This article is a work in progress. If you have any questions, thoughts, or corrections, contact us.

Common mistakes and how to avoid them

Top capital provider mistakes

status: draft

Top capital provider mistakes

Ten mistakes that cost capital providers returns, time, and portfolio quality. Every item here represents a pattern observed across multiple deals that went wrong.

The common thread: assumptions that were never tested, diligence that was skipped because the asset class thesis was compelling, and structures that worked in the base case but broke in stress.

status: draft

1. Falling in love with the asset class and ignoring the originator

The mistake: Deploying based on an asset class thesis without equivalent rigor on the originator.

What it looks like in practice:

A credit fund with a strong view on the consumer credit cycle deploys into a consumer lending originator because the asset class thesis is compelling. The collateral analytics look excellent: strong static pools, reasonable advance rate, attractive spread.

The diligence on the originator is lighter. Management seems capable in meetings. The CEO’s prior company failure is noted but rationalized. The servicing operation is outsourced to a third party with no contractual obligation to continue post-acquisition.

Eighteen months later, the originator hits a growth wall. The CEO departs. The fund discovers their collateral is being serviced by an entity with no economic incentive to perform, and the backup servicer hasn’t been adequately warmed up. Loss rates exceed projections by 40%.

The portfolio-level cost:

  • Loss rates 30-50% above modeled expectations
  • Workout costs of $200K+ as servicing transitions
  • Staff time equivalent to 0.5-1.0 FTE for 12-18 months managing the situation
  • Reputational damage if the situation requires disclosure to LPs

Warning signs you’re making this mistake:

  • Your IC memo has 10 pages on collateral and 2 pages on the originator
  • Reference checks consist of LinkedIn reviews, not phone calls
  • You’ve never visited the originator’s operations
  • “Key person” risk is noted but not quantified or mitigated

How to fix it:

Apply equal weight to originator diligence and collateral diligence. Build a two-track IC process that requires both to pass independently.

Originator diligence non-negotiables:

  • Reference checks on key management (call former employers and investors, not just LinkedIn review)
  • Review of prior business history with specific attention to failures and departures
  • Visit the physical operations before committing significant capital
  • Assessment of servicing infrastructure and backup servicer readiness

Assess the “key person” question directly: who are the 2-3 people without whom the originator does not function? What do your documents say if they leave? What happens to your collateral?

status: draft

2. Setting triggers too tight

The mistake: Calibrating triggers to historical averages instead of historical peaks.

What it looks like in practice:

You set a delinquency trigger at 4% (30+ day DQ rate) for a consumer installment originator whose historical 30+ DQ rate has averaged 3.5% with seasonal peaks to 4.8% in Q1. The deal trips the trigger in February of its first full year, trapping excess spread and forcing sequential pay. The originator’s business plan breaks.

The portfolio-level cost:

  • A distressed situation on a deal that was performing within historical norms
  • Amendment to reset the trigger costs 4-6 weeks and $50K in fees
  • The originator is damaged financially and operationally
  • The relationship becomes adversarial
  • Future deals with this originator (or their referrals) are unlikely

Warning signs you’re making this mistake:

  • Your triggers are set at historical average performance
  • You haven’t analyzed seasonal patterns in the originator’s data
  • You’re using spot triggers instead of rolling averages
  • You haven’t stress-tested what happens when triggers trip

How to fix it:

Set triggers at historical peak plus a buffer, not at historical average. If historical peak 30+ DQ is 4.8%, set your trigger at 6.0-6.5%.

Build in seasonal buffers: if Q1 DQ historically runs 100-150 bps above the annual average, set your trigger to accommodate Q1 seasonality.

Include a rolling average option: a 3-month rolling average DQ trigger is less prone to seasonal volatility than a spot trigger.

Formula: trigger = historical 5-year peak DQ rate + 150-200 bps buffer.

Before closing, run a scenario where the trigger trips. What happens to the structure? Does the deal still work? Is early amortization triggered, or just cash trapping? Make sure you understand and can live with the consequences.

status: draft

3. Not stress-testing to maturity

The mistake: Running stress scenarios only through the early portion of the facility term.

What it looks like in practice:

You model a 3-year warehouse through 18 months in your base and stress cases. The deal looks fine. You don’t run the stress case out to month 36, missing that in the down scenario, the OC test breaks at month 24, triggering a rapid amortization event the portfolio team is unprepared for.

