lending club

Will Zhong An follow the same post IPO trajectory as Lending Club?

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In December 2014 we hailed the Lending Club IPO as “the netscape moment for Fintech”. In February of this year, we described the rumoured Zhong An IPO as the Netscape moment for InsurTech.

The Lending Club trajectory, with the stock well below their IPO price, does not augur well for Zhong An. That is the question we address as investors start to think about the Zhong An IPO in Hong Kong.

We start with what we call our Wind Socket Analysis.

Wind Socket Analysis

The flight time from New York to London is about 7.5 hours, vs about 8.5 hours going the other way.

The one hour difference is due to tailwinds and headwinds. Whether you are on an Airbus or Boeing makes little difference. The Pilot cannot make much difference. Translated into company value, the market matters a lot more than the organisation or the management team. A base level is essential- don’t try flying the Atlantic in a small plane and don’t leave a transatlantic plane in the hands of an untrained pilot. In a crisis a great Pilot makes the difference. However all things being equal, what matters are tailwinds and headwinds.

Tailwinds for Zhong An

This is simple. China is a massive blue ocean market. A growing middle class is buying Insurance for the first time. It is a once in a lifetime land grab opportunity and the incumbents are not strong. Compare that to US or European Insurtech ventures selling to consumers who already have a lot of insurance from big, smart insurance companies.

Zhong An has a good plane & crew

You can see this tailwind in the numbers. ZhongAn offers more than 300 insurance products and has written more than 7.56 billion policies for more than 535 million customers. They are clearly executing well. Having raised $900m there is every reason to believe they will continue to do so.

Possible Headwinds

The Chinese economy is in transition, from manufacturing and export led to a more broadly diversified economy driven by consumption and higher value services. The bull case is this is like betting on America a century ago. China bears point to all kinds of issues, such as excess debt, non-performing loans and massive construction over building. If this is your view of the China economy you will avoid the Zhong An IPO. I incline to the bull case but there will be much volatility and there maybe a 1929 type event along the way in China. Nobody knows. Anybody who says they know probably has something to sell you.

Another issue, raised by a Fintech Genome member is about innovators dilemma faced by Ping An insurance, which is a major shareholder of Zhong An but may also could be a competitor down the road. As @EricForgy put it, writing from Hong Kong with a deep knowledge of the insurance business:

“As interesting as Zhong An is, I actually think Ping An is more interesting and is likely to have an even bigger impact on the rest of the world. I think Lufax is just the beginning of their outward expansion. Zhong An itself is struggling to make profit. If you note the numbers imply many small policies (per customer). They are trying to branch into more profitable lines of insurance, but as they do, they will start competing with their parent Ping An. I’m interested to see how that dynamic plays out. I think Ping An wins in terms of technology and Zhong An is no doubt using a lot of Ping An’s technology. Ping An is also trying to export a lot of their AI tech.”

The numbers that Eric Forgy refers to show rapid growth in revenue but declining profitability. Investors can take two different points of view on this:

Either: this shows the whole proposition is flawed.

Or: this is like Amazon and in a market opportunity as big as Insurance in China, it pays to invest for growth.

Which it is will be revealed by a deeper dive into the financials, which we do not have yet. If you have any insights, please share them on this thread on Fintech Genome.

Disruption from a supersonic plane.

All things being equal, headwinds and tailwinds drive value. But a new supersonic plane will change the outcome and that new plane may need a different type of pilot or at least some retraining. A supersonic plane will cut the NYLON journey time to about 3 hours. The equivalent of a supersonic plane in Insurance will be almost real time settlement using blockchain (which we covered many times, one example here).

Zhong An clearly sees this and is investing in Blockchain. So I do not expect Zhong An to be blindsided by blockchain. When both tech and regulation is ready, I expect Zhong An will be ready. The key is that both tech and regulation need to be ready – just like with supersonic planes. This is one area where I would be confident that Zhong An will get it right, because in China big connected companies and government work closely together.

The Lending Club trajectory since IPO

Lending Club did an IPO at $15, rocketed up past $20 and then crashed to an all time low of $3.51 (where I was fortunate enough to buy after posting this). It is now around $5.20. I sold my shares (Lending Club is still a great company, but valuation now is less compelling than other opportunities).

I did not invest in Lending Clun at IPO, because I had reservations at a fundamental level which I posted here. At $15 there was no room for error. At $3.51, the price implied that the whole model was dead and the team was incompetent, neither of which was true.

Many stocks never give you this opportunity. You never get a chance to buy in below the IPO price. Think of Facebook and Salesforce; the price goes down a bit occasionally but not for long.

If you have any insights, please share them on this thread on Fintech Genome.

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Bernard Lunn is a Fintech deal-maker, author, investor and thought-leader.

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Back to the future of P2P Lending, we interview one of those peers

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The founding idea of both Lending Club and Prosper was Peer To Peer (P2P) Lending. Along the way, professional intermediaries aka Institutions got into the act and we started referring to Market Place Lending or Altfi. P2P Lending means no other intermediaries – just Lender + Borrower + Platform. The imperative to scale fast, to keep equity investors happy, forced the platforms to get capital from professional intermediaries. Something was lost in this transition. Professional intermediaries add fees and also tend to be less loyal as they see their job as moving money around fast to protect their investors. 

Hector Nunez is a good example of those original P2P retail investors. He has been investing in notes on Prosper since the early days. In an ironic twist that tells a lot about Fintech in the capital markets, Hector also has a job as a doorman at 75 Wall Street in New York City, which used to house trading rooms and now has been turned into apartments (in the new FiDi or Financial District of Manhattan). Hector was one of the early investors in Prosper loan notes and turned his $5k original stake into $138k over 10 years. This is a track record that most professionals would envy. See later for how this translates to IRR.

