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

img_1088

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.

If you want to see these insights before your competitors, join over 15,600 of your global peers who subscribe by email and see these trends reported every day. Its free and all we need is your email.

 

 

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.

Searching for the Priceline of Fintech after Lending Market Meltdown Week

fukushima-no-1-meltdown-confirmed-japan1

You could have bought Priceline stock below $10 in 2001. For many years you had little to show for it. From then until 2008, you had some appreciation, but not much. Then the stock shot up above $1,000 (as of writing it is $1,261). Yes that is 100x return from a liquid public company! Could Ondeck ($ONDK) or Lending Club ($LC) be a similar story today? Or could one of the still private ventures such as Prosper, SOFI, Funding Circle and Kabbage seize the day?

Ondeck – first in, maybe first out.

Ondeck was the first Lending Market to go public, before Lending Club. Both have been hammered since their IPO and last week was a blood bath that we call Lending Market Meltdown Week, with gloomy news from Lending Club and earlier layoffs from Prosper and an earnings miss from Ondeck. There are three scenarios for Ondeck. One is that Ondeck is the bargain of a lifetime, like buying Priceline after the Dot Com crash. The opposite scenario is that Ondeck is headed to the deadpool. Or Ondeck could be bought by a bargain hunting PE firm for a small premium – possibly after further pain.

We outlined the Ondeck bear case when Ondeck did its IPO.

In November 2014 we took a negative view of Ondeck based on an analysis of their Customer Acquisition Costs and their APR %. Investors who heeded that warning would have saved a bundle. Sign up for Daily Fintech by email so you get your insights ahead of the pack – its free.

In Nov 2014 we wrote:

“The weakness in the Alternative Credit model is a very old-fashioned metric – Customer Acquisition Cost. If they have to pay a lot of money to brokers or to advertise, their CAC maybe too high.

A high CAC is fine if you get a lot of repeat business. That translates to a high Life Time Value (LTV). The metric to track is CAC/LTV. That works in a SAAS business. You spend a lot of money to acquire the customer because the churn rate is low, your CAC/LTV ratio is still OK. If you spend a lot of money to acquire the customer and the churn rate is high, your CAC/LTV ratio will be bad and that translates into a profitability problem.

This is where Alternative Credit businesses that offer short term “stop gap” funding have a fundamental CAC/LTV issue. When pressed about the high APR rates (which you get to by multiplying the interest on a 30 day loan by 12 or a one day loan by 365), the response from Alternative Credit businesses is that the APR rate does not apply in their case because the borrower only needs that “stop gap” financing occasionally.

If that is true, they have a churn problem aka a CAC/LTV issue. If it is not true, because borrowers become reliant on “stop gap” funding, then those APR rates are true and that puts the borrower into financial difficulties. That is where you can end up on the front page in a bad way, like Wonga. Reputation risk and regulatory risk are closely related in the social media age.”

We went looking in the latest 10Q to see if anything has changed in those 18 months.What we wanted to see was whether they were either getting more repeat business (ie lower CAC) or making money on lower APR % (ie getting higher credit quality borrowers). Either is fine and might signal opportunity.

The Priceline story

That 100x return from a liquid public company had three ingredients:

  • Total crash in sentiment (all tech was dead).
  • Fundamental tail winds – the Priceline model was right and the Internet was just getting started.
  • Patient smart management that executed well.

Could that be the story for Ondeck? Or Lending Club?

Most likely Ondeck scenario is a cheap buyout

We discarded the quick trip to the deadpool thesis because Ondeck has plenty of cash compared to any that it might be burning.

Nor did we see any evidence of the big upside Priceline of Fintech story. We don’t see any evidence of a big uptick in credit quality or of repeat customers. It is possible that Ondeck is doing this but the results are not yet visible. If you have some insights in that regard, please share them in comments.

So, Ondeck is a boring story – no sudden death and no rebirth to greater glory. Some sharp-pencilled analyst at a PE fund will figure out a value story and take it private. At below $400m market cap, Ondeck is too far below the small cap hell threshold of $2bn to survive as a public company unless there is evidence of a Priceline type story. We suspect that many PE firms had been looking at Ondeck before last week and the valuation just became more compelling. This is all about valuation and timing. Wait a bit longer and you may get it cheaper. Wait too long and somebody else snaps it up.

