Methodology: Where's the yield coming from?

High yields in DeFi often raise eyebrows. Luckily, in schUSD's case, you are not the yield. Alpha is generated from professionally audited, SEC regulated, lending, risk management and due diligence work executed by the Covenant VC team. Covenant VC's managers use scientific and time tested methods to optimize portfolio returns while minimizing downside risk.

A track record of outperformance since 2011

The Covenant team is part of a 500M institutional loan syndicate that has delivered exceptional deal flow and returns, ranging from 18.65% during Covid 19 pandemic lows, to 21.7% between 2011 to 2022. For Chateau's portfolio, Covenant will deploy funds to select loans from this portfolio, employing their scientific method of: 1. Selecting loans with mispriced risk, 2. Maintaining a hyperdiversified portfolio, 3. Employing rigorous risk mitigation methods to achieve high sharpe returns. Chateau's portfolio returned 33% in 2024.

scUSD's exceptional returns are driven by 3 main factors:

1. Mispriced Risk

• Small business loans in the loan syndicate schUSD sources from average 36% gross return, and have a historical default rate ranging from 5% to 8% from 2011 - 2022. Yield/Default = 4.5x (higher is better)

• By comparison, credit card portfolios currently average about 23% gross return with a historical default rate ranging from 1.5% to 6.8%. Current Yield/Default 7.6x

• Similarly, sub-prime auto portfolios have average return of 16% with default rates ranging from 2.8% to 6.05%. Current Yield/Default = 2.64

• Risk is measured in terms of interest rates. Higher interest rates are the investor's reward for bearing a higher risk.

• Mispriced Risk is a concept where the correlation between risk (default events) and interest rate diverge to the benefit of the lender. An example would be a bond that pays a high yield such as a junk bond yield, while having a AAA investment grade rating.

• However, Market perception is that small company loans are riskier than larger company loans

• Leverage is 4X more relevant to predicting loan default than company size according to Moody's

2. Hyper Diversification

In the illustrative graph below depicting the trajectories of individual portfolio positions, an n=10 positions is insufficient to understand overall portfolio behavior. In contrast, with hyper-diversification we target an n=100+ which increases reliability

E is the overall portfolio expected return while X is the distribution from which each individual portfolio position is sampled from, namely, xi . In this way we track our portfolios both on a micro and macro level.

3. Risk Mitigation

Risk Management

Covenant employs comprehensive risk management strategies that deliver high sharpe returns

1. Maximum Concentration: No loan can be more than 10% of the fund or 1% of a side account. Each portfolio is comprised of a minimum of 50 loans participations.

2. Security UCC 1 filings on all company cash flow, accounts receivable, and unencumbered assets.

3. Personal guarantees 80% of loans are backed by personal guarantees of the owner. Guarantors must have minimum 650 credit score.

4. Minority participant: Covenant never invests more than 20% of the principal of a loan.

🔐 Risk Mitigation in Credit Investing

Covenant VC follows a multi-phase process to underwrite, structure, and monitor credit investments. This framework is designed to reduce default risk, ensure accurate documentation, and maintain strong financial controls throughout the lifecycle of each loan.

📋 Summary of Phases

Phase 1: Initial Sourcing and Screening

• Loans are sourced internally and via syndicate partners

• Borrowers are logged, tracked, and monitored over time

Phase 2: Preliminary Information & Indicative Terms

• Collection of borrower data: financials, credit profiles, social signals

• Daily review of loan files

• Preliminary, non-binding interest issued with indicative terms and participation levels

Phase 3: Due Diligence & Documentation

• Deep underwriting, financial ratio analysis, borrower interviews

• Verification of bank accounts and legal structures

• Personal guarantees documented; legal review of agreements completed

Phase 4: Funding and Monitoring

• Loan documents are managed in proprietary systems

• Direct debits established for repayment

• Loan performance monitored daily; net asset values (NAVs) updated quarterly