March 2016 • Representations and warranties about the  loan portfolio made by the seller (and the terms of any repurchase obligation and other remedies in the event of a breach of such representations and warranties) will need to be robust enough to give comfort to the investing fund about the loan portfolio because the fund, as a borrower under a loan facility or the issuer of securitisation securities, will itself need to make representations and warranties about the loan portfolio. Leverage and first child as collateral Use of leverage to increase the returns on a fund’s investment in marketplace loans may be important to attract investors to the fund. Although the number of banks willing to provide loan facilities collateralised by marketplace loans is increasing, most of the lenders currently operating in this space will require a substantial collateral package and conservative borrowing base tests. It is not unusual for such lenders to require the fund to pledge all of its assets to collateralise the loan and require the principals of the investment manager to provide personal indemnities with respect to certain willful breaches made by the borrower or the investment manager. More than one manager has said (in jest, we believe) that some lenders exclude the principals’ first born children from the collateral package only because of potential UCC perfection issues. It is also not unusual for such lenders to require that 100% of cash collections from the loan portfolio be used to pay down fees, interest and outstanding principal under the loan facility. This means that the fund must rely on its ability to borrow from the loan facility to meet all obligations, such as paying the fund’s operating expenses and meeting investors’ withdrawal requests. In light of the lender-friendly loan terms, the investment manager may wish to hold a marketplace loan portfolio through a wholly- 2 owned subsidiary and restrict the reach of the lender lending against that portfolio to the assets of that subsidiary. Securitisation of marketplace lending portfolios With several rated transactions consummated in 2015, the securitisation of marketplace lending assets is becoming a critical link in the broader funding environment for marketplace lenders. At the end of 2015, total issuances stood at nearly $45 billion, with consumer loans and student loans comprising the bulk of the securitised assets.

To date, securitisation of marketplace loans has been limited to loans originated through a handful of the top platforms, but as the asset class is better understood and other originators mature and establish longer performance records, the securitisation of marketplace loans is expected to grow. Despite the optimistic forecasts for future growth, there are issues that, if left unaddressed, may limit the demand in the securitisation market for marketplace loans. The start of 2016 saw the first downgrade of certain tranches of marketplace lending securitisations, primarily due to an uptick in defaults on unsecured consumer loans. In response, some marketplace lenders have increased rates charged to borrowers. Proper, a leading marketplace lender active in unsecured consumer loans, has increased rates to certain borrowers by as much as 140 basis points. Another challenge is the fact that some originators may not be prepared to provide the full set of representations and warranties found in asset backed securitisations (such as representations and warranties concerning credit quality, origination and servicing). While certain originators have met the demand for traditional ABS representations and warranties, others have resisted.

Whether the resistance will last or whether the market will come to accept the underlying underwriting performed by the originators and the related servicing with a more modest set of representations and warranties remains to be seen. Tax challenges A non-US investor investing in a fund that invests in marketplace loans will typically be concerned about investments that could potentially generate effectively connected income from a US trade or business (ECI). The investment manager will need to consult with the fund’s tax counsel and accountants to analyse the loan origination process of each platform and the fund’s loan purchase process for each platform to determine if the fund’s investment in the marketplace loans create ECI issues. Depending on the results of this analysis, careful structuring of the investment process and appropriate disclosure of ECI risks in the offering materials will be needed to minimise both ECI risks and the fund’s disclosure liability. ECI is just one of several issues that an investment manager will need to address. Depending on the fund’s structure, the manager of the fund will need to address other tax issues, such as potential phantom income and related PFIC issues. Investing in marketplace loans is not something that can be done casually.

The investment manager must not only conduct substantial diligence on the platform and its sponsor but also carefully consider certain important issues, many of which are discussed above. THFJ A BO UT TH E AUTH ORS Joseph Suh and Thomas R. Weinberger are partners in the Structured Finance & Derivatives Group at Schulte Roth & Zabel LLP (SRZ).

SRZ is a full-service law firm that represents leading investment managers in connection with investments in marketplace loan products. .