So it made sense to get Hector’s take on some of the big shifts in this market.

What is the difference between retail and institutional investors?

Our thesis is that three things separate the retail investor from the institutional/professional investor:

  1. Access to tools, techniques and data. Fintech is democratizing the tools, techniques and data that used to only be available to professional intermediaries. This is a work in process. Some tools are still only available to professional intermediaries, simply due to how they are priced, but this will change as new players come into the market. Techniques can come from books, blogs, forums and online courses. Platforms give access to data to encourage investors. So it is only tools that are lacking and entrepreneurs who build these tools know that this is primarily a pricing decision and that selling to 100 retail investors at 1c is the same as selling to one Institution for $1 and may be easier. We asked Hector about some of these tools.
  1. OPM (Other People’s Money). Institutions invest OPM. Retail investors invest their own money. To invest well you have to be a) contrarian and b) right. It is hard to be contrarian when you invest OPM – you have explanation risk. Retail investors have no explanation risk. When they are contrarian and wrong, they only have to explain it to the mirror and learn from why they lost.
  1. Concentration. One Institution can lend a lot of money and that is a quicker way to scale a platform than persuading lots of retail investors to use the platform. One retail investor might be able to deploy $300k while an Institution can easily do 100x that i.e $30m (but that $30m can also disappear equally fast as Institutions tend to be more trigger-happy). Getting 100 retail investors to deploy $300k or 1,000 to deploy $30k certainly takes longer, but it gives the platforms more long-term capital. One way to think about the retail investor is like a bank depositor who takes more risk and does more work for a much higher return.

Hector explains how he invests

I asked Hector to explain his investing approach:

Prosper gives borrowers credit grades (“AA,” “A,” “B,” “C,” “D,” “E” and “HR”) in which the investor sees and gets to invest in the loan the way she/he sees fit. In my case, I’m investing in only 2 grades (“B” and “E”). I have other grades but those are the ones that are in beta mode or that I ceased to invest in. Because there are only 3 or 5 years terms, it takes that long to purge the grades that I’m no longer interested in investing. Now one can argue that this is the disadvantage in retail P2P lending in that once something goes wrong, there’s no essential bail out. I would argue that this is actually beneficial because it teaches me to stay away from certain kind of loans with certain kind of attributes. As opposed to “jumping ship” early and probably not learning exactly why the loan went south. So I set a fixed amount of notes in 3 credit grades that I’m going to invest in and that number is 200. diversification is key and that by having 100 loans (notes), the investor is almost guaranteed to have a gain.

Agile Investing and IRR

Institutional/professional investors focus on IRR (Internal Rate of Return). It is a metric that shows performance. Hector, like most retail investors, does not obsess about IRR because he is not selling to investors.

What Hector is doing – and other retail investors work in a similar way – is what I call agile investing. Like agile programming, you start small and add more and refine the approach as you get market feedback (what you win and what you lose).

In Hector’s words:

Here’s what I started with: 5K which 10 years later (this upcoming March) is currently @ ~$138K. Please note that this includes both my trial and error loans as well as my lower interest loans. I started with 5K, then I put in an additional 10K, then 15K, another 30K and then another $20K. Throughout this process I’ve taken out then put some funds back in so overall, my principle is ~$80K and the rest is in excess of principle.

If Hector was running a Fund and pitching OPM for money, he would track all of those inputs and outputs to calculate IRR. That is how intermediaries work and IRR is a useful tool. However, what Hector is describing is how individual investors work which is to experiment and put more into what works. This is what I call “agile investing”. Note that “individual investors” could mean people with a lot of money to invest – think of Family Offices and Prop Traders.  So this maybe the new mode of investing that the micro asset managers use (see later for follow/copy/mirror model investing).

Ceiling?

I asked Hector what kind of “ceiling” he sees for this way of investing.

I cap off 200 loans for each grade that I’m investing, because I believe there is a point where too much diversity negates gains and losses. Also, years ago, Prosper imposed a percentage limit on both retail and institutional investors which affects the monetary amount that I could invest in. Currently it is @ 10% for the 1st 24 hours. In other words, when a borrower posts his/her loan on Prosper, any investor could only contribute (invest) to 10% of the borrower’s total loan within the 1st 24 hours of the borrower’s loan. After that, the cap is lifted and the investor could invest any monetary amount. I only invest to the 10% limit so monetary wise I’m also capped. So my overall monetary ceiling is currently @ ~$400K and my overall note ceiling is currently @ a little over 500 which includes my beta loans. Once, I reach those goals, I will then have to branch out into other platforms i.e Folio and apply my tried tested and proven strategy on that platform.

Hold to maturity or trade on secondary market?

Prosper announced in September 2016 that they were Closing Down Their Secondary Market for Retail Investors. Prosper had been running a secondary market via FOLIOfn since 2009.

This is the sort of tool that Institutions have taken for granted for a long time.

The old fashioned idea of a bond was to hold it to maturity, collecting interest along the way and many Institutions still like to work this way.

I asked Hector for his take on this:

“Personally I’m not affected by this move as I never had plans on selling my notes on Folio. Remember, we had Folio as an option to sell and I knew it and I never bothered to look at Folio to sell my notes. And in that aspect, I believe I was a typical investor and part of the reason why I think Prosper and Folio parted ways. Remember, if loans default, there’s still a chance we can recoup our losses via the collection agency which work on our behalf (as opposed to losses in the stock where there is no chance of recouping). With Prosper there’s a chance that the collection agency can recoup some if not all your principal with the interest (all for a small fee of course which the agency automatically takes from the funds recovered). I did create a Folio account but that was as a security blanket which I would have put in use had the majority of my investment soured. As the story went, it never did.”

