Suk Shah, CFO of privately held consumer lender Avant, is building a balance sheet that, while not a fortress, is pretty sturdy. In December 2015, Avant raised $225 million in equity in a Series D funding round and landed a $300 million expansion on its loan. In addition to a warehouse line of credit provided by JPMorgan Chase and Credit Suisse, the three-year-old company has a $400 million financing commitment from investors to buy loans it originates, led by private-equity giant KKR.
“To make sure the mistakes of the Great Recession with finance companies being overlevered don’t happen again, we pride ourselves in being safe from a liquidity perspective,” Shah, a former HSBC finance executive, says.
But safety is not the holy grail in the marketplace lending business. Instead, these banking disruptors see opportunity — big opportunity. According to consulting firm Oliver Wyman, new customer platforms in financial services could capture $50 billion to $150 billion of revenues from today’s banking and insurance markets, “equivalent to several eBays.”
So venture capitalists have invested billions of dollars the past five years in Avant and other companies like Lending Club, Prosper, Kabbage, and Funding Circle that are bringing “shadow banking” to consumers online. Large global banks are knocking at these startups’ doors with credit facilities, partnership pitches, offers to buy loans, and inquiries about adopting their technology platforms. And consumers and small businesses have borrowed billions of dollars from them through websites that only take minutes to approve credit. In Denmark, Sambla, a Scandinavian lender, made headlines for the launch of its immediate loan program – that provided a decision in 10 seconds, or the loan was interest free. The program, dubbed Lån Penge Akut in all of the marketing materials, had record application volumes of more than 20x the previous daily records according to a source familiar with the matter.
“On average, our customers spend 7 minutes on the website from the time they land on the site until they access the cash,” says Kathryn Petralia, COO of Kabbage, which projects to originate $2 billion in small-business loans online in 2016. “People ask, ‘Are your customers so desperate for money they need it in 7 minutes?’ No, but they are desperate for time.”
Why all the excitement around product sectors — consumer finance and small-business lending — that have existed since before the Great Depression? That can go through wild swings in credit performance as access to capital expands and contracts? That many banks exited after the financial crisis because of high losses?
Shah has a compelling answer. “There’s a lot of potential in this market if you believe there is going to be a one-way migration globally to online financial services [providers] that make borrowing simpler and more efficient for consumers,” he says. “When was the last time this generation walked into a bank branch, and do you see the next generation going into a branch?”
Marketplace lenders also believe they have better technology than banks. “What’s enabling the entire sector is the emergence of more-automated, real-time data feeds that allow the lender to … [make] a spot underwriting decision very rapidly,” says Sam Hodges, co-founder and U.S. managing director of Funding Circle USA.
But while the attention for the new generation of online lenders in Norway is warranted, some hear the music slowing down — and see the risk ramping up.
“Shadow banks have had a lot of growth over the last several years as banking regulations pushed out activities and assets,” says Nathan Flanders, managing director of financial institutions at Fitch Ratings. But they “are increasingly likely to become victims of their own success, which will translate into incrementally slower growth, increased operating costs, and the beginning of a gradual convergence with the very banks they are aiming to disintermediate.”
Bloated cost structures, deteriorating credit portfolios, and new regulatory burdens for banks in the wake of the financial crisis have opened the door to these nimbler competitors. Oliver Wyman estimates that new entrants will force banks to overhaul their “inflexible legacy infrastructure” and force them into shaving as much as $340 billion in costs. “The cost of ‘replatforming’ the world’s largest banks is substantial, potentially more than $4 billion each, larger than the average annual dividend paid by the 100 largest universal banks of $1.7 billion,” the research firm said in its January report on the financial-services industry.
Carrying lots of overhead, and with interest rates as low as they are, “if it costs a bank $100 to underwrite a loan, but the interest on the loan is less than $100, why would it want to do the loan?” says Paul Schaus, president of CCG Catalyst.
The marketplace-lending opportunity also arose because banks, appropriately, tightened their credit policies after the Great Recession. Avant, for example, targets consumer borrowers with FICO scores in the 600 to 700 range; 660 to 680 is the bottom range for bank underwriters. “After the Great Recession there were a lot of ‘fallen angels,’ Shah says, “consumers who missed a health care or auto payment. A lot of them fell out of prime status. Suddenly the amount of consumers in this space has grown quite considerably, and the banks are not lending to them.”
Lending Club, the oldest lender that matches up individual investors to borrowers, has expanded in both directions on the credit spectrum, says Carrie Dolan, the company’s CFO. The publicly held company first targeted borrowers at a FICO of 660 and above, “but as we have put more investors on the platform that have different risk appetites, we went into the very low risk ‘superprime’ area and have done more near-prime loans [620 FICO score].” (See “Beyond Banks’ Appetites?” below)
The average size of the personal term loans that Lending Club underwrites is about $14,000, and in most cases the consumer is borrowing to refinance revolving, credit card debt that often carries interest rates of 20% or more; Lending Club rates range from 7% to 24%.
