Borrower refinanced in month 14 and my annualized return came in under 5%

Posting this because I did the modeling carefully and still ended up with the wrong answer, and the mistake was in the structure rather than the math.

I bought a partial rather than a whole note. For anyone who hasn't seen one, the seller keeps the note and sells you a defined slice of the payment stream, in my case the next 84 payments of 612. I paid 34,900 for that, which the seller quoted as an 11% yield. Underlying was a performing first, UPB 79,400, coupon 8%, 51 months of clean history, BPO 138,000, so 58% ITV. The collateral was genuinely good and I spent real money confirming it, 1,450 all in on the collateral review, a drive-by valuation and my own attorney reading the participation agreement.

The agreement said what these usually say. On a payoff, I'm entitled to my remaining discounted balance calculated at my stated yield, and the seller takes everything above that as the back-end holder. I read that clause. My attorney flagged it. I decided it was fine because the borrower had 51 months of history at 8% and I assumed the loan would run for years.

Borrower refinanced in month 14. Rate environment moved, he had equity, he did the obvious thing. I received 14 payments of 612 and then a check for my remaining amortized balance. Total return over the 14 months worked out to about 4,480 of interest, which is the 11% I was promised. Take out the 1,450 of diligence and I netted 3,030.

Then the money sat. It took me seven months to find the next thing I actually wanted, so the 34,900 was committed or idle for 21 months to produce 3,030. That's about 4.7% annualized on the capital, on a deal I underwrote as an 11% deal and put roughly 50 hours into.

What I'd do differently. I'd have negotiated a minimum return period into the participation agreement, meaning if the loan pays off before month 36 I receive interest as if it had run to 36, or a flat prepayment fee to the partial holder. Sellers of partials will discuss this and I didn't ask because I didn't want to look difficult. I'd also model every note at a three-year average life rather than to maturity, because a performing borrower with equity and a payment history is exactly the borrower who can refinance. And I'd stop treating fixed diligence cost as a rounding error on a 35,000 position, since 1,450 is over 4 points before I've earned anything.

The underwriting on the collateral was fine. I bought a duration I didn't have.