Carvana : 101 – Explainer on Recent Refinancing Transactions

Carvana 101 - Explainer on Recent Refinancing Transactions

On December 28, 2018 we announced the completion of our second refinancing transaction, and since then we have received several questions from analysts and investors about these transactions and our financing platform in general. The goal of this document is to provide answers to those questions as clearly as possible.

The main takeaway is that while the refinancing transactions are new to Carvana, similar transactions are becoming increasingly common in the FinTech world, and we believe they represent a highly effective and sustainable step forward in Carvana's finance receivable monetization strategy.

The key to the refinancing transactions is the lower cost of funds available when loans are funded as a fixed pool rather than under an ongoing purchase or "forward flow" commitment. Several important differences between funding a fixed pool of loans and funding loans under a forward flow commitment are summarized in the table below.

Two Types of Loan Sales: Comparison of Typical Features*

Sale of Fixed Pool of Loans	Forward Flow Commitment
Collateral attributes	Fixed	May change as new loans are sold
Funding commitment	One‐time	Ongoing commitment
Rating agency treatment	More favorable	Less favorable
Debt advance rate	Typically higher	Typically lower
Spread between debt interest rate and common benchmarks	Typically lower	Typically higher

*Notes: Rating agency treatment, debt advance rate, and spread between debt interest rate and common benchmarks comparisons assume all other factors are held constant and are based on our understanding of typical patterns in the industry. Any individual transaction may be different based on specific market conditions, deal characteristics, and other factors. One‐time funding commitments may include a short prefunding period.

Since December 2016, Carvana has sold the loans it originates on its website through two primary channels: whole loan sales to Ally under a Master Purchase and Sale Agreement (MPSA) and whole loan sales to a trust under a Master Transfer Agreement (MTA). Both of these channels represent forward flow commitments to purchase loans from Carvana on an ongoing basis.

Sales of fixed pools of loans afford several benefits over sales of loans under a forward flow commitment. The first benefit is that fixed pools of loans have fixed collateral attributes (i.e., loan characteristics such as credit score, LTV, geography, vehicle age, etc.) rather than attributes that may change over time as additional loans are added to the pool. The fixed collateral attributes increase cash flow predictability,and therefore rating agencies and funders of the pool expect less variance. All else being equal, reduced risk and variance lower the cost of funds and increase the value of the pool.

1. Comparison to Existing Models

The refinancing transactions completed in Q3 and Q4 were modeled after similar refinancing transactions completed by both public and private FinTech companies. These transactions seek to benefit from the lower cost of funds associated with fixed pool financing, while also leveraging the strengths of the FinTech model.

In general, there are multiple models utilized by consumer loan originators to capture the benefits of fixed pool financing. Three such models are summarized in the table below.

Three Models for Capturing Fixed Pool Financing Efficiencies*

Model 1	Model 2	Model 3
Warehouse and securitize	Whole loan sales with assumption of future fixed pool financing built into initial price	Whole loan sales with additional revenue if originator arranges fixed pool financing
Initial sale price	N/A	Higher	Lower
Revenue opportunity after initial sale	N/A	No	Yes
More efficient financing available on fixed pool	Yes	Yes	Yes
Originator holds loans before fixed pool financing	Yes	No	No
Fixed pool financing is a securitization	Yes	Optional	Optional
Example usage	Traditional finance companies	Both	FinTech Companies

*Notes: Initial sale price, revenue opportunity after initial sale, and more efficient financing available on fixed pool assume all other factors are held constant and are based on our understanding of typical patterns in the industry. Any individual transaction may be different based on specific market conditions, deal characteristics, and other factors.

The most common approach for traditional automotive finance companies is the warehouse and securitize model. In the warehouse and securitize model, finance companies aggregate loans on their balance sheet using a warehouse line of credit for a period of time before executing a securitization transaction with a fixed pool of loans to pay down the warehouse line and replace it with lower cost debt. Traditional finance companies typically have a single focus business model and sufficiently low cost of capital to make the warehouse and securitize model attractive to them and their investors.

A second approach used by traditional finance companies and others is to sell loans on an ongoing basis to an investor who expects to execute a fixed pool loan sale or securitization at some point in the future. In these cases, the originator may partially monetize the benefits of the future more efficient fixed pool financing by earning a higher initial purchase price that embeds the assumption of future cost of funds improvements.

A third approach increasingly used by FinTech companies is to sell loans on an ongoing basis, and then, provided market conditions allow it, arrange more efficient fixed pool financing on behalf of investors and earn revenue from their unique position as the originator.

The third approach is attractive to FinTech companies in part due to the specific characteristics of their business models. Specifically, many FinTech companies, including Carvana, combine a rapidly growing technology business with the origination of consumer loan assets. Typically, the rapidly growing technology business targets a much different investor base and faces a higher cost of capital than the consumer loan assets. Loan sales to buyers who conduct significant due diligence on the assets before purchasing them is a more efficient capital structure strategy which ensures that multiple investor bases, each with their own expertise, can invest in the company's assets and earn the expected rates of return that suit them.

2. The Q3 Refinancing Transaction

How did Carvana come up with the idea for these refinancing transactions?