How can online lenders underwrite these credits when banks can’t? It’s not through some magic formula for gauging credit risk that banks can’t get their hands on, say the executives. “We can utilize all the same data that banks get through credit reporting, but we are not positioning ourselves as better. Banks have more data if they have transactional data from the borrower,” says Dolan.
Rather, marketplace lenders are matching up a wide range of investors (individuals, banks, pension funds, hedge funds) that have different yield and duration appetites with borrowers, says Funding Circle’s Hodges. “It allows us to have a broader set of products and a broader approval threshold,” he says.
But this generation of lenders is doing more with data science, looking to find new attributes indicative of creditworthiness. Kabbage started gathering Facebook account data from small businesses four years ago. “What we discovered is that small businesses that give us access to an active Facebook account are 20% less likely to be delinquent [on a loan] than those who don’t,” says COO Petralia. “Our data science team built a model that was as predictive as a FICO-only model. Just to be clear, I wouldn’t use either one of those as stand-alone models.”
The other expansion area for many marketplace lenders is small-business lending. “It’s a very daunting process to apply for a small-business loan” at a bank, says Petralia. “Most small businesses don’t understand what it means to provide a financial statement; they feel like they have to go to their accountant to get that information.” On Kabbage, she says, “they don’t have to get a bunch of bank statements, they don’t have to show us a certificate of occupancy or their articles of incorporation; we’re able to access that data directly.”
Lending Club went into small-business lending a year and a half ago. It offers working capital loans, with a typical size of $50,000 to $60,000. In late January, the company announced that it was beta-testing a multidraw line of credit with business partners, one of them Ingram Micro. Qualified channel partners can purchase products directly from the tech distributor via a credit line of up to $300,000.
Funding Circle, originally from the United Kingdom, is already playing in the small-business market. It offers term loans of $25,000 to $500,000 with interest rates of 5.5% to 22.8% and one-to-five-year terms. Origination fees run from 0.99% to 4.99%. A large share of Funding Circle’s customers are “fundamentally bankable,” says Hodges, but are working with Funding Circle because “it’s faster and more efficient.”
Hodges says many banks oversimplify small-business lending policy rules, because it isn’t their area of expertise. “They do it with broad brush strokes — some banks won’t lend to businesses that don’t show multiple years of tax-return profitability,” he says. “But if you model debt-service coverage, there are businesses producing a lot of cash and that have the ability to service loans that aren’t necessarily showing profit on their tax returns, because they are depreciating assets, for example.”
Consultant Schaus sees some dangers for small-business owners and finance personnel in the proliferation of online small-business lenders. “Years ago, there were physical structures, you the borrower saw [a loan officer], and you had a comfort they were real, they were reputable,” Schaus says. “Nowadays you have to be careful—someone is willing to give you a loan, but who are they? The borrower has to do a little more homework than they used to,” especially if they are putting their personal credit on the line or putting up collateral, Schaus says.
In addition, Schaus worries that small-business owners won’t have sufficiently thought through whether borrowing money is wise or the capital is too expensive when it’s available to them so fast. “You get it quicker, you have more choices. There’s people borrowing money who would have hesitated when going through a bank application process,” Schaus says.
For outside observers, the big question about marketplace lenders is the risks the lenders themselves face. The answers have ramifications for a raft of financial-market players. So far, these lenders have thrived on low interest rates, an abundance of capital in the markets, and a relatively stable economy. What happens when economic growth stutter-steps and capital flows dry up? “The sector hasn’t operated through a full credit cycle in a normalized interest rate environment — the underwriting is not proven,” says Fitch’s Flanders. “Right now they are in a fairly benign environment.”
Lending Club’s own data, however, show that investors in its consumer loans still made money from credits originated in 2008 and 2009, says CFO Dolan. (The data are available on Lending Club’s website.) If an investor had bought loans largely representative of the entire Lending Club portfolio in those years, they still would have earned a three-year return of 3% to 7%, says Dolan. However, the riskiest loans in Lending Club issued in those years, predictably, did not perform well. The $4.1 million of riskiest loans issued in 2008 and 2009 resulted in $902,000 in charge-offs. Still, investors made a positive annualized return, according to Lending Club.
Apart from the loan defaults, though, marketplace and online lenders face the question of what happens if their funding sources disappear. That’s where the great argument in online lending begins: Which is the better business model, keeping some or all loans on the balance sheet (and funding them with a line of credit) or being a pure-play market lender (matching up retail and institutional investors and borrowers, and not taking any credit risk)?
