Some many months back, in fact prior to their listings, I wrote a piece questioning the lofty valuations of the marketplace lending platforms (LC and ONDK) as they entered the public markets. The basic thesis was recognizing the fundamental business these platforms engaged, i.e., money lending, and how others in the same space, albeit not as “technology positioned”, delivered the same product and/or service, and I thus intimated that the newbies should be valued with similar metrics to the incumbent financial institutions.
In observing the platforms’ performances over the last year, as well as evolving market conditions, my thinking has changed. In fact, I have furthered my assessment of relative values, and am concluding that there are actually distinct shortcomings in the current technology-enabled model vis-à-vis the conventional banking institutions.
The basic premise in the P2P space was that credit card rates were way too high, so why not provide an alternative to reduce the cost. Behold, lower rate amortizing term loans. Sounds fine, but essentially, such a model is based on price, i.e., something the big guys have an advantage. True, a great technology interface, rapid underwriting and credit decision making were part of the thrill, but in the end, the “product” was better priced credit than other lenders provided. Maybe 70% of P2P clients were “refinancing” high interest rate card debt, so bang…. the proposition seemed supportable.
Well consider any market that competes on price. All participants ride the price levels downward, so where’s the differentiation? There will always be someone that beats you, whether it’s sustainable or not. This is where brand and a broader offering come in. Consider all the major credit card providers, whether Capital One, Chase, BofA, Wells, and others. They have the ability to adjust price for consumer credit as they monetize the broader banking relationship in many other ways. Think about it. I posed the question to a couple of the execs at a P2P platform, anxiously awaiting the response to what happens if Capital One or Chase come out with a permanent 3% card to their best consumer borrowers. Recall that the P2P players target the top 10-15% of FICO scores, so price is the driver for the credit-worthy consumer.
But look at what’s happening now. Because the P2P platforms have just-in-time funding, i.e., they intermediate the transaction, using investor capital to fund loans, and rather than using core (and insured) deposits, they are beholden to their “cost of funds” to drive the price of credit to their borrowing customers. In recent months, such investor capital has dried up, concerned with performance (risk-adjusted returns), as losses and delinquencies have been moving north. So to attract such capital, higher returns are being sought by investors, read a higher cost of funds to the platforms. This of course results in a higher price of credit to the consumer, which all the platforms have raised borrower loan rates. So much for the market positioning of better borrowing costs.
We can further review the business model, and unlike banks that may be able to monetize their customer relationships over many products and services, and during an extended life cycle, these platforms live and die by their immediate transaction volume. Turn on the spigot and they can grow as we have seen. But without new deals, growth stagnates. There is limited if any recurrent income, and the life time value of a customer is limited. Are there recurrent borrowers? Certainly. But to that point, might those that refinance their credit card debt go back out and run up those credit limits once again, increasing their overall credit risk for the next time round?
There have been discussions about the technology enabled, algorithmic underwriting that the platforms utilize, which should be a value proposition. Machine learning, AI, looking at credit factors beyond just FICO scores. A bit of history here. Consumer loans are relatively small, and with bank margins very slim, such credit historically was limitedly profitable. Enter Bank of America in 1958 with the introduction of BankAmericard, the first all-purpose credit card, in an attempt to do consumer lending quicker, faster, cheaper and more profitably. With direct marketing followed by a broad licensing program, the use of “plastic” became part of the banking and credit nomenclature in a huge way. MasterCard, an association of other banks, was developed as a competitor, and BofA and its licensees, evolved into VISA International. Such “plastic” became the protocol of consumer credit, and, while the interest rates were and still are lofty, this was to offset the expected portfolio losses, as underwriting mechanically had issues. The banks were still earning an ongoing net spread. To be cost effective, the process of underwriting a new card applicant has been credit scored since the 1960’s, with possibly in retrospect antiquated algorithms, but still the process was streamlined with scoring methodologies to expedite decision making and deployment. How much human underwriting time can actually be spent on granting a card with a $500 credit limit, given the amount of profits that can be had? Don’t you think Capital One and Chase apply technology and algorithmic underwriting to their current card business as a matter of efficiency? And lastly, have you actually looked at the unit economics of a P2P loan, particularly the marketing cost of origination. Banks can cross-sell; the platforms have one product directly originated. I do acknowledge that some platforms have different types of loans now, but the fundamental model characteristics remain.
So the query is posed. Where lies the sustainable value in these platforms? The product is not unique, i.e., consumer loans. They compete largely on price, which in any market is a concern. The model requires new relationships to grow, rather than monetizing a relationship many times over. The ability to grow is further challenged in a “just-in-time” funding model, with such cost of funding subject to more volatility than the banking industry. As few hold a recurrent revenue portfolio, there doesn’t seem a tangible asset to place value, nor is there the ongoing net interest spreads to capture. There is now a move towards balance sheet lending. Hmm. Seems like the banks have something with being a depository with a stable and well price funding pool. That said, how and with what do the platforms fund their balance sheets with? More equity? A bit dilutive, eh?
Finally, is there real intellectual property contained therein, such as risk assessment and underwriting methods, that the larger card issuers and consumer lenders do not enjoy? This of course begs the questions, are these sustainable models, and do they have strategic and economic value for an acquirer, as it appears that many have “for sale” signs up? Maybe for someone outside the space looking to enter gingerly, but for a big player, what would they be buying? What is the value add?
While this assessment is not meant to be a complete disparagement of P2P or online finance. In fact, I am one of the biggest bulls on online lending and capital formation. Money lending is actually the “world’s oldest profession”, even longer recognized than the business of carnal frivolity according to the Code of Hammurabi in 1800 BC. Modern banking developed during the Renaissance periods with the brilliant European merchant banks, such as the Rothschilds, Warburgs, Medicis, Fuggers, and Barings, that transitioned from “merchant” activities to extending credit to other merchants, as the depth of their knowledge was unparalleled and they found the returns from money lending were more attractive than trading goods. The predicate of their activities was knowledge and information: about their clients, the markets, the external conditions, and how to price their risk. Theirs was keenly an information business. And now, we live in an information world, where data and facts are readily available, in all quantities and qualities, able to be assembled and analyzed for risk and return assessment. Information technology is meant to be applied to finance and money lending. It is only natural and commonsensical. But what will the sustainable models look like: that’s for another chapter.