Example of how tranches work
Last updated
Last updated
As explained earlier, pools usually consist of two tranches: Junior and Senior.
Junior: first-loss capital designed to align the interests of originators with those of investors in the senior tranche. In this way, the originator has "skin in the game" because if the expected return on the senior tranche is not achieved, this will result in losses for the originator.
Senior: capital with priority for receiving returns, with fixed returns but with lower risks.
For this example, let us assume a Pool of $1 million with an expected return of 20% for the Senior tranche, a subordination of 10% and the operation lasting one year.
In this example, Senior tranche investors participate with $900,000 and Junior tranche investors participate with $100,000.
We can speculate on four scenarios:
After one year, the originator has achieved a return of 50% of the allocated capital in this example pool.
This results in the Senior tranche investors receiving their agreed upon 20% ($180,000 in this example) and the Junior tranche investors receiving the remaining profit ($320,000).
After one year, the originator has achieved a return of 18% of the allocated capital in this example pool
This results in the Senior tranche investors receiving their agreed upon 20% ($180,000 in this example) and the originator receiving no return since it was used to fulfill the senior tranche.
After one year, the originator has achieved a return of 14% of the allocated capital in this example pool
This results in the Senior tranche investors receiving their agreed upon 20% ($180,000 in this example), which would result in a loss to the originator of U$40,000 to meet the expected return on the senior tranche.
After one year, the originator has suffered a loss of 20% of the allocated capital in this example pool
This results in investors in the Senior tranche suffering a loss of 11.1% ($100,000 in this example) and a total loss of the Junior Tranche's initial capital.
Although both tranches suffered a loss in this example, the Senior Tranche's loss was only 11.1%, while the junior tranche suffered a 100% loss because its $100,000 were allocated to the Senior Tranche as a guarantee.