Cross platform investing

Institutional investors are strong on diversification. Hector agrees, but has a slightly different take:

“I believe in that old cliche that you should not put too many eggs in one basket. I am all about cross platform investing. Should one platform go south, you have another to pick you right up; however I only believe that to a point. My belief is that too many investments would cancel themselves out leaving the investor with little financial movement either way (gain or loss).”

Hector is referring is what Institutional Investors call “closet indexing”, when investors diversify so much that the end result is very close to an index (which you can buy for very little from somebody like Vanguard).

One way to diversify is to go global. I asked Hector whether he would consider investing outside America, via platforms in those countries. Hector was clear on this front and his logic was interesting:

No and as of now I don’t have any plans on doing so. There are a couple of reasons why. First, I must complete my investment goal on Prosper before I step on to a new Market. I will make an exception with Folio because I already have an account and I’ve been doing my research with them for quite some time. Second, I trust the American market more than international markets because I feel that I have a better pulse on the US market than that of another country. Probably this is because I live in the US. My strategy relies much on understanding their personal financial background in the context of some event that makes them need a loan. Example: A person could be asking for a loan because he/she may have psychological issues and need their medical expenses paid off and the borrower has a pretty decent financial history while another person may be asking for a loan for a vacation and have a questionable financial history. I would lend to the person in medical need not because of what the borrower is going to use my funds for but rather because of their proven financial track history.

Hector ends with what all good investors have – humility and a learn it all attitude rather than a know it all attitude:

Believe it or not I’m still learning on Prosper and still letting my “beta” notes play.

Can I follow/copy/mirror Hector?

One theme that we have been exploring on Daily Fintech is the emergence of Micro Asset Managers enabled by the follow/copy/mirror model:

  • Copy and mirror trading platforms like eToro, Zulu Trade, Darwinex.
  • Thematic investing marketplaces that allow new micro-managers to emerge by creating their own financial product (equity based), and actively manage it; like Motif Investing, and Wikifolios.
  • Even social research platforms like StockTwits are stepping into this space by offering Follow functions and rankings of the subscriber micro-managers.

This is an alternative to either passive low cost index tracking or high cost active hedge funds. The idea is simply to follow/copy/mirror an investor who is investing their own money. This allows a passive investor (who does not want to work hard at the investing game) to follow/copy/mirror the active investor (somebody like Hector) who gets some share of the upside. That active investor does not need to gather or manage investor’s assets, so they do not need to charge an AUM fee. This is a game-changer in the massive asset management business.

Hector was eloquent that IRR % was more important than total funds under management:

I believe that the amount of money one has in investment is not the sign or bar of performance rather it is the rate of return. A person can have a million dollars in stocks and come out at years end with 1.1 million and another investor could have 100K and turn a profit of $20k and it is the latter investor that I would be most impressed with and try to emulate.

The follow/copy/mirror model is working today in VC (Angel List) and in Public Equities and in FX, but I am not aware of anybody doing it in Fixed Income/Lending. Hector is the sort of investor I would like to follow/copy/mirror. I asked Hector for his take on this:

I welcome you and any potential retail Prosper investor to follow my lead. I could give you or anyone nice fundamental tips in getting started as well as giving you warnings and recommendations. If you or anyone wishes to get started, please let me know.

It will be interesting to see if the Lending platforms start to offer this or if some other platform specific to the follow/copy/mirror model offer a cross-platform capability.

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What does the Credify story tell us about Market Place Lending and $LC stock?

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This story broke on Wednesday 15 November. 

The story is that the founder of Lending Club, Renaud Leplanche, who was ousted in a scandal in May was creating a new venture to compete with Lending Club called Credify. Headlines talked about 2nd Act or Comeback.

The story came out in the Wall Street Journal (WSJ)  and appeared to be good old-fashioned journalism – digging around for a scoop by looking at corporate filings.

I do not think there is much of a story about Credify itself. The chances of success for that venture are slim (more on that later). The story hangs on 3 threads:

– What does this tell us about the state of online journalism?

– Does this justify selling Lending Club stock?

– What does this story tell us about the transformation of consumer lending

What does this tell us about the state of online journalism?

News drives markets and digitization is changing news, so this is indirectly a Fintech story.

As a media entrepreneur this aspect of the story interests me.

This was either a non-story done under time pressure that had a big impact or an old-fashioned scoop from hard core investigative journalism. The latter is to be celebrated because the economics of digital media don’t allow much budget for hard core investigative journalism. Imagine All The Presidents Men today.

The time pressure on journalists today is intense, because the online ad model post search, social and adblockers, does not allow time for hard core investigative journalism.

There is no site for Credify (various spellings and .tld urls end up in a blind alley) and nobody is talking on the record. Let’s assume the story is true. It certainly appears that a company called Credify was created by Renaud Leplanche. Without a famous name impacting a public stock, this event would have gone unnoticed – just one out of 1,000,000 new businesses created each year in America alone.

So I incline to this being a non-story done under time pressure. Of course, only time will tell and events may prove me wrong. Credify may launch and quickly get to the $50m in revenues mentioned in the WSJ article as the target for 2017.

A non-story done under time pressure unsettles markets because, if it comes from an authoritative source such as WSJ, other publications repeat the story citing the original post as evidence. That is what happened in the Credify story, which was briefly on the technology front page (Techmeme).