Kabbage is hoping to shred Ondeck into coleslaw

Kabbage is in the same game as Ondeck – SME loans – but they stayed private. Their marketing emphasises the K in their name – cute does sell as anybody who looks at kittens online will attest – or should I say kute? However an SME owner will go for a really boringly named venture if their lending terms are even fractionally better. No matter who wins the SME lending market (it is big enough for multiple winners), the SME owners will benefit from the competition and that will be good for the overall economy.

The Daily Fintech thesis is that SME Lending is a market opportunity big enough to drive a truck through. Looking globally we see the micro entrepreneur intersecting with what we traditionally call consumer lending. That is why we devote one day a week to this subject – Wednesday’s coverage by Jessica Ellerm.

Priceline had a unique model. If you have a unique model you are ignored, laughed at, fought and then you win (in the 0.1% cases where a unique model is actually correct – you have to be contrarian and right). It is unclear that Ondeck has a unique model. The basic value is faster, more efficient loan processing than banks using digital forms and big data analytics. That is valuable. There is an arbitrage between what it costs a bank to process a loan and what an AltFi originator such as Ondeck, Kabbage or SOFI manages. The inefficiency of bank loan processing leaves plenty of room – but like all arbitrage plays, winning is about speed of execution.

This leaves Ondeck vulnerable to a better, faster, cheaper alternative. The technical innovation around digital forms and big data analytics makes it possible for many new entrants. One is reaching some reasonable scale – Kabbage. This Atlanta based private venture raised a $135m Series E in October 2015, so they are well capitalised. Investors were already in a “show me” mood in October 2015, so although we do not have access to the financials because Kabbage is private, we take the $135m Series E as a proxy for good traction.

Nerdwallet has a good comparison of Kabbage vs Ondeck vs Paypal. FitsSmallBusiness adds PayPal into the SME owners short list. WeRockYourWeb adds Lending Tree and Lending Club into the mix. SME owners who know how to use Google can quickly add FundBox, Prosper, CAN Capital and Funding Circle into the mix. In short, SME owners who annoyed their local bank manager by beating them at bridge have more options (ok, enough Mr Smith Goes to Washington fantasies, we understand that Banks have depersonalised service and you are unlikely to ever meet a bank manager).

One venture success mantra that works is “build xxx that does not suck”. The AltFi Loan originators are doing “loan application processing that does not suck”. Google with email and Amazon with hosting are examples of hugely competitive markets that rewarded a better, faster, cheaper alternative. They also had patient capital – you know, like somebody buying Priceline in 2002 and waiting 14 years for a 100x return. VC funds are constrained by need to give liquidity to to LPs and public market investors think they have to exercise the liquidity option (unless they are Warren Buffet); but that is another story. The point is that a great user experience and great customer service is what matters. Zappos is another “build xxx that does not suck” in an overcrowded competitive market. Banks and Altfi management teams should study Zappos more than Lending Club as this is a service business.

SOFI shows how fast follower should be done 

Sofi (as in Social Finance) bills themselves as “a modern finance company that’s fueling the shift to a bankless world”. SOFI is a startup financial services business that uses technology. This is an example of what we call the Great Fintech Convergence  – who cares whether it is a tech powered Financial Institution or a tech company that is regulated, as long as the terms are right? You can come from Fin or you can come from Tech – the destination is the same.

SOFI made a smart move. They started with student loan refinancing. The bet was that this would lead them to consumers who would become good credit risks, because their earning power would increase as their career took off (as the ROI on education is still strong because the R part is good even if the I part has suffered from horrendous inflation). From this market entry they moved into Mortgages and now their site is also talking about Personal Loans and Wealth Management. This HENRY strategy (High Earning Not Rich Yet) is explained well in this A16Z post.

SOFI is not touting any tech secret sauce. Nor is this a network effects game. This is a strong management team using everything in their arsenal to go after the big picture – the vertically integrated bank model morphing into a networked marketplace model.

