Margin says one thing, return on capital says another
Two loans, the same size. Gross margin overstates the wide loan's advantage by a factor of seventeen — and the whole of it rests on a default estimate.
Two loans of the same size to the same sponsor. One is a 200-basis-point senior loan
against a stabilised asset; the other a 550-basis-point whole loan against a transitional one.
The margin says the second is better by 2.75 times. The return on capital says it
is better by 1.10 — a tenth. The margin overstates the advantage by a factor
of about 17.
That is what “a lending business that manages to gross margin will select the wrong
deals” means when it is written out. On this pair the margin happens to point at the same
answer, for reasons that are almost entirely wrong — which means on a slightly different
pair it would point at the wrong one.
The four adjustments between the margin and the return
Fees first, because they annualise over the term and a short loan spreads them over fewer
years. Then the three deductions: what the lender pays for its own money, the expected loss, and
the cost of doing the work.
Loan A
Loan B
What it is
Margin over the reference rate
200
550
what the term sheet says
Arrangement fee, annualised
15.0
50.0
bigger effect on a short loan
Exit fee, annualised
—
33.3
Gross revenue
215.0
633.3
less cost of funds
−60
−60
the lender’s own funding
less expected loss
−7.5
−90.0
PD × LGD
less operating cost
−15
−45
underwriting, servicing, monitoring
Net spread
132.5
438.3
In basis points a year. Two 50 loans, sized the same to isolate the pricing.
Look at the fee line. Loan B’s 1.50% arrangement fee over three years is worth 50
basis points a year against Loan A’s 15 over five — and the exit fee adds another 33.3.
Fees close some of the gap in B’s favour. The expected loss and the operating cost open it
back up. Neither appears in the number anyone quotes.
And then the adjustment that decides it
Net spread is still not the return, because the two loans do not tie up the same capital. A
transitional whole loan is risk-weighted three times a stabilised senior loan, and the capital is
the scarce thing.
Loan A
Loan B
Profit a year
662,500
2,191,667
Capital held
2,000,000
6,000,000
Return on capital
33.1%
36.5%
Margin says B is better by
2.75×
Return on capital says B is better by
1.10×
The wide loan holds three times the capital. That is the adjustment the margin cannot see.
306 bp of net spread advantage — 306 basis points — and only 3.4 points of return on
capital, because it took three times the capital to earn it. That is the whole discipline in one
comparison, and it takes eight rows.
How fragile is the wide margin?
B’s remaining advantage rests on an estimate. Move the probability of default and hold
everything else constant.
Loan B’s probability of default
Expected loss, bp
Net spread, bp
Return on capital
Verdict
1%
30.0
498.3
41.5%
B still wins
2%
60.0
468.3
39.0%
B still wins
3%
90.0
438.3
36.5%
B still wins
4%
120.0
408.3
34.0%
B still wins
5%
150.0
378.3
31.5%
B now loses to the senior loan
6%
180.0
348.3
29.0%
B now loses to the senior loan
Everything else held constant. Only the default estimate moves.
B ties with the senior loan at a 4.36% probability of default — 1.45 times the
assumed 3%, or 136 basis points of PD. That is well inside the error of any default
estimate. A 350-basis-point margin advantage that disappears if the estimate is wrong by less than
half is not a margin advantage. It is a position on the accuracy of a PD estimate, taken without
anyone saying so out loud, and it belongs in the credit paper in exactly those words.
The clause that gets conceded at eleven o’clock
Rate floors have a habit of being given away late in a negotiation, because they cost the
borrower nothing on the day the loan is signed. Here is what one is worth on the senior loan.
If the reference rate falls by
The floor earns, a year
As extra margin
As a share of Loan A’s credit margin
25 bp
125,000
25 bp
12%
50 bp
250,000
50 bp
25%
100 bp
500,000
100 bp
50%
150 bp
750,000
150 bp
75%
200 bp
1,000,000
200 bp
100%
300 bp
1,500,000
300 bp
150%
A clause that costs the borrower nothing on the day it is signed.