Does this justify selling Lending Club stock?

No.

$LC stock did decline a bit the day after on the 16th and by more than 5% a day later on the 17th and a bit more on the 18th. Over $125m of market value evaporated. Nobody knows for sure why a stock moves – in this case there were also options expiring, the stock had gone up sharply and may have needed a correction, there was a negative post on Zero Hedge (do they have positive posts?) and a story about Lending Tree that defined them as competitors (incorrectly in my view).

Disclosure; I bought LC stock after the May crash (got in at 3.51). That is why I was paying attention to the Credify story. My investing approach is to do a lot of fundamental analysis before buying so that I have context to look at news as it comes in and make a Buy/Sell/Hold decision. This story was a Hold decision – it was “noise on the line”.

Reactions of retail traders on stock forums mostly also did not think that the story was significant. This was a sample reaction:

“Not sure why Laplanche startup would be more concerning than Goldman’s market entry.”

Which brings us to the final part of this story.

What does this story tell us about the transformation of consumer lending?

Lending Club is the bellwether of MarketPlace Lending. It may well be bellwether of the whole Fintech market. If Lending Club fails, investors will tell Fintech entrepreneurs “stop trying to compete with banks, go back to the old model of selling software to banks”.

I am calling this market the transformation of consumer lending, because so many of the names don’t quite fit any more:

– P2P Lending. This is what it was called when early visionaries such as Renaud Leplanche were getting started about 7 years ago. Individual lends to individual via the platform – beautifully simple and revolutionary concept. Whatever else Renaud Leplanche does with his life, the world owes him a debt of gratitude for making that work.

– Market Place Lending. This name evolved when fast moving credit hedge funds and other institutional lenders in moved in. Now the value chain got longer. Individual lends to Institution which lends to individual via the platform.

– AltFi. In this iteration, the market place disappears. The credit hedge fund buys or builds the digital loan origination technology so that they can lend directly to individuals from their own balance sheet. This is also sometimes called balance sheet market place lenders. There are also hybrid models with some balance sheet lending and some market place lending.  Examples include Avant and SOFI.

– Digital Lending. In this iteration, the credit hedge fund disappears. Banks buy or build the digital loan origination technology so that they can lend directly to individuals from their own balance sheet. As Banks have a lower cost of capital they can beat the credit hedge fund. First out of the gate is Goldman Sachs with Marcus. They will beat the AltFi Lenders because of lower cost of capital.

Consumer Lending is such a massive market and we are still in the early days, but it is an utterly different market from when Renaud Leplanche was doing his pioneering work in the founding days of Lending Club.

One thing that gives me confidence in Lending Club (and Prosper but they are still private so I cannot buy their stock) is that the original P2P Lenders are still there. They may only be one lender, along with Banks and other Institutions, but they are still there. The humble retail lender has confidence because they get good risk adjusted returns compared to any other credit avenue (if they are careful). That confidence gives me confidence as an equity investor.

There is some news that would prompt me to sell LC stock. If the new CEO was also caught doing something wrong my take would be “once means nothing, twice is coincidence and three times is a trend and I am not waiting around for the third time”. The Lending Club Board proved in May that they are vigilant and decisive, so I think this is unlikely.

Fintech is fundamentally about the democratization of technology. Given the right tools, smarts and hard work, a retail lender can do what a credit hedge fund does. There has never been a shortage of people with smarts and hard work. Now they are also getting the tools. That is the revolutionary promise of Fintech in a nutshell.

Given that analysis, what would a smart entrepreneur who knows consumer lending do today:

– P2P Lending. Building consumer trust and network effects is a long game and the consumer lending market is no longer in the nascent phase that rewards a long game.

– Market Place Lending. Building Institutional trust takes time. The May scandal that led to Laplanche being fired broke that trust. This would be a hard sell.

– AltFi. This was a good play a few years ago, but with Banks like Goldmans getting into the game, this would be highly risky today.

– Digital Lending. Only an option if you are a licensed deposit taking bank.

That analysis told me that it was not time to sell LC stock and that the next iteration of this market is back to the original P2P Lending model of empowering retail lenders on a mass scale.

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Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech & operates the Fintech Genome P2P Knowledge platform.

4 Scenarios for Lending Club – the proxy for Fintech disruption or hype $LC

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When Lending Club did it’s IPO in December 2014 I declared it as the Netscape moment for Fintech (when it became conventional wisdom that this was going to change the world). I could be accused of contributing to the Fintech hype, which became intense in 2015 with investors flooding into Fintech ventures. Meanwhile the $LC stock price tanked to such a level that by late May 2016, after the Lending Club CEO ouster, the conventional wisdom became that yes this was the Netscape moment for Fintech and we all know how the Netscape story ended – they were crushed by Microsoft.

That is one of the 4 scenarios that we analyze in this post – that incumbency wins, that big banks crush Lending Club and that Marketplace Lending becomes a footnote in banking history. In that ending, George Foreman beats Muhammad Ali in Rumble in the Jungle.  Conventional wisdom expected that George Foreman would win. But that is only one of 4 scenarios that we analyse.

Disclosure: I bought some Lending Club stock after writing this post in May (I was fortunate enough to get in at 3.51). In two of my 4 scenarios that was a dumb move. However, spoiler alert, my analysis is that one of the other two scenarios is more likely.

4 Scenarios

# 1 Like Netscape getting crushed by Microsoft, Lending Club will be crushed by big banks.

How this would play out. Banks refuse to lend to borrowers via Lending Club, so they will be dependent on retail lenders (which is only one of three lender channels that Efi Pylarinou analyses in this post and not enough to fuel rapid growth).

