By James Alexander, CrowdFunding Beat Guest Editor, Capital Formation for Direct Lenders.
…Is Really Good News for Borrowers and Possibly Investors
“It’s only the beginning” – that’s how Renaud Laplanche, CEO of Lending Club, nicely summarized the state of marketplace lending today. The bad news is, the incumbents have set a high bar and created a cacophony of also-ran pretendants, challenging investors to find the winners in this high-potential sector. Also brewing on the horizon are uncertain economic times, sure to present their own challenges in the near future.
Following are some recommendations of platforms which might warrant investor attention. We particularly focus on those platforms with:
innovative business models;
economic resilience across business cycles; and
Business Cycle Update
It’s important to consider the overall credit environment when assessing lending platforms. In the eleven business cycles since 1945-2009 (11 cycles), the average expansion period (previous trough to peak) was 58.6 months, according to our friends at the NBER. If we assume the current expansion began in June 2009, we are now 66 months into the current business cycle. Even in the context of Federal Reserve printing presses working overtime, we are deep into the current business cycle.
We’ve arrived at Prosperity! Although there are scant signs of any imminent reversal to the current benign credit environment, there is likely not much upside – in other words, more likely downside risk to loan loss rates.
Picking the Winners
Lending can be divided roughly into two categories, consumer and small business. The respective leaders in these categories, Lending Club (NYSE:LC) and OnDeck Capital (NYSE:ONDK) both executed successful IPOs in late 2014. It should be noted both these platforms were founded in 2006. We should applaud the investors, executives and employees of these companies for their eight years of Penelopean patience. Surely there were dark days along a not-so-straight route to IPO.
The leading consumer credit platforms, Lending Club and Prosper Marketplace together originate more loans each months than the rest of the industry in the US combined, an estimated $800 million per month. Both Lending Club and Prosper underwent re-starts in 2009, following action requiring SEC registration. As a testament to execution, other relatively unknown consumer credit platforms, including Payoff and CircleBack Lending were also founded in 2009.
Investors would do well to ignore the me-too consumer lending platforms, and focus on experienced operators who have learned from the incumbents and are now applying that knowledge to create better lending models.
Freedom Financial – One such platform is Freedom Financial, where former Prosper and Lending Club executive Joe Toms runs the company’s direct consumer lending practice. Founded in 2002, Freedom has roots in debt settlement and counseling, which has created deep understanding of distressed consumer behavior. Freedom’s ability to engage with borrowers, over months–or even years–as debt counselors, should lead to loss rates a fraction of comparable unsecured loans. Freedom is also well positioned for the next inevitable economic downturn.
CircleUp – I’m including CircleUp in the consumer category, not because they lend to consumer, but rather provide capital to high quality consumer product companies. There is an interesting phenomenon occurring in venture capital: whereby most early-stage equity capital investments is flowing toward technology companies; and starving high quality non-technology companies of much needed capital. This could be a great time to invest in early stage consumer product companies, which tend to perform better across economic cycles and seem to offer compelling value in relation to comparable technology companies. Not coincidentally, Scott Sanborn, COO of Lending Club recently became a board member of CircleUp.
Banks don’t seem to like small businesses, and even appear to go out of their way to avoid lending to this crucial segment of the US economy. Compared to consumer lending, business credit is often characterized by higher yields, shorter duration and less regulation. The downside is the manual nature and greater complexity of underwriting a business loan. With OnDeck now leading the way among technology-enabled business lending platforms, there are select platforms poised to revolutionize business lending as ‘non-bank banks’.
Able Lending – is a Peter Thiel-backed small business lending platform with an innovative business model called collaborative lending. In short, a collaborative loan involves backers, including friends & family willing to help fund your loan. Backers fund 25% of the loan and Able matches the other 75% of the loan. For investors this provides protection, similar to subordinate or first-loss protection in securitization.
FastPay – Founded in 2009 in Los Angeles, FastPay provides factoring to media companies, including publishers, advertisers, ad agencies and app developers. Specialty finance is often about exceptional underwriting capabilities and occupying a defensible vertical. FastPay has a strong pedigree in both regards: the founder spent a decade at DreamWorks; the COO held significant positions at Wonga, Green Dot and Capital One, for example.
Passive or Active Investing
For investors looking to gain exposure to direct lending, the investment thesis revolves around the possibility to achieve high yield, short duration fixed income returns. In addition, for the bold there is the possibility to gain equity exposure among emerging and established platforms.
Investors are faced with a myriad of choices today to gain exposure to direct lending. The best advice might be to acknowledge your level of understanding of underwriting and decide to be a passive–letting others make lending decisions for you–or active lender. Most investors will choose the passive lending route initially. There are various choices today to gain passive exposure by going directly to the platforms or selecting a third-party manager.
One final thought, offering the potential for three-dimensional exposure to direct lending is Orchard Platform. This platform of platforms plans to offers investors exposure to myriad consumer and small business assets; in a passive or actively managed manner. The management and backers of Orchard are among the most impressive in this sector.
A heartfelt thanks to the leaders who continue to disintermediate banks and establish lenders. It’s only the beginning!
Capital Formation for Direct Lenders