A 150-basis-point fall in the reference rate over a five-year term is unremarkable, and on
this loan it is worth 750,000 a year — 75% of the entire credit margin, the
margin that took weeks of underwriting to justify. The negotiator who concedes the floor to close
the deal has given away more than the credit team gained by pricing the risk correctly. It is
worth computing this line before the final session rather than after it.
What an early repayment actually costs, which is not what most people expect
A loan that repays after eighteen months of a five-year term has not earned what the
committee approved — that is the received wisdom, and the loan itself flatly contradicts
it.
Loan A held for
Revenue, bp
Operating cost, bp
Return on capital
5.0 years
215.0
11.0
34.1%
3.0 years
225.0
15.0
35.6%
1.5 years
250.0
25.0
39.4%
1.0 years
275.0
35.0
43.1%
On the loan considered alone, an early repayment pays the lender better.
Held to term the senior loan returns 34.1% on capital. Repaid at eighteen months it returns
39.4%, because the arrangement fee annualises over a shorter life and the fee is
larger than the extra underwriting cost per year. On the loan considered alone, an early
repayment makes the lender more money.
The damage is entirely in the redeployment
The capital was committed for five years. If the loan goes away at eighteen months the money
has to be re-lent for the remaining three and a half, and that is where the sentence is really
about.
Replacement margin
Total profit over the five years
Against holding to term
Verdict
2.00%
3,637,500
+225,000
still ahead
1.75%
3,200,000
−212,500
the early repayment has cost money
1.50%
2,762,500
−650,000
the early repayment has cost money
1.25%
2,325,000
−1,087,500
the early repayment has cost money
1.00%
1,887,500
−1,525,000
the early repayment has cost money
The loan repays at 18 months. The capital was committed for five years, so it must be re-lent for the remaining three and a half.
With no prepayment protection the lender can absorb about 13 basis points
of margin compression before the early repayment leaves it worse off over the five years it had
committed. That is a very thin tolerance, and it is why the instinct is right even though the
loan itself did better.
Which reframes what prepayment protection is for. It is not a penalty and it is not a
windfall. It is the amount of margin compression the lender can survive if the loan goes away
early. On this loan, 100 basis points of protection widens the tolerance from 13 basis points
to 41. That is a far better argument to make across a table than
“we always ask for it”.
Three lines for the next credit paper
State the return on capital next to the margin, not instead of it — the two together
are the comparison, and either alone is a half-truth. State the probability of default at which
the deal ties the alternative, because that is the estimate the approval actually rests on. And
state the margin compression the deal can absorb on an early repayment, because that is what the
prepayment clause is buying.
None of the three takes more than a spreadsheet column. All three change which loans a
committee approves.
The workbook behind this article
Every figure above is a live formula in the companion file for
The Real Estate Debt Investor, which also holds the margin-to-return bridge line by line, the PD sensitivity, the floor grid and the early-repayment round trip. It is free, and it needs no account and
no email address.
Should corporate debt be fixed or floating?78.1818 per cent of gross debt fixed, and a net floating exposure after cash of -608,000.00 — the proportion, not the instrument.
Does an undrawn revolver count as liquidity?67.4567 per cent of the headroom, and it leaves at a fall in annual revenue of 8.4127 per cent — not the 13.3333 per cent the board deck implies.
Does supply chain finance count as debt?66,049,315 released, and leverage of 2.7622× or 3.1362× depending on which balance the test is asked of — the second is a breach at today's EBITDA.
How do you set a minimum cash balance?Three components, 124,596,281 in total — and the double count that turns a margin of 27,403,719 into an apparent shortfall of -3,988,281.
Is a 2/10 net 60 discount worth taking?An annualised 14.8980 per cent against a revolver at 4.50 per cent — worth 5,471,890 a year, and 0.3132 turns of reported leverage.