Evidence that this is true. After the problems that led to the Lending Club Board firing the Founder CEO, banks put a hold on lending via Lending Club (and other MarketPlace Lenders). Given the old world disclosure problems analysed by Efi Pylarinou in this post, it would have been amazing if banks had not put a hold on this while they did extra due diligence.

What will happen to Lending Club stock in this scenario? A big bank buys them for a firesale price to get access to technology and talent. There will be competition from multiple big banks, so a competent investment banker should extract a reasonable price, but there won’t be any champagne corks popping among Lending Club shareholders in this scenario.

What will happen to other MarketPlace Lenders in this scenario? They will also be acquired for firesale prices and nobody will back another MarketPlace Lending venture. It will be game over.

Likelihood rating: Least Likely.Conventional wisdom currently favours this scenario, yet I rate it as Least Likely (the next scenario is even worse for Lending Club shareholders and a bit more likely). The reason I rate this conventional wisdom as Least Likely is that it is based on a fundamental misunderstanding. Banks don’t own this money. it is a Liability on their Balance Sheet because when we Deposit money with a Bank, we are lending money to a bank. When we wire money to a Credit Hedge Fund, we are lending them the money in the hope that they will return it with profit later.  Banks and Hedge Funds are intermediaries just like Lending Club is an intermediary. So if the real investors (you and I and richer versions of you and I) decide we get a better risk adjusted return by lending via Lending Club than by lending to a bank or Credit Hedge Fund, then that is what we will do (for some more on this idea, read this post).  For some insight on how this could happen, read Jessica Ellerm’s brilliant post on how Fintech innovation may finally be coming to the deposit part of banking.

Note: even Least Likely is a possible scenario. We can declare this scenario Totally Unlikely if and when the Jeffries securitization deal that was put on hold during the disclosure problems finally closes. (I put Goldmans in a different category because they clearly have their own ambitions in marketplace lending).

# 2 The first “run on a marketplace”.

Like a run on a bank, when trust goes, it goes fast and leads to panic. This is “reverse network effects”. We have seen a run on a bank many times before in the past. A “run on a marketplace” would be unprecedented, but these times are different.

How this would play out. Lenders cannot withdraw their money (as bank depositors can) so it is not exactly like a run on a bank, but lenders can refuse to lend any new money and that will have the same fundamental effect. In a vicious cycle, retail lenders and equity investors get scared away, leading to more bad news, leading to… In this scenario, I worry less about what a few bankers think (Scenario #1), but I worry about what millions of consumers (retail lenders and equity investors) think.

Evidence that this is true. Just look at the $LC stock price.

What will happen to Lending Club stock in this scenario? Not even a firesale buyout, total loss.

What will happen to other MarketPlace Lenders in this scenario? One may prove reliable enough and emerge triumphant in a Rocky like “last man standing” result. But that is a very slim chance. More likely is the same as Scenario # 1.

Likelihood rating: Unlikely. Calm voices who look at the actual returns of retail investors such as the ever insightful Peter Renton at Lend Academy show that the risk adjusted returns are good. Individual retail lenders tell a similar story. The panic at the moment seems restricted to the media and this sort of hype/despair cycle is normal. The Lending Club Board clearly understands the issue and that is why they took decisive action in May.

# 3 Like Priceline, the stock will bounce along the floor for years and then return 100x for really patient investors.

Management slowly get past all the serious execution challenges and, because digitisation is unstoppable and digitisation means that marketplaces and networks always win in the end, the eventually upside is stunning. That is what actually happened to Priceline (no, not a measly 10 bagger but a “10x 10 bagger” aka 100x return).

How this would play out. Scott Sanborn and his team get the Board’s backing to patiently execute on their plan. There are two big execution challenges:

  • Employee stock options are under water. They either face a talent drain or issue new options that hurt common shareholders. Both choices are ugly.
  • The growth is outside America, but going for that growth will be expensive.

This will be difficult. Their Q2 results are likely to be ugly. There will be lots of setbacks and bad news cycles. That is why the stock will bounce along the floor for years (and years is a long time when day traders are considered long term investors compared to HFT).

Evidence that this is true. Hiring a credible Chief Capital Officer. In this scenario, it takes years to execute on a recovery plan, so yes that is only one of many results that the management team needs to deliver on.

What will happen to Lending Club stock in this scenario? For most investors, who give up during the years when it bounces along the floor, a loss. For a tiny number who stick with it (based on conviction or just forgetting they own the stock), a massive return.

What will happen to other MarketPlace Lenders in this scenario? Few will have the patience to execute like this and will take acquisition offers, making the last man standing even more valuable.

Likelihood rating: Possible. I am not an insider. I have no idea what is going on inside the Lending Club Board. However I do know that a) these are solvable execution challenges with a lot of patience and hard work and b) Boards are typically not very patient these days and so while this is Possible, I think the next Scenario is more likely. Also I think the value of MarketPlace Lending (which will be massive) will get distributed across an ecosystem rather than sticking to only one or two Facebook style behemoths.

# 4 Buyout, probably from a Chinese company.

How this would play out. The Lending Club Board accepts an offer.

Evidence that this is true. None, there won’t be evidence until the Lending Club Board accepts an offer, but we do know that one Chinese investor bought after the stock crashed and now owns over 11%.

What will happen to Lending Club stock in this scenario? Some premium to the market price at the time of offer.

What will happen to other MarketPlace Lenders in this scenario? Investment bankers representing them have their phones ringing off the hook.

