I will start with a few definitions to set the stage.
By Digital Alternate Lending Platforms (Digital Alt Lenders) I mean a new generation of non-bank lenders that originate, underwrite and provide credit across a variety of asset classes via a digital platform, with the use of varied data sources, some traditional, some non-traditional, advanced data analytics, big data technology and machine learning. Digital Alt Lending is the act of lending by Digital Alt Lenders.
By Marketplaces I mean a subset of the Alt Lenders universe, where the marketplace originates, underwrites, arranges for providing lending by connecting borrowers and lenders. A marketplace will not retain ownership of the loans it originates.
By Digital On Balance Sheet Lenders (On Balance Sheet Lenders) I mean a subset of the Alt Lenders universe that retain ownership of the loans they originate.
By Hybrid Lenders (Hybrids) I mean a subset of the Alt Lenders universe that act as marketplaces for some of their origination and also retain ownership for the remainder.
By P2P Lenders I mean a subset of the Alt Lenders universe that connect individual borrowers with individual “retail” lenders, as opposed to institutional lenders, hence the term peer for peer 2 peer, P2P.
By P2P Lending and Crowdlending or Crowdfunding applied to lending – to be used interchangeably – I mean the act of enabling individuals (lenders) to provide credit to other individuals or enterprises (borrowers). I will use Crowdlending throughout this post for simplicity’s sake.
Crowdlending started in the UK in 2005 with Zopa. Many P2P lenders followed suit across the globe. Lending Club and Prosper are but two of the leading examples in the US. Initially crowdfunding brought the promise of disruption in the lending industry, by taking brick & mortar processes, moving them online or digitizing them and making them more efficient. The promise of disruption was based on pure disintermediation, removing traditional lenders, banks and non-banks from the equation by connecting individuals with individuals, peers with peers. Pure Crowdlending does not exist anymore. Most if not all platforms are growing by leaps and bounds with the help of institutional lenders (hedge funds, pe funds, even banks now). Individual “retail” lenders, or peer lenders now make up less than 10% of the lenders volume on most if not all major platforms. This somewhat defeats the original “peer” purpose of disintermediating banks, and Crowdlending has morphed into the Digital Alt Lending space.
Although I do not have specific data to fully ground my views, I think the majority of Digital Alt Lending platforms are marketplaces, with a minority being on balance sheet lenders and hybrids. All platforms go through the same growth pattern from a debt perspective. The platform will first secure an equity funding and use part of the equity to fund its origination to prove the concept. The platform will then secure a small warehouse facility to fund its origination and over time and with origination growth will graduate to bigger and more sophisticated warehouse facilities with a blended cost of debt trending lower as the size of the facilities grow larger. The end goal will be for a platform to either a) graduate to very mature institutional take out at the lowest cost of debt possible or b) graduate to the securitization markets both private and public. To be clear not all asset classes will lend themselves – no pun intended – to the securitization markets, hence the bifurcated paths.
Let us now review the dynamics of Digital Alt Lenders. Digital Alt Lenders need a) a digital system (the “system”) which I colloquially refer to as the secret sauce and includes the origination/underwriting/credit scoring/servicing tech + data analytics + data sources + big data (if any) + machine learning (if any), b) adequate cost of capital, c) distribution channels.
Which of the three above vectors provides long lasting, meaningful and defensible competitive advantages?
Cost of Capital: Any Digital Alt Lender can start with a lower cost of capital based on executive prowess or preferential business relationships. In the long run the surviving Digital Alt Lenders will tend to gravitate to similar cost of capital proportionate to the volume of their underwriting and where the market stands on the credit cycle. I do not see this vector providing a long lasting competitive advantage.
Secret Sauce: Let’s deconstruct the secret sauce. Data sources and software code can be secured and built by anyone with the right resources. What stands out is the credit scoring and underwriting algorithm + machine learning if any. I am of two minds here. On the one hand I can picture platforms that build superior underwriting and compete on that alone by achieving relative and absolute dominance and delivering on the elusive dynamic pricing of credit the industry has been chasing as the holy grail for a while. On the other hand there is enough supply of highly skilled engineers, of sharp data analysts, of financial engineers for every Digital Alt Lenders to all converge to best in class credit scoring. What say you reader? Do you think the secret sauce can potentially be a long lasting competitive advantage?