When the stress scenario actually materializes, you’re caught off guard. The workout requires resources you hadn’t allocated and generates losses you hadn’t reserved for.

The portfolio-level cost:

  • An unanticipated workout situation in a facility the team thought was performing
  • Additional staff time for 12-18 months
  • Potential loss on recovery beyond what was modeled
  • LP communication challenges if the situation wasn’t disclosed as a risk

Warning signs you’re making this mistake:

  • Your cash flow models don’t extend to legal final maturity
  • Your stress scenarios only run for 18-24 months
  • You don’t model originator operational stress (just collateral stress)
  • You haven’t asked “when does this deal break and how bad does it get?”

How to fix it:

All cash flow models must run to legal final maturity, not just expected maturity.

Your stress scenario must include:

  1. A 6-month ramp period where originations are 50% below plan
  2. Loss rates 2x the base case for 24 months
  3. Originator operational stress (servicing deterioration, coverage ratio breach)

At IC, the question to answer is: in the down scenario, what happens to the facility month by month through maturity? When does it go wrong and how bad does it get?

Build a “walk away” analysis: at what point in the stress scenario do you stop funding and let the deal amortize? What’s your recovery value at that point?

status: draft

4. Insufficient diligence on servicing operations

The mistake: Spending 80% of diligence time on collateral analytics and 20% on servicing.

What it looks like in practice:

You deploy $75M into an auto originator with strong static pool data. The collateral analysis is thorough: vintage curves, roll rates, recovery analysis.

You don’t visit the collections floor. You don’t test the servicing system’s ability to produce required monthly reports. You conduct a single call with the servicing manager.

Post-close, report quality is poor and delinquency deteriorates faster than the data suggested it should. Collections performance is 15-20% below what the tape implied.

The portfolio-level cost:

  • Collections underperformance contributing to 30-40 bps of incremental loss
  • On a $75M portfolio, that’s $225K-$300K in additional losses
  • Cost of hiring a backup servicer and potentially transitioning servicing
  • Staff time managing the servicing relationship

Warning signs you’re making this mistake:

  • You’ve never visited the originator’s collections operation
  • You can’t describe the collections workflow from first contact to charge-off
  • You haven’t tested your ability to replicate their servicer report calculations
  • You don’t know the backup servicer’s actual readiness level

How to fix it:

Conduct an operational site visit for every deal above $25M. Spend at least a half-day on the collections and customer service floor. Talk to the people who actually do the work, not just the executives.

Request three months of historical servicer reports and test your ability to replicate their calculations from the raw data. If you can’t reconcile, that’s a problem that must be resolved before closing.

Test the backup servicer engagement. Call the backup servicer directly and ask how ready they are to take over. Ask for their most recent readiness review. Ask what they would need from you to begin servicing within 30 days.

For every deal, know: who actually calls delinquent borrowers? What happens at 15, 30, 60, 90 days? How are charge-off decisions made? What recovery channels exist?

status: draft

5. Underestimating workout costs

The mistake: Pricing deals with credit loss reserves but no explicit workout cost reserve.

What it looks like in practice:

You price a deal with a 150 bps loss reserve in your return model. This accounts for expected credit losses but nothing else.

When the deal enters workout, you discover: workout legal costs of $200K+, portfolio management time equivalent to 0.5 FTE for 18 months, backup servicer onboarding costs of $75K, and a 12% reduction in collateral recovery value due to servicing deterioration during the transition.

The portfolio-level cost:

  • A deal modeled at 13% gross return delivers 8-9% after workout costs
  • Carry mechanics may be affected if returns fall below hurdles
  • Staff capacity consumed by workout management unavailable for new deals
  • LP communication challenges if returns significantly underperform

Warning signs you’re making this mistake:

  • Your return model includes loss reserves but no workout cost reserve
  • You haven’t priced backup servicer transition costs
  • You don’t know what workout legal representation costs
  • You haven’t modeled staff time as a cost

How to fix it:

Include an explicit workout cost reserve in your return model: minimum 50-100 bps on top of expected credit losses, more for complex structures or weak servicers.

In structuring, ensure the deal economics include enough subordination to cover not just expected losses but also workout administration costs.