Likelihood rating: Likely. Not only do we already see a big Chinese investor in the company, the business logic is impeccable:

  • To be a big player, Lending Club has to get into China, which is a huge market but very difficult to get into without a) deep pockets b) local partners.
  • China is a huge market for consumer loans but none of the MarketPlace Lenders in China has the organisational strength and technology of Lending Club (or Prosper or SOFI or Funding Circle).

Combine huge market and good platform and you get a great result.

Note on Scenario Ratings. I only have 5 – Totally Unlikely, Least Likely, Unlikely, Possible, Likely. I don’t try to put % numbers on this as that gives a false sense of certainty. I am looking at this as an investor and the end result for an investor is binary – profit or loss. Even a Least Likely scenario could come to pass and investors simply have to a) have confidence in their analysis and b) enough diversification to not be “weak hands” that are shaken out by a negative news cycle that drives trading sentiment and drops the share price temporarily.

Personal Note. Like most people, I love a triumph over adversity story such as Muhammed Ali in Rumble in the Jungle but my personal sport is skiing and the triumph over adversity story that I love is Franz Klammer’s comeback in 1984 as an “old man” of 30 on his home run – the Hahnenkamm.   Watching at the time, I hoped he would win but thought it Totally Unlikely.

There are two types of Fintech innovation. One type of Fintech innovation says to Banks “we bring you lunch”. It is a variant of traditional Fintech where the venture prices on a transactional revenue share basis instead of via a traditional software licensing model.

The other type of Fintech innovation says to Banks “we eat your lunch”. It is disruptive and the potential and risk for backing this type of venture is much higher. The fate of Lending Club is a bellwether for this latter type of disruptive Fintech innovation. How it prospers or fails will impact the broader sentiment about whether disruptive “we eat your lunch” Fintech innovation is viable.

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech & operates the Fintech Genome P2P Knowledge Network. Bernard Lunn is a Fintech thought-leader.

Marketplace Lending depends on savers moving on from bank deposits

Deposits

The Fintech is dead meme is now in full flood. Authoritative sources such as this Deloitte report (with sensationalist headline from Business Insider) add credibility to this meme.  This feels like the Internet is dead consensus in 2002. At the time I vividly recall the relief with which media companies and retailers greeted the demise of the Internet – “phew, pleased that craziness is all over and we can get back to business as usual”.

This time is NOT different.

These boom and gloom cycles are the norm. 4 of our 2016 Predictions in December have already come to pass (updates in italics):

#   3. Momentum Capital (short term hype chasing) into Fintech will slow down but Innovation Capital (funding long term value creation) will increase because the reality of the opportunity is not impacted by the hype cycle. The crash was obvious but we are also seeing new VC rounds getting done and Lending Club stock bouncing off the bottom.

#  5. Consolidation will start in Lending Marketplaces. There will be a fierce battle for a winner takes most network effects market (similar to what we saw in ride sharing in 2015). This is happening now. It looks like Lending Club and Prosper will survive and thrive unless the whole model is flawed (which we do not believe for reasons explained below).

#   6. The strange inversion we saw in 2015, when private companies were valued higher (on paper at least) than public companies, will end in 2016.The headlines will refer to Unicorpses. This is happening but is not yet over. It means private valuations have further to fall and public valuations (of a few winners) will rise.

#     9. Calls for regulating Fintech startups more intensely will follow at least one high profile blow up. The Lending Club blow up qualifies and has led for calls for more regulation.

3 Predictions for 2016 still to come 

(Apart from predictions relating to Bitcoin and XBRL which do not impact this story)

#   7. Analysts covering Banks will start referencing Fintech disruption when referring to a drop in profits at a major bank. This will happen if Banks start losing depositors (see later).

# 8. Moves by Big Tech and Big Retail into Financial Services will eclipse moves by Fintech startups and will worry bankers a lot more. This could come from Western Big Tech (Google has big ambitions & can play a major role in origination and comparison) or from Chinese Big Tech (Alibaba has already demonstrated big ambitions in Finance)

# 10. The Great Convergence between Banks and Fintechs commences, as both get judged on the same metrics by consumers,regulators and investors. Growth, gross margin, Customer Acquisition Cost, Churn, Lifetime Value are metrics you can use to evaluate Banks or Fintechs or Tech Enabled Financial Institutions (aka grown up Fintechs or efficient digital banks).

 

The Mortgage Elephant in the room

Mortgages dwarf all other lending at over $1 trillion per year in the US alone. No wonder Wall Street chose this market for securitisation. No wonder that this market could blow up the global economy when it went wrong in 2008.

As long as lenders don’t do anything silly with loan to value ratios, it is a great business. For consumers it is all about the best % rate. Making the process easier (classic Fintech advantage) is minor compared to best rate. With good collateral (if loan to value ratios stay sane) banks and AltFI can offer low rates. Which means that lowest cost of capital wins. Which means that Banks will win. It is simple. If you stacked up these two players, which will win:

  • Player # 1 has lower processing costs.
  • Player # 2 has lower cost of capital.

That’s right Player # 2 (ie banks) win that race.

Game over?

Not quite. This is why the headline focusses on deposits.

Would Sir like some NIRP?

It has not escaped the attention of some savvy folks like Warren Buffet that paying a Bank to keep your cash is pretty weird. As Berkshire Hathaway has $63 billion in cash reserves, what Mr. Buffet decides to do with the cash has some ramifications. Even if we don’t stay long in the strange world of NIRP, investors are looking for better than zero or close to zero interest rates. So if lenders can find good risk adjusted returns on Lending Marketplaces they will seize that opportunity. If the borrowers are willing to put up their house as collateral, the risk adjusted return looks a lot better than bank deposits.