Founded a few short years ago in 2011, SOFI raised a whopping $1 billion in September 2015 (billed at the time as enabling them to delay IPO until the market is ready). Although SOFI is based in San Francisco, the approach feels more like a Wall Street approach, with seasoned ex Bankers on the team. For another big shot at this brass ring, this time from core Wall Street, see Goldman Sachs moving into retail banking.

Could Lending Club be the Netscape moment in a bad way

When Lending Club had their IPO we called it the Netscape moment for Fintech. The first part of that story played out. Venture capital rushed into Fintech in 2015. Students of tech history will recall that the Netscape story did not end well  – they ended up being crushed by Microsoft.

We see no signs of the second part of that story in the case of Lending Club. There is no equivalent of Microsoft – a single behemoth competitor run by a brilliant and tough CEO. Lending Club has over $600m in cash with a cash burn that puts the company in no danger of a liquidity crisis. At a market cap around $1.5bn they have moved into small cap hell territory and trader’s mantra is “don’t catch a falling knife”, so we can expect further pain in the stock price. Lending Club is now a cheap stock. Wow.

Lendacademy has a good summary of what went wrong that led to the CEO resignation as well as a look at their latest financials.

The positive way to read the announcement was that Lending Club has an active and responsible Board that came across something bad and took quick action. There is always the suspicion that “if you see one cockroach, there must be more” and that suspicion will be a drag on the stock for a bit longer; but if you take a longer term view (like those smart enough to hold onto Priceline) you could be handsomely rewarded.

Unlike Ondeck, Lending Club has network effects on its side. This could be a a Priceline story. Two out of three ingredients are here:

  • Total crash in sentiment. Tick – all Lending Marketplaces are dead.
  • Fundamental tail winds. Tick – we are not going back to a vertically integrated bank model and Lending Club has enough network effects to be at least one of a couple of big global winners.
  • Patient smart management that executed well. TBD. Lets see who the new CEO is.

If you incline to the view that Lending Club’s trajectory is southbound, this HBR article about negative network effects will reinforce your thinking. TL;DR, network effects are about trust and trust can be lost. One assumes that the Lending Club Board fully understand this. The new CEO will come in after this Tylenol Moment. The immediate actions of the new CEO will be interesting to watch.

Prosper could have it right with Prosper Daily

Prosper started even earlier than Lending Club – in 2005. They went through a near death experience thanks to a brush with regulators that they did not handle well and re-emerged in 2013 with new investors and new management. This is a battle-tested team. They clearly opted to stay private and they got their painful cuts over before the Lending Club scandal broke.

The reason I think Prosper may have got this right is their acquisition of Billguard in September 2015.  This Israeli venture found a clever way to find all those small errors in your credit card bills. They offered it free, because this was a networks effects game – other users saw a wrong charge and highlighted it so that you could take action. In March 2016, post acquisition, it was rebranded as Prosper Daily.

The name Prosper Daily signals that Prosper aims to pass the  toothbrush test.  The reason this is so important is that regular use means low CAC – see our November 2014 analysis of why Ondeck was flawed. This is why banks have done so well for so long. Because we used them all the time for our current account needs, we were more likely to turn to them when we wanted a loan.

The sort of customer who checks for small errors in their credit card bills is more likely to be the kind of prudent customer who is a good credit risk and who may still want loans when other have become credit averse – a subject we covered here.

Funding Circle

In our 2016 Predictions we had # 9 as “Calls for regulating Fintech startups more intensely will follow at least one high profile blow up.” Tick that box after Lending Club CEO resignation (actually two ticks as the Zenefits story has the same trajectory). The regulatory backlash after Lending Market Meltdown Week will take time to play out, so more pain is to come.

This is were Funding Circle is interesting. We wrote about Funding Circle in October 2015 as the only UK lending marketplace crossing the Atlantic to take on the US market; all the other big players are American. Funding Circle has done a lot of innovation in this market  – the first listed investment vehicle to buy lending marketplace loans, Europe’s first peer-to-peer ABS – but it is their proactive leadership in setting up the Peer to Peer Finance Association (together with Zopa and Rate Setter) that may help them stay a step ahead of the regulatory mess coming out the Lending Club news.