Build a workout playbook before you need it:

  • Know who you’d call for workout legal representation and their hourly rates
  • Have backup servicer relationships in place across asset classes
  • Understand the mechanics of directing a trustee
  • Know what your documents allow you to do and what requires amendments

Budget workout costs at IC. Include them in the deal ROE calculation. If the deal only works because you’re ignoring potential workout costs, reconsider the deal.

status: draft

6. Over-relying on rating agency analysis

The mistake: Using the rating agency presale report as a substitute for your own cash flow model.

What it looks like in practice:

You approve a rated ABS investment based primarily on the rating agency analysis and limited independent diligence. The agency gives it an investment-grade rating with comfortable enhancement levels.

The agency’s assumptions prove optimistic on prepayment speeds. The deal’s WAL extends by 18 months and yield is significantly diluted. The rating never changes because the credit performance is fine, but the investment economics are materially worse than modeled.

The portfolio-level cost:

  • The investment delivers 9% against a 12% target on a $20M position
  • Underperformance of approximately $600K over the holding period
  • The rating never changes, so no trigger is ever pulled
  • LP reporting shows “performing” investment that underperforms

Warning signs you’re making this mistake:

  • You read the presale report but haven’t built your own model
  • You don’t know how the agency’s assumptions differ from yours
  • You’re relying on the rating as your primary risk assessment
  • You haven’t stress-tested assumptions the agency didn’t stress

How to fix it:

Use rating agency analysis as one input, not your primary analysis. Build your own model from the loan tape.

Understand how the rating agency’s assumptions differ from yours:

  • Their stress scenarios are calibrated to a rating standard (BBB survives X% losses)
  • Your return threshold is different (you need 12% IRR, not “avoid default”)
  • They focus on credit risk; you need to model prepayment risk, extension risk, and reinvestment risk

Pay particular attention to prepayment assumptions. Rating agencies often use a single CPR assumption that doesn’t capture tail scenarios. A deal that works at 15% CPR may fail at 8% or 25%.

Model the deal under your own assumptions. If your model produces a materially different outcome than the agency’s, understand why before investing.

status: draft

7. Not visiting the originator’s operations

The mistake: Closing a deal based entirely on video calls and document review.

What it looks like in practice:

You close a $50M warehouse with a student loan refinancing originator after six months of video calls. You never visit the offices. The management team is articulate on calls. The data room is comprehensive.

Post-close, you discover the “30-person team” is actually 12 people, 8 of whom are engineers. Loan origination decisions are made by 2 credit analysts with limited authority to deviate from automated underwriting. The “robust collections operation” is one person and an outsourced call center.

The portfolio-level cost:

  • In a stress scenario, the originator’s operational fragility becomes apparent
  • What seemed like a scalable operation is actually thin and highly key-person dependent
  • If one or two people leave, operations may deteriorate rapidly
  • You’ve committed $50M to an operation you didn’t actually understand

Warning signs you’re making this mistake:

  • You’ve never been to the originator’s office
  • Your understanding of headcount and operations comes from management presentations
  • You’ve never met the people who actually do the work (credit, collections, tech)
  • You haven’t observed the day-to-day operations directly

How to fix it:

Site visits are non-negotiable for any commitment above $10M. Spend at least a full day. Meet the people who actually do the work (credit, collections, technology, compliance), not just the executives.

Build a site visit template: what to observe, what to ask, what to request copies of:

  • Org chart with actual headcount, not planned headcount
  • Key system screenshots and workflow demonstrations
  • Sample loan files (randomly selected, not curated)
  • Physical observation of collections and customer service operations

Red flags during a site visit:

  • High staff turnover evident in job postings or conversations
  • IT infrastructure that looks fragile (manual processes, Excel-heavy workflows)
  • Executives who can’t answer operational questions without deferring to junior staff
  • Operations that look materially different from how they were described

status: draft

8. Pricing without understanding your own cost of capital

The mistake: Quoting spread to win a competitive deal without checking whether the deal clears your hurdle under stress.

What it looks like in practice:

Your fund quotes SOFR+275 to win a competitive deal against other capital providers. You win the deal.

When the fund controller calculates management fee drag, the LP preferred return, and the cost of the fund’s own back leverage, the deal is accretive only in the base case. Any credit deterioration destroys the return.