Lending Marketplaces have two sides. If Lenders move to these markets looking for better risk adjusted returns than bank deposits, then Lending Marketplaces will thrive (and Banks will suffer).

Disclosure: the author was lucky enough to buy Lending Club stock at $3.51 on May 17 (after writing this post).

Daily Fintech Advisers provide strategic consulting to organizations with business and investment interests in Fintech. Bernard Lunn is a Fintech thought-leader.

The three channels on the Lending Club platform

lending club

Lending Club is a public company and therefore, discloses more detailed information than the private lending marketplaces like Prosper. Looking into their annual reports, the three distinct channels of their matchmaking business (Borrowers matched with Lenders) and their growth can be found. To put things in perspective:

Lending Club has facilitated $16 billion in loans since its launch in 2007 (up to Dec 2015)!

Mostly consumer loans (all in the US) with the exception of a brief business shift into SMEs that didn’t take off. Indirectly, Lending Club does cater to the funding needs of entrepreneurs that choose to borrow on their personal account and fund business endeavors at the very early stage.

Lending Club’s channels of distribution:

–       The original P2P business

which is executed through “Notes” on it’s fractional loan platform

–       The 20th century asset management business

which functions through LC Advisors, a wholy owned investment advisor &

which is executed through “Certificates and Funds” distributed by conventional third party marketers

–       The Whole loan platform

which executes through “Whole Loan Purchases” on the Lending Club Whole loan paltform

 It all started in 2007 with the P2P platform and the other two channels were added on the way as the business grew. The $16 billion facilitated in the past 9 yrs, were channeled roughly

20% through the fractional loan platform (Notes); 35% through certificates and funds (LC Advisors); and 45% via the Whole loan platform.

The pure P2P channel in 2015, issued $1.57billion Notes. The growth through this channel has been x1.5 year-on-year over the past two years (2013-2015). Flat growth of the fractional loan platform business.

LC Advisors, a SEC registered advisory wholly owned by LC

The asset management business of LC Advisors offers the possibility to lend through ownership of a fund. Both qualified individuals and institutional investors can hold loans through this channel.

Lending club’s managed Funds:

  • Conservative Consumer Credit Fund (CCF)
  • Broad-Based Consumer Credit Fund (BBF)
  • High yield Consumer Credit Fund (HYF)

This channel was opened in 2011 and the CCF fund invested only in the two top quality grade notes (i.e. less risky credit spectrum) and the BBF is a diversified fund investing in all loan grades; and HYF picks the more risky credits for those seeking higher yields. The required minimum is $500k and therefore, only qualified investors can invest in these private placements. Most of the subscriptions have come through third party marketers, like Morgan Stanley internationally and Oppenheimer in the US.

The diversified BBF fund is the largest, $882million with more than 800 investors reported and 17% non-US holdings. The CCF fund has $108mil and the HYF $74mil with less than 100 investors. The CCF however, has more than 40% non-US investors.

These managed funds (hedge fund packaging in other words) were in the press in 2012 but since have been in stealth mode in the media, despite the fact that the volume and the servicing fees from this part of the business have been growing more than the Notes business.

The third channel, the whole loan platform, currently accounts for 48% of the volume of loans facilitated and for 56% of the servicing fees.

What is the whole loan platform?

Banks and other institutional investors want to own loans as assets on their balance sheet or want to serve their customer base with loans. Lending Club offers the Whole Loan platform which allows a bank to actually own the loan on their balance sheet. Lending Club simultaneously has a servicing agreement with the bank (so earns all the servicing fees). Such purchase agreement programs can be customized. Regulations require that the investor-bank has access to the underlying borrower information but wont contact directly the borrower or use that information in ways that violate privacy laws. This is exactly the part that the disclosure dispute with Jeffries came about (LC wasn’t disclosing appropriately to the borrowers on the LC platform the fine details of the whole loan purchase agreements that gave access to the bank-investor to their info).

The whole loan platform is the channel that was “hit” last November when Santander withdrew from the consumer loan market. Santander had to offload $1billion of Lending Club consumer loans that they were holding on their books through this channel. The interruption of their whole loan purchase agreements were due to regulatory pressure with regards to capital requirements and nothing to do with any frictions between LC and Santander.

Lending Club’s business breakdown by distribution channels

  Screen Shot 2016-05-16 at 9.52.54 AM

Source: Daily Fintech; Lending Club 10-K report 2015

Over the past three years,

Lending Club’s whole loan platform business has grown Tenfold. The certificate business has Tripled and the Notes business has doubled.

The roughly $9billion processed in 2015, were channeled 18% from the pure P2P channel, 34% from LC advisors and 48% from the whole loan platform.

What do you think?

If you didn’t vote on Lending Club skiing accident: 20th century disclosure ghosts; you can vote here.

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech. Efi Pylarinou is a Digital Wealth Management thought leader.

Lending Club skiing accident: 20th century disclosure ghosts

disapoint

They were going fast, they were adapting new technologies, high growth rates, they were the first to go public. Of course, they weren’t wearing a helmet (not fashionable) and the crash happened on the lower slopes.

In January we wrote in “Lending marketplaces grow up and get boring”:

“Lending marketplaces have heavy elements of old-fashioned finance and are becoming less innovative and cool, as they grow up.”

 And in “Tiny bank, huge ROE: WebBank’s Fintech hidden recipe””

“Lending marketplaces have mirrored the old-fashioned credit card businesses practices, in order to be able to match lenders and investors from any state to a borrower in a state with strict usury laws.”

