What is a concentration limit?
A concentration limit is the percentage of a borrower's total receivables portfolio that can come from one customer category while still getting "full credit" from a lender. When receivables in an asset portfolio exceed a concentration limit (at which point they are considered "excess concentration"), capital providers do not lend against the excess receivables.
Concentration limits are outlined in credit agreements, which means that they are specific to credit facilities and negotiated on a per-debt deal basis between a capital provider and borrower. Common examples of concentration limits include the percentage of a portfolio that comes from a single customer, geography, or industry.
We previously covered advance rates and how they determine how much a capital provider will lend to a corporate provider. If all receivables got the same treatment from a capital provider, a borrower's effective advance rate would be the same as its stated advance rate.
However, because certain portions of borrower portfolios can be ineligible (i.e., they are not counted as collateral) or above a collateral concentration threshold, it is often the case that a borrower's effective advance rate is below its stated advance rate. The excess concentration (see our diagram below) will not be considered part of the borrowing base. Why does this matter? Because it means that the composition of a borrower's portfolio directly impacts its cost of capital and unit economics!
If you're modeling your business' profitability based on an advance rate assumption that turns out to be too high, you're likely to run out of funding sooner than anticipated. Companies with asset-based finance deals (fintechs like invoice factoring, home-buying, or BNPL ventures fall in this category) need to monitor and manage their borrowing base in order to ensure they get access to funding at the best possible terms, and to hit their growth and origination targets.
Why do capital providers specify concentration limits?
Capital providers specify concentration limits to ensure that their investments are protected from client, geographic, and other types of concentration risk.
In an extreme case of key client risk, you can imagine an invoice factoring company that wants to raise debt based on the cashflows from those invoices. If all of those invoices came from one customer, the riskiness of the entire debt raise would depend on the single customer's propensity to pay. On the other hand, if those invoices came from several dozen companies, the risk of the investment would be spread out across many parties.
More broadly, you can think of concentration limits as a way to diversify a capital provider's risk exposure, and to protect against highly correlated risks within a single portfolio.
While it's certainly reasonable for capital providers to ask for concentration limits in a debt raise, the right level for thresholds can be hard to agree on when it comes to funding non-traditional, esoteric, or bespoke asset types. If funding receivables backed by online influencers, for example, should concentration limits be set by geography, social media channel, or some other criterion? Navigating that uncertainty requires fintechs to understand their own growth strategy prior to executing a debt raise.
Why do concentration limits matter to fintechs?
Concentration limits matter to fintechs, especially those raising debt, because they can significantly affect a company's effective access to funding—even after a debt raise has been negotiated and closed. In addition to key term sheet considerations like the interest rate, advance rate, and minimum credit facility utilization, concentration limits should be a key point of capital strategy for all companies that rely on asset-based finance.
Fintechs that are able to accurately monitor, predict, and manage their portfolios can avoid having excess concentration and may be able to adjust their business strategy to ensure profitability (e.g., a BNPL company might be able to make more originations in Oregon and fewer in Ohio in order to stay below the concentration limits in its credit agreement).
Want to learn more?
Concentration limit monitoring and management is just one of the many operational and financial hurdles required to successfully raise and manage debt capital. If you're interested in learning more about software that can help you streamline your debt capital operations, just schedule a demo, take a self-guided product tour, or watch our 60-second product walkthrough below. We'd love to chat!