The portfolio-level cost:

  • You’re managing a position where the margin for error is essentially zero
  • Minor credit deterioration triggers underperformance
  • Several such deals drag the fund’s net return below its hurdle
  • Carry clawback mechanics may be triggered

Warning signs you’re making this mistake:

  • You quoted pricing without checking fund-level economics
  • You don’t know your fund’s fully loaded cost of capital
  • You’re pricing deals to win without checking if they’re worth winning
  • Your base case return barely clears the hurdle

How to fix it:

Build a fully loaded cost-of-capital calculation for every deal:

  • Cost of LP capital (return hurdle, typically 8-10% preferred)
  • Management fee drag (1-2% depending on fund structure)
  • Back leverage cost (if used)
  • Operating cost per deal (staff time, overhead allocation)

Know your minimum return threshold before going to term sheet, not after. If your hurdle is 12% net, you need 15-16% gross to cover fees and provide cushion.

Confirm the deal clears your hurdle at the stress case, not just the base case. If the deal only works in the base case, you’re not being paid for the risk.

If you’re using back leverage, model the deal both with and without it. The unlevered return should at minimum cover your cost of unlevered capital.

status: draft

9. Ignoring concentration risk at the portfolio level

The mistake: Approving individual deals without tracking correlation at the fund level.

What it looks like in practice:

You deploy into five consumer lending originators over 18 months. Each deal passes IC individually. By the time the fifth closes, 60% of the fund is in consumer credit, three of the five originators have similar credit profiles and geographic concentration, and all five have vintage exposure concentrated in 2023-2024.

A macro shift hits consumer credit broadly. All five positions stress simultaneously.

The portfolio-level cost:

  • Correlation across the portfolio causes simultaneous stress in multiple positions
  • Fund-level covenant compliance is tested
  • LP redemption requests arrive at the worst possible time
  • Diversification benefits you assumed existed don’t materialize

Warning signs you’re making this mistake:

  • You don’t track concentration at the portfolio level
  • Each deal is evaluated in isolation
  • You don’t know what percentage of the fund is in each asset class
  • You haven’t assessed correlation between positions

How to fix it:

Track concentration at the portfolio level, not just the deal level. Build a portfolio-level heatmap showing concentration by:

  • Asset class (consumer, auto, real estate, etc.)
  • Originator stage (early, growth, mature)
  • Vintage year (when were the underlying assets originated)
  • Geographic region
  • Credit tier (prime, near-prime, subprime)

Set portfolio limits before deploying:

  • No single asset class above 40% of committed capital
  • No single originator above 15%
  • No single vintage year above 30%

Review correlation assumptions annually. Similar spreads don’t mean uncorrelated performance. Consumer installment loans and consumer credit cards may have 0.7+ correlation in a downturn.

status: draft

10. Not planning for the downside scenario

The mistake: Approving deals with a base case and a stress case but no “originator ceases operations” scenario.

What it looks like in practice:

You approve a deal with a detailed base case and a stress case assuming 1.5x base losses. You don’t model a scenario where the originator ceases origination entirely and you need to manage a static, amortizing pool for 36 months while maximizing recovery.

When the originator does halt origination (CEO departure, funding gap, regulatory action), you have no playbook. You spend 8 weeks figuring out what your documents say, who has authority to direct the trustee, and what the backup servicer needs to get going. During those 8 weeks, collections deteriorate.

The portfolio-level cost:

  • Collections deteriorate during the response period
  • Recovery value declines by 10-20% due to delayed action
  • Staff time consumed by crisis response
  • Legal costs to understand your own documents

Warning signs you’re making this mistake:

  • Your stress case assumes the originator continues operating
  • You’ve never modeled a “wind-down” scenario
  • You don’t know what your documents allow you to do if the originator stops
  • You haven’t tested backup servicer readiness

How to fix it:

For every deal, write a one-page “downside scenario” document before closing:

  • If the originator stopped operations tomorrow, what happens?
  • Who does what?
  • What triggers are pulled, in what order?
  • What is the expected recovery timeline and value?

Include in the credit memo an explicit “wind-down analysis” section:

  • Estimated recovery value at various loss multiples
  • Workout cost estimate
  • Timeline from originator cessation to final recovery

Ensure your legal documents give you (or the trustee, directed by you) the authority you need to take control. Don’t discover missing rights in an emergency.

Test the wind-down scenario before closing. Call the backup servicer and confirm their readiness timeline. Know what it would cost and how long it would take.

status: draft

← All Topics