Lowering the cost of funds for our customers' loans is part of our long‐term business plan. As part of that plan, we frequently engage numerous legal and financial experts with significant experience in consumer finance transactions. The legal team who assisted with our refinancing transaction has worked with numerous FinTech companies and other originators, including Affirm, Avant, CarMax, and Ally and with investors participating in loans from FinTech companies such as LendingClub, SoFi, and Funding Circle.

As with other FinTech companies, our refinancing transactions leverage our unique position as the originator of very high quality loans on our platform to lower the cost of funding our customers' loans.

When did the process of facilitating the first refinancing transaction begin?

We began exploring the option of a fixed pool financing transaction in the second half of 2017, received initial senior debt terms around the end of 2017, and hosted multiple due diligence visits at our home office over the first half of 2018 before completing our first transaction on August 7, 2018. Given that this was our first refinancing transaction, it required a significant amount of initial legal and financial legwork as well as due diligence from various parties.

How did the Q3 2018 refinancing transaction work?

The net result of the Q3 2018 refinancing transaction was a transfer of loans from a forward flow trust (defined below) with less efficient financing to a fixed pool trust with more efficient financing.

To execute the transaction, Carvana identified a senior debt provider with an interest in funding fixed pools of loans and assisted the senior debt provider and an independent rating agency with due diligence. The significantly lower cost of the new senior debt allowed the forward flow trust's certificate purchaser to earn a higher rate of return and for Carvana to earn a fee. Once all terms were agreed to, Carvana facilitated the transfer of loans from the forward flow trust to the new fixed pool trust. Carvana primarily earned its fee for arranging the more efficient senior debt financing, not for executing the operational mechanics of the transaction.

Which party sold the fixed pool of loans in the Q3 refinancing transaction?

The seller of the loans in the refinancing transaction was a trust called Sonoran Auto Receivables Trust 2017‐1 (the "forward flow trust"), which was created in conjunction with our increased forward flow commitment completed in November 2017. This trust purchases loans on an ongoing basis under the MTA and is funded on an ongoing basis by Ally and a certificate purchaser that provides the remaining funds.

Which party purchased the fixed pool of loans in the Q3 refinancing transaction?

The purchaser of loans in the refinancing transaction was a new trust called Sonoran Auto Receivables Trust 2017‐1 Term (the "fixed pool trust"), which was created in conjunction with the refinancing transaction. The trust was funded by a new senior debt provider and the same certificate purchaser who purchased the certificate in the forward flow trust.

Who initiated the refinancing transaction?

As part of our long‐term financing plan, we are frequently in contact with financial institutions who have an interest in funding consumer auto loans. In the case of our Q3 and Q4 refinancing transactions, we identified a large asset manager interested in offering senior debt financing on a fixed pool of loans at terms that were significantly better than those available to the forward flow trust. We approached the certificate purchaser in the forward flow trust to determine whether they would be interested in purchasing certificates in a new trust with better senior debt financing and higher yielding certificates, and the certificate purchaser agreed.

Why doesn't the certificate purchaser arrange its own refinancing?

Financial institutions who fund consumer auto loans typically do a substantial amount of due diligence on loan pools and their originators before funding. As originator of the loans sold under the MTA, Carvana is uniquely positioned to assist financial institutions, independent rating agencies, and other parties with due diligence, which may include a detailed review of data, technology, and operations.

How are the financing terms in the refinancing transaction determined?

The terms of the refinancing transactions are determined based on a detailed process involving several parties. The process begins with an independent rating agency using historical loan performance data and its domain expertise to develop a base case cumulative net loss estimate, which can then be used to estimate future loan cash flows under various scenarios. The output of this rating agency analysis informs the advance rate offered by the senior debt provider. The interest rate on the senior debt and requiredrate of return on the certificate is informed by market data on similar assets provided by investment banks, adjusted as the parties see fit for perceived differences in risk, liquidity, originator maturity, or other factors.

3. The Q4 Refinancing Transaction

What were the differences between the Q4 2018 and Q3 2018 refinancing transactions?

The Q4 and Q3 refinancing transactions had a very similar structure, with one primary difference. In the Q3 transaction, all loans sold to the new fixed pool trust were purchased from the forward flow trust that originally acquired them under the MTA and immediately resold to the new fixed pool trust. In the Q4 transaction, two types of loans were sold to the new fixed pool trust. The first type was purchased from the forward flow trust that originally acquired them under the MTA and immediately resold to the new fixed pool trust, as in the Q3 transaction. The second type consisted of newly originated loans that were sold to the new fixed pool trust prior to being sold to any other purchaser.

In total, the new senior debt provider funded $449 million to the new fixed pool trusts for them to purchase loans, with the remainder funded by the certificate purchaser. Additional details on the two fixed pool trusts are provided in the table below.

Comparison of Q3 and Q4 Transactions

Q3 2018 Refinancing Transaction	Q4 2018 Refinancing Transaction
Primary origination date range of fixed pool of loans	Nov 2017 - July 2018	July 2018 - Dec 2018
Purchase and sale price of fixed pool of loans that had previously been sold under MTA	$253.0M	$134.4M
Carvana refinancing fee	$4.0M	$2.3M
Principal balance of loans sold to fixed pool trust that had never previously been sold	N/A	$115.2M*

*Includes $97.8M in principal sold on the date of the refinancing and $17.4M in principal sold shortly thereafter at the end of a short prefunding period