Lending Marketplace Meltdown Week caused blood in the streets, which brings out those who  are greedy when others are fearful.

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

5 Opportunities as Lending Marketplaces enter hyper growth 

By Bernard Lunn

Marketplace Lending

Image courtesy of Ethos Private Wealth 

Thesis: hunger on origination side from small business + hunger on investor side starved of yield by prolonged ZIRP + banks withdrawing due to balance sheet and capital ratio issues = window of opportunity big enough to drive a truck through.

Evidence:

+ Lending Club valued over $5 billion in public market after their Netscape moment for Fintech IPO.

+ Prosper $5 billion loaned to 250,000 people.

+ Funding Circle going global. 

+ $1 billion raised by SOFI.

+ 2 year old Avant raising $325 million at a $2 billion valuation.

= investors willing to write really big checks to back the big winners.

Prize:

These businesses are scaling like crazy and are still no more than 5-10% into the market. This Morgan Stanley report has the data.

5 Opportunities: 

It looks like the big marketplace winners have already been declared. Before the SOFI and Avant announcements, I would have said the same thing. If there is another strong team with great traction out there, expect to see open check books being waved around. It is certainly too late to start a marketplace from scratch – those days are over. I also see the end of niche plays. SOFI may have started with student loans but all marketplaces win on network effects and volume. So whether you are consumer or a business and within consumer whether you are a Millennial Student or a Baby Boomer refinancer does not matter.

However here are 5 second order impact type of opportunities. Moving into a hypergrowth market is great if you have a unique proposition. You don’t need to worry about market demand, only about how you get traction with a new service.

  1. More innovation on originations front. Today we are seeing relatively simple digital data entry by borrowers and basic data science as the key innovation. That was enough to get traction in the early days simply because the lumbering paper driven process at banks was so bad. Now that a digital origination service is the baseline, we can expect to see more innovation on both the data capture side and the data science part. Innovators that we are seeing on this front include Kreditech and IWOCA. It is likely that some of these innovators will be acquired by the big marketplaces.
  1. Serving entrepreneurs in the “markets formerly known as emerging”. These entrepreneurs have been even more badly served by banks than their peers in the West and they have high GDP growth economies on their side. For example, see what this entreprenur turned VC turned entrepreneur again – Alok Mittal – is doing in India.
  1. Banks will find a role to play by being the low cost capital provider. This is what Banks do in Corporate Lending – a low margin high scale game where cost of capital is the primary issue. They will mostly exit the originations business; some may decide to be a player in originations by buying one of those innovators. Banks never liked serving small business anyway. Now they can just lend to bundles of small businesses as if they were one large Corporate.
  1. The Wealth Management industry reshapes around this new reality. They will work with the emerging breed of micro asset managers who know how to process the data streaming out of lending marketplaces using their APIs to offer their clients a better risk adjusted return on capital.
  1. The move from short term lending to term lending. Nobody wants to repeat the Wonga debacle. Merchant Cash Advances are not much better. Term Loans at transparent APR is what any prudent small business owner wants. That is why we highlighted Dealstruck a year ago. The firms offering short-term loans will move more into term loans as competition and transparency puts the focus on APR. The short-term lenders making that transition will have one big advantage – data. The data on who repaid short-term loans and how much revenue and cash flow coverage they had to do that is key to assessing their credit worthiness for term loans.

Daily Fintech Advisers provide strategic consulting to organizations with business and investment interests in Fintech.

The fast money moving into P2P lending and the danger of another subprime meltdown



Hope springs eternal, but math is merciless.

Financial innovation makes us hope for better outcomes for all. We hope that the securitization of mortgages leads to more people being able to afford to own their own homes. Seven years after the subprime mortgage meltdown, we hope that P2P Lending will enable people and small businesses to “make ends meet”.

That is the hope and the hope is always based on a hypothesis that has enough truth for it to be credible.

It is hard to remember that Countrywide Financial was once seen as an innovator that was bringing down the cost of mortgages for poor people. Hindsight is always 20/20.