Matt Levine at Bloomberg View last week opened up an inquiry:

“Lending club got into trouble for being “too much like a fintech” and/or “too much like a bank”. ..But maybe it’s both”.

Increased elements of old-fashioned and conventional business choices have been appearing this year in the US lending marketplace. They come from many directions. SOFI in March decided to setup a Hedge fund, as a solution to manage the one leg of the three legged stool of the business, the lending leg (Think of your Business as a Three Legged Stool | Ron Suber @Prosper). Funding Circle six months ago launched a listed fund vehicle on the LSE and recently created the first Asset backed security with loans originated from its platform (this is a European ABS but the assets are held by a US asset manager). Lending Club, a US RIA, owns a conventional asset management business, LC advisors, that has grown to manage $882mil AUM!

Elements of conventional business practices in lending marketplaces already existed in the US from the start, in order to circumvent the cross state usury laws differences (i.e. mirroring the credit card business practices).

More than one year ago, the second batch of elements of maturity were clear (see “P2P Lending” to “Lending Marketplaces”: the graceful dance has started). Moving away from P2P lending and transforming into lending marketplaces through the involvement of institutional money on the lending leg of the stool. Currently, 80+% of LC’s transaction volume is through these bridges/channels. This is the part of business that the skiing accident happened.

A legal dispute between Jeffries and Lending Club. Jeffries seemed to be planning to bundle some LC loans. The disagreement came from the way that Lending Club disclosed to borrowers their right when using the platform. In layman terms, Jeffries wanted to make sure that loan applicants clearly understood that they were handing over their rights to the lender (Jeffries in this case) in order to complete the processes faster. This “power of attorney” allows the lender (the Jeffries on the other side of the trade) access to information of the borrower, like income and assets.

Matt Levine, Bloomberg View “LendingClub’s Troubles Bring Back Bad Memories” covers more details for those interested. He sprinkles his brilliance as a journalist:

“Signing your own loan agreements is so quaint and 20th-century! In the brave new world of financial technology, lenders will get your tax returns through an API, fair lending standards will be superseded by algorithms, and, you know, blockchain. … But probably it was just a pretty boring disagreement between LendingClub’s banking lawyers and Jefferies’ banking lawyers.”

Bottom line IMHO,

Lending Club’s stock price has been penalized disproportionally by an old fashioned Disclosure Dispute.

 A Fintech is getting crushed (stock price down 45% in one week). Barclays dropped 20% at most when the LIBOR manipulation scandal broke out, with far broader industry and consumer implications (imagine all financial instruments indexed and priced off LIBOR, all the way down to the floating mortgages of Auntie Mary). How can we explain such a reaction, to an all familiar carelessness? Taleb would say, this isn’t a black swan. This can only be explained by this confession:

 “ We thought we were in bed with a virgin; it turned out to be a 20th century woman (gone through multiple plastic surgeries)”

Source: Fintech fiction

 The second wake-up call (not sleeping with a virgin) came from another familiar source. Non-disclosure of investment holdings of the CEO of LC and of one board member (John Mack, ex-CEO of Morgan Stanley) in a business that is linked to LC business. Laplanche owned 2% of Cirrix Capital without disclosing this investment. Cirrix is a 20th century business practice (still works): they borrow money (called leverage in the 20th century) and then buy loans. Cirrix Capital had been investing in Lending club loans. Things started to get tangled because during Laplanche’s reign at LC, the board and the risk team agreed to a 15% percent limited-partnership stake in Cirrix. This meant that LC added to its “Book” a position in Cirrix, another 20th century element. So LC started running a book and a position in a business that was making money by leveraging loans from LC and other marketplaces. How does that stink? What ghost from the 20th century is that? Mixing trading with lending businesses, and leaving room for the possibility of a Cirrix heavily concentrated LC portfolio; these seem eerily and rings bells of problems faced by Bear sterns, Merill Lynch, Morgan Stanley in the past.

The Book with a position in Cirrix, the disclosure disputes with a securitization counterparty on the Street, have spooked the market! Not because it is a black swan, on the contrary because it is all too familiar and it makes borrowers, investors, and shareholders feel dumb (as they thought they were sleeping with a virgin).

Two Disclosure bumps on the ski slope

The accident didn’t come from higher borrower default rates (we were all focused in that area as rates were spiking up + smells of recessions); it didn’t come from lenders pulling away from the table because the risk/return trade-off wasn’t decent anymore.

It came from the bridges being built between Fintechs (online lending marketplaces) and the incumbents (institutional money). The market has paused and so has the dance between the banks and the lending marketplaces. Unfortunately, this halt is damaging to consumers and SME that have been served through these channels as the traditional ones have been shut down from regulators. What may happen now in reaction to this skiing accident? We don’t want the slopes to close down! However, agencies and regulators may step in and start reviewing the agreements between banks and online lenders. The Prudential Regulatory authority in the UK and the Consumer Finance Protection bureau (CFPB) in the US may start examining individual company practices. The P2P finance Association in the UK, a self-regulatory body of the sector that has been proactive in setting industry standards, maybe facing a great problem (i.e. a membership line-up to join the transparency movement on P2P platforms).

The tangled web behind the scenes of lending marketplaces has been growing and a Fintech that can handle the corporate governance issues of this business, would be solving a real problem. Any Fintech out there that can handle this?

What do you think?

Where will the pain come from?

 

Daily Fintech Advisers provides strategic consulting to organizations with business and investment interests in Fintech. Efi Pylarinou is a Digital Wealth Management thought leader.