At what wealth does a family office pay?A five-person office costs the same $2,442,000 at $100m as at $2bn. Against a tiered multi-family schedule the two curves cross exactly once.
Does the fulcrum move with enterprise value?A worked capital structure at three enterprise values. The break migrates from the first lien to the subordinated notes without a single document changing.
How many companies does a reserve pool defend?Holding pro rata to the Series D costs $14.76m per company. A $40m reserve defends 2.71 of forty — and 61 per cent of the cost is the last round.
How much room a 1.15x downside actually leaves79 basis points of margin. The leverage covenant fails first, five basis points before the coverage covenant the chapter reports on, and 4.6 per cent of EBITDA is the whole cushion.
How the GP catch-up is actually solvedMost write-ups state the catch-up formula then hardcode the answer. Set it as a solve and it moves on its own when the carry rate does.
Six ways to state the same fund's return7.12 per cent, 18.04 per cent, or 1.323 times the public market — one fund, one set of flows. The eleven-point gap is the valuation, and it is not cash.
The IRR at which a closed-ended fund merely tiesA drawdown fund advertising 13.25 per cent ties an evergreen netting 8.64. On committed rather than called capital, 78.7 per cent of the edge vanishes.
The month a remediation trigger has to be armed byMonth 8, on a one-year window and a 14-week hiring lead time. The date is 12W − L/4.33 and holds for any portfolio size — the book only changes the euros.
Two routes to the same NAVFive findings in one quarter-end close, and not one of them was a modelling error. Every one was a control that did not exist.
What a CBAM certificate buffer costs to holdCarry and protection are both linear in the buffer, so the break-even probability is identical at 5 per cent and at 30 — and 2027 costs exactly twice 2026.
What a clawback actually collateralises24 million recovers 13.20 net of tax and 7.20 is escrowed. The rule is e ≥ 1 − t, and every euro won on the tax clause lands uncollateralised.
What a co-investment programme actually saves37 basis points, and a 22.8 per cent total-loss rate erases it. At the usual per-deal cap a single failure is 37 per cent of the annual cohort.
What a diligence exercise actually recoversEighteen basis points is only the part that reaches the yield. Three of the four instruments never do, and the exercise is worth thirty-one.
What a follow-on reserve is actually worth0.019 turns under plain dilution, 0.285 under pay-to-play. The optimum is a property of the shareholders’ agreement, not of the portfolio.
What a lease mark-to-market is actually worth5,788,000 becomes 807,365 once the over-market stream, the expiry dates and the cost of re-letting are priced — and nothing at all below a 43.7 per cent renewal rate.
What a minimum payment actually does£81.53 leaves the account and £20.46 reaches the debt. On minimums alone the set clears in 258 months and repays 1.78 times what was borrowed.
What a month of delay costs in an enforcement463,000 euros of present value a month. No single error about enforcement, and no pair of errors, moves the indifference point from 58.7 cents to the 72 on the table.
What a pro rata cheque actually costsDefending costs 1.25 times the initial cheque across two rounds, not more in each — and below a 521 exit the follow-on dollars come back worth less than they cost.
What a subscription line does to the IRR20 per cent becomes 38.41 on the same asset while the multiple falls. Two dollars of interest buys 18.4 points, and the longer the line runs the cheaper each point gets.
What one point of fees actually costsOne point on the annual charge turns 738,846 into 567,961 over forty years — 23 per cent of the pot, and 2.43 of wealth lost per 1 of fee.
When the promote stops clearingCarried interest is not proportional to performance near the hurdle. It is a step function, and $2m of headroom is what stands between a promote and none.
Why a secondaries bid-ask gap has no zoneThe seller’s floor and the buyer’s ceiling are one formula at two rates. At equal required returns the zone is exactly zero — here it is 11.02 points apart.
Why refining a due diligence rubric makes it weakerThree of twelve managers carry a terminal flaw and the average approves all three. Splitting eight domains into sixteen makes it easier to hide, not harder.
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