underwrite, originate, service, and manage customers. As we covered in our post on the modern lending tech stack, servicing is a key part of the operations of most fintechs, which means many fintechs need to evaluate and select backup servicers to work with as they grow.
It's not uncommon for fintechs in the lending industry to service their own loans, especially when they first start out. Startups usually start with small portfolios, so their portfolio and servicing operations are (initially) easy to manage.
Why are backup servicers important?
The fintech-as-servicer arrangement becomes riskier when a fintech scales its operations and raises debt capital from outside sources. In particular, debt capital providers that offer fintechs an asset-based credit facility may fear that, in the event that something happens to the fintech, the outstanding portfolio of assets (which acts as collateral for the credit facility) may be in jeopardy as well. A portfolio of receivables isn't worth much if no one can collect it, or if the status of borrower payments can't be found. If a student loan startup faces bankruptcy, for example, how might that startup's creditors ensure that the outstanding portfolio of receivables can still be collected and tracked?
Enter the backup servicer, a vendor that is often required in fintech credit agreements, as a contingency plan. The backup servicer stands by ready to assume servicing duties in the event that something happens to the primary servicer (which is often the fintech, or debt capital borrower).
How does backup servicing work?
Backup servicers typically offer three different levels of commitment: cold, warm, and hot.
These terms refer to the frequency of the backup servicer's data and portfolio updates (i.e., how often the backup servicer refreshes its borrower and payment data to ensure accuracy) and the speed with which the backup servicer can assume servicing duties. The more frequent the updates, the "warmer" a backup servicer is said to be, and the more a fintech can expect to pay for the engagement. Below, we provide high-level explanations of cold, warm, and hot backup servicer offerings that fintechs may come across (please keep in mind, however, that backup servicing details will vary by asset type, capital provider requirements, etc.).
Cold backup servicer. In a cold backup servicer arrangement, loan and repayment data is updated infrequently and it may take several weeks for the backup servicer to take over servicing duties from the primary servicer.
Warm backup servicer. In a warm backup servicer arrangement, loan and repayment data is updated moderately frequently and it may take 1-2 weeks for the backup servicer to take over servicing duties from the primary servicer.
Hot backup servicer. In a hot backup servicer arrangement, loan and repayment data is updated frequently and a backup servicer can take over servicing duties from the primary servicer immediately, if necessary.
Want to learn more?
Capital providers often require fintechs to select a backup servicer as a condition of a debt capital raise. While choosing a backup servicer tends to be straightforward, fintechs are often surprised by the cost and complexity of having to interface with a number of vendors in order to raise and manage debt capital.
If you're interested in learning more about software that can work alongside your backup servicer and help you scale your capital markets function, just request a demo from a Finley capital markets expert. We'd love to chat!