Wealth Systems: Direct Lending, Part I
The Oldest Wealth Engine
One of the classic wealth building activities is lending.
It can be an incredibly powerful wealth engine, but like every other financial activity it does not come without risk.
Let’s explore how a Direct Lending wealth engine works.
Assuming you close a new loan every 90-days, you create 4 layered income streams per year.
Important Side Note:
Technically, the return of principal vs the interest you receive are taxed differently and need to be treated differently… but that’s more advanced material, and we will always rely on CPAs and tax professionals for those tactical essentials - let’s stay at 30,000 feet.
Fast forward 18-months and you have 6 active repayment income streams.
Suddenly your first principal is returned, and you can re-invest that back into your engine — increasing capital risk, but also creating more surface area for further principal repayment + collected interest.
It can be an incredible feeling getting this engine moving.
Let’s explore the history of this activity, and then look at some of the high-level mechanics of making these loans.
The History of Private Direct Lending
Direct Lending as a formalized investment practice evolved over centuries, with significant contributions from influential financial families like the Medici and Morgans. Their activities, though not always labeled "direct lending" in contemporary terms, laid the groundwork for modern private lending practices.
The Medici Family (15th-18th Century)
The Medici family, a powerful and influential dynasty in Renaissance Italy, played a pivotal role in the development of modern banking practices, which are foundational to direct lending.
Banking Innovations: The Medici Bank, established in the 15th century, was one of the most respected and successful banks in Europe. They introduced innovative banking practices, such as double-entry bookkeeping, which improved the accuracy and reliability of financial records.
International Financing: The Medici were known for their international financial dealings, providing loans to various governments and monarchs across Europe. This can be seen as an early form of direct lending, where they bypassed traditional intermediaries to deal directly with borrowers.
Influence on Trade and Commerce: Their financial support significantly influenced trade and commerce, facilitating cross-border transactions and providing capital for various ventures, similar to how direct lending supports businesses today.
I write about the Medici in deeper detail here.
The Morgan Family (19th-20th Century)
Fast forward to the 19th and 20th centuries, the Morgan family in the United States, particularly J.P. Morgan, played a similar influential role in the development of modern financial practices related to direct lending.
Industrial Financing: J.P. Morgan and his banking institutions were instrumental in financing the industrialization of America. They provided direct loans and investments to key industries, such as railroads and steel, much like direct lenders provide capital to businesses today.
Corporate Restructuring and Private Banking: Morgan was known for restructuring corporations and stabilizing financial markets during crises. This involved direct negotiations and financial arrangements with businesses, akin to modern direct lending practices.
Influence on Banking Regulations: The activities of the Morgans, particularly during financial crises, led to significant banking reforms and regulations. Their influence helped shape the modern financial landscape, within which direct lending operates today.
This is a closer look at the financial foundations of the Morgan Dynasty.
Families like the Medici and the Morgans made loans for multiple reasons, including risk mitigation and earning a return. Their lending practices were strategic, aligning with broader goals of wealth accumulation, political influence, and economic impact.
Medici Family Financial Objectives
Profit and Wealth Accumulation: The primary motivation for the Medicis' lending activities was profit. By lending money at interest, they accumulated vast wealth, which was a standard practice in banking at the time.
Political and Social Influence: Their financial power translated into political influence. By lending money to monarchs and governments, the Medici could secure political favors, titles, and influence policies. This aspect of their lending practice went beyond mere financial return.
Cultural and Artistic Patronage: Part of their wealth was used to patronize arts and culture in Renaissance Florence, enhancing their social status and legacy. This was not directly a risk mitigation strategy but a long-term investment in social capital and legacy building.
Diversification and Risk Management: Through international lending and involvement in various commercial ventures, the Medici diversified their risk. Lending to different entities in different regions mitigated the risk of financial collapse tied to any single borrower or region.
The Medici were actively funding dozens of artists, and more than one army.
They were also closely tied with the Vatican and made significant financial contributions to the Catholic Church that required significant resources.
Morgan Family Financial Objectives
Earning Returns: The Morgans, particularly during the era of J.P. Morgan, focused heavily on earning returns through their lending and investment activities. This included financing major industrial projects and corporations.
Economic Stability and Control: J.P. Morgan's interventions in financial markets during crises were partly to stabilize the economy, which indirectly protected his own financial interests. For instance, his actions during the Panic of 1907 were crucial in stabilizing the banking system.