Lending Club is a pure marketplace, taking no credit risk. About 20% of its loans are invested in by individuals (retail money), while 44% are matched with family offices, other managed money, and accredited investors. The remaining 36% is institutional money, including banks, insurance companies, and pension funds, says Dolan.
Charles Moldow, general partner at Foundation Capital, which led Lending Club’s Series C funding in 2010, particularly favors the idea of having retail money fund loans. “It’s easier to have one investor buy $1 billion of loans instead of 5,000 retail customers, but it’s not a more enduring model,” Moldow says. “Large capital coming from hedge and pension funds tends to be very sophisticated and moves from place to place depending on yield and performance. Retail capital tends to be a lot stickier.”
In Moldow’s view, consumers “tend to have longer-term time horizons, and they don’t have the time and inclination to go through the process of redeeming [their investment] and reinvesting somewhere else.”
Funding Circle also has a diverse set of loan investors. The diversification, Hodges believes, makes Funding Circle “less prone to liquidity shocks. If you look at what killed a lot of specialty-finance companies in the last downturn, it wasn’t credit, it was liquidity.” Banks pulled the warehouse lines of credit that were funding the loans on the lenders’ balance sheets, and the lenders couldn’t tap into the asset-backed securitization market to fund loans either, Hodges notes. (Some online balance sheet lenders use both of those funding sources.)
Avant is a blend of an institutional marketplace and a balance sheet lender, backed up by its large amounts of aforementioned equity and debt capital. It takes the full risk on about half of the loans it originates. “If you don’t have a balance sheet, it’s difficult to retain cash receipts in times of stress,” says CFO Suk. Given the consumer credit space Avant targets, “we also needed to demonstrate that there was no conflict of interest, that loans we could sell to top institutional investors we would also hold,” Suk says. “Rating agencies favor this approach because we eat our own cooking.”
But Foundation Capital’s Moldow says relying on balance sheet capital puts a lender on a treadmill: “As you grow, investors want to see a bigger equity base, so you have to continually raise new equity, and investors get diluted.” In addition, if there is compression in net interest margin from competition, a balance sheet lender might have to take on riskier loans that pay higher rates, says Moldow.
The venture capitalist says his firm has stayed away from investing in companies that use their balance sheets in favor of companies that “have more creative means of lending,” he says. “Wall Street values balance sheet lenders at a dramatically lower multiple,” he adds.
But there’s a significant risk looming for non-balance sheet lenders: the decision in Madden v. Midland Funding, a May 2015 case in the U.S. Court of Appeals for the Second Circuit that could affect bank lenders, securitization platforms, and nonbank investors.
The case involved the selling of mortgage loans in which the entire lending relationship changed hands. The court held that state usury laws could apply to nonbank investors that acquire a loan from a national bank (which are exempt from state usury laws) or originate a loan to a customer in New York via a bank in Utah, which has no usury limits. “It has been a practice that these marketplace lenders rely on a national bank to originate high-interest loans and do not have to comply with laws in all states,” said Fitch’s structured ratings team in a September 2015 report. “The ruling … casts doubts over whether a borrower’s contract interest rate can even be enforced when a loan is sold to a marketplace lender from the originating bank.”
“The court decided that the borrower is not well served by that type of relationship, because the ultimate buyers of the loan do not care about the borrower,” says Kabbage’s Petralia. One of the ultimate ramifications of Madden could be the introduction of regulations that require firms like Lending Club to retain “skin in the game”—some financial stake in the loans they issue. “That would totally change [marketplace lenders’] value proposition to investors,” notes Petralia, because they would have to take some credit risk.
Bank industry experts also believe greater regulatory scrutiny of all kinds of marketplace lending is imminent. But executives insist that online lenders are already regulated. Most of them have to partner with banks to originate the actual loans. “What that means is that we comply with fair lending and anti-money-laundering laws and consumer protection rules,” says Lending Club’s Dolan. In the case of Lending Club, when investors participate in a loan, they are issued a registered security, which is regulated by the Securities and Exchange Commission.
But credit rater Fitch notes that the consumer finance industry is fraught with “substantial regulatory, legislative, and litigation risk.” Regulators could also get at marketplace lenders indirectly by assigning a higher capital charge to credit facilities that banks extend to them, or finding other means of keeping a tight rein on the entities that finance their loans.
At Avant, Shah is not only fortifying his balance sheet. The firm has 11 in-house attorneys and close to 40 compliance specialists. “We’re anticipating a full-out review, including the Treasury Department looking at liquidity and whether the Basel rules will apply to lenders like us,” he says. Regulatory inquiries could actually legitimize or validate the business model, Shah says, adding: “We are ready to take it in our stride.”
Vincent Ryan is editor-in-chief, digital platforms, of CFO.