The hopeful hypothesis in the P2P Lending story is that by automation and cutting out the spreads charged by banks, we can dramatically reduce the cost of borrowing money. When financial institutions can borrow at “almost zero cost” in our central bank driven Zero Interest Rate Policy (ZIRP) and we can let machines do the hard work of credit analysis at almost zero cost, why should consumers and small businesses pay such high rates?

The simple populist answer is always “banker greed”.

The reality is more complex. Credit analysis is complex. Lending has limited upside and lots of downside, so the math has to be right. In equities, you get big upside with the big downside risk, so it is less about math and more about potential in technology, markets and management. Lending is easy when the data is there, as it is for mainstream consumers that have a healthy FICO score and as it is for Corporate Bonds. It is much harder in markets where lenders cannot simply plug in a credit score from companies such as FICO, Moodies and S&P into their models. These are hard data problems and complex algorithms.

For the Alternative Finance P2P marketplaces, the math is still merciless. If a consumer is poor and cannot make it from payday to payday, the credit risk is tough. That merciless math has already brought Wonga into the headlines in a bad way. The reality for many bricks and mortar retailers and Merchant Cash Advance companies is equally tough.

Alternative Finance P2P marketplaces cannot solve the fundamental problems in the economy. However, because of the popular hope created by these marketplaces, the sentiment and brand damage when those hopes are dashed will be dangerous for those marketplaces (and will lead to more regulation).

The simple takeaway from the Subprime Mortgage blow out was:

“It’s the Transparency, Stupid!”

Or to be more accurate, it was the lack of transparency. Lenders were being asked to trust credit rating labels that were paid for by the firms selling the loans. Actually the data was there, but many lenders chose to simply trust a surface rating rather than do the hard analysis.

As the Who sang: “Won’t get fooled again”

Institutional Lenders that lend into Alternative Finance P2P marketplaces now do the hard analysis and the marketplaces give them the tools to do this. Marketplaces want transactions but they are also fully aware that too many bad transactions will put their business in peril.

So, hope does spring eternal. Data can solve the problem because economic incentives are aligned to that.

However the danger lies in the P2P part of Alternative Finance P2P marketplaces. This was how the concept originated, but the reality today is that the lenders are mostly institutional funds. The retail lender can be divided into two types:

  • “Day Lenders”.They are like the day traders in the late 1990s and they are as savvy as the institutional lenders, with high speed trading rigs, tech and data analysis skills and a tough, fast moving trading mentality.This article from Lending Memo is good at explaining how they work. TL;DR summary, make sure you know how to code to an API. High Frequency Trading (HFT) sidelined the day traders, because they could not afford the co-located servers at the Exchanges. In Feb of this year, the FT reported on Lending Club and Prosper installing “speed bumps” (paywall link) in order to prevent this happening to P2P lending.
  • Retail Investors looking for extra income. The average consumer sees a headline rate and a credit badge put on by the marketplace and is so excited by that compared to what they get from a bank, money market fund or bond funds that they ignore the mandatory small print warnings. This is where a subprime mortgage type meltdown risk lurks.

Alternative Finance P2P marketplaces are currently in the fast money phase.

This is the world of Hedge Funds and tech savvy retail traders. They are are doing well on these marketplaces because the markets are still inefficient and opaque. They are arbitragers and that is a good business that rewards those who are fast, tech savvy, smart and tough. That is a good phase to go through. The next phase is where the big and more patient money will come in and that will bring down interest rates and the arbitragers will move onto the next inefficient and opaque marketplace. Efficiency, transparency and regulation is the big win for the Alternative Finance P2P marketplaces because they don’t care about the actual interest rate; all they care about is the volume of transactions from which they make their fee.

The upcoming IPO of Lending Club is bringing lots of new money into new marketplaces. Not all of them will be equally vigilant about protecting both sides of the marketplace. Most of them will fail because marketplaces always consolidate down to a few big ones (think NYSE vs NASDAQ). The danger to the whole ecosystem is that some nasty scandals from some unscrupulous players bring the whole concept into disrepute.