Influence in Corporate America: Lending and financial restructuring gave the Morgans significant control over major industries. This control was not just for profit but also for shaping the industrial landscape of America.
Risk Mitigation through Diversification: Similar to the Medicis, the Morgans diversified their investments across industries and companies, reducing the risk inherent in lending and investment.
Their lending practices were carefully designed to balance profit-making with risk management, often achieved through diversification and strategic investments in various sectors and regions.
Now let’s unpack how these deals are structured and closed.
How The Deals Are Done
There are “handshake” deals.
I have made precious few of them, and despite my ignorance they have always worked out. I would not advise lending money, exposing balance sheet, risking resources of any kind without steadfast agreements.
Let’s discuss some of those mechanics and key terminology.
Incorporating security mechanisms into a loan agreement is crucial for mitigating risk and ensuring repayment.
Here are five effective security mechanisms:
Collateral: Collateral is an asset pledged by the borrower to secure the loan. If the borrower defaults, the lender has the right to seize the collateral. This could include real estate, equipment, inventory, or other valuable assets.
Personal Guarantee: This involves having a third party, often someone with a strong financial background, guarantee the loan. If the borrower defaults, the guarantor is held responsible for repayment. This adds an extra layer of security if elements of the underlying business activity are uncertain but the principal is established.
Covenants: These are terms and conditions in the loan agreement that the borrower must adhere to. They can include financial covenants (like maintaining certain financial ratios) and non-financial covenants (like not taking on additional debt). Breaching these can result in penalties or immediate repayment.
Escrow Accounts: For specific types of loans (like construction loans), setting up an escrow account can be effective. Funds are released from this account as certain milestones are achieved, ensuring that the loan proceeds are used as intended.
Seniority Clauses: Including a clause that prioritizes the repayment of this loan over other debts in case of default or bankruptcy can provide additional security. This makes the loan a 'senior debt,' reducing risk for the lender.
Each of these mechanisms serves to protect the lender's interests and increases the likelihood of loan repayment.
I typically layer these together to tier protection and enhance security.
Covenants in a loan agreement are specific conditions or clauses that the borrower must comply with.
Here are several covenants that can be particularly effective in increasing the security of a loan:
Debt-to-Equity Ratio Covenant: This requires the borrower to maintain a certain ratio of debt to equity. It ensures that the borrower doesn't become overly leveraged, maintaining a healthy balance between borrowed funds and their own investment in the business.
Interest Coverage Ratio Covenant: This covenant requires the borrower to maintain a minimum ratio of earnings to interest expenses. It ensures that the borrower generates enough earnings to cover interest payments, reducing the risk of default.
Dividend Restriction Covenant: Limits or prohibits the payment of dividends to shareholders until the loan is paid off. This ensures that cash is retained in the business for operations and loan repayment, rather than being distributed to shareholders.
Capital Expenditure Limitations: These covenants limit the amount the borrower can spend on capital expenditures without the lender's consent. It prevents the company from making large investments that could jeopardize its ability to repay the loan.
Cross-Default Covenant: This clause states that a default on any other loan or credit agreement constitutes a default on this loan. This encourages the borrower to maintain good standing on all debts, reducing risk for the lender.
Insurance Requirements: The borrower is required to maintain adequate insurance (like property, liability, or business interruption insurance). This protects the lender's interest in the collateral and ensures business continuity in case of unforeseen events.
Financial Reporting Requirements: The borrower must regularly provide detailed financial statements and other relevant financial information. This allows the lender to monitor the borrower's financial health and intervene early if there are signs of trouble.
Covenants are the key to an effective agreement.
They play a key role in managing risk and enhancing security for the lender. You should utilize them in conjunction with each other.
Look Ahead to Part II
The first step is always establishing a vocabulary and broader contextual understanding.
In Part II we’re going to build on the concept of Covenants by looking at more unconventional methods of risk mitigation + upside creation, such as:
Revenue Participation
IP Pledge
AR Financing
Inventory Financing
… and more
Then we’re going to discuss several critical due diligence concepts and practices so you can scan opportunities appropriately.
Ultimately in Part III we’re going tie this together and look at sample Loan Agreements and discuss other considerations before considering activating this wealth engine.
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