Distribution Channels: It all starts with origination. If one is able to secure proprietary channels to originate debt, then one is ahead of the curve. If one is able to lock down over time, via exclusive partnerships, defensible working relationships, these channels, then one will win in the long run. Surely distribution channels can provide a sustainable advantage.
If I am right, then Digital Alt Lending Platforms will necessarily converge towards partnerships with either Banks on the consumer side of the equation or Banks and Payments Processors on the SMB side of the equation or specialty service providers for other niche asset classes (solar, real estate for example). Why? Because Banks and Payments Processors and speciality service providers have the relationships with the borrowers, and accessorily the lower cost of debt. Further, as the Digital Alt Lenders have had early and significant success, Banks will want to (and the early signals are that they are) partner with Digital Alt Lenders to ensure they will be significant players in consumer and SMB space. The alternative will accelerate their demise.
If the secret sauce can be differentiated in the long run, then Digital Alt Lending Platforms will continuously pour resources into data analytics, machine learning, data scientists, credit algos, trying to always stay ahead of the arms race. Else, the arms race will tapper off in the long run to a relative status quo.
Remember, the ultimate prize is to graduate to mature institutional takeouts or the securitization markets. As such, pure disintermediation will never come to fruition. It is as if the Crowdlending movement was coopted by the traditional lending and capital markets narrative.
Where does this leave us? Well, to the title of this post. To efficacy.
Now, Crowdlending experienced material growth in part because of the 2008/09 financial crisis. Banks mostly, and to a lesser extent non-bank lenders retrenched from lending to consumers and SMBs by tightening their underwriting thresholds – forced by regulators, their poor performance and the resulting need to clean their balance sheets. Crowlending growth led to Digital Alt Lending growth as the Banks still shied away from significant credit expansion (both willfully and because of their regulatory problems). Essentially one path to securitization of credit, the Bank path, has been substituted for another, the Digital Alt Lending path. This leads us to the efficacy of the latter.
Digital Alt Lending holds several advantages:
1) Opex Advantage
2) Lower cost of acquisition
3) Faster, more nimble underwriting
4) Potentially superior data analytics that could deliver more precise and granular credit pricing
5) Unencumbered by legacy systems
6) Ability to look at various data sources
7) Ability for investors to cherry pick the exact risk/return profile they seek when purchasing loans
8) Up to now, not under as much regulatory scrutiny as banks – will this last?
Digital Alt Lending also holds several disadvantages:
1) No platform has gone through a full credit cycle
2) Many executives and founders are not steeped in lending and/or capital markets
3) Marketplaces do not have a skin in the game (by definition, but this can be mitigated with tweaking the model and demanding marketplaces hold capital against their originating activities)
4) Most actors are VC funded and hardwired for hyper growth which may lead to poor credit decisioning in the short term
5) Untested credit pricing models and still short of historical data and performance
THE QUESTION is “Will Digital Alt Lenders be more effective at allocating capital from lenders to borrowers than Banks and the traditional system were up until 2008/09?” This question is especially relevant as the end path is the same, i.e. the lowest cost of capital possible with the highest volume possible.
Neutral scenario: The allocation will be neither better nor worse. Digital Alt Lenders may be more efficient at acquiring borrowers or at providing credit swiftly or at pricing credit accurately over periods of time but will not be over the long haul or some gains will be cancelled by some losses (e.g. lower cost of acquisition erased by poor credit pricing).
Worst Case scenario: If we take for granted lower cost of acquisition and swifter credit, we are left with credit pricing. Worst case would come about from massive mispricing and the past repeating itself.
Best Case scenario: Better credit pricing, better analytics on top of a lower cost of acquisition leading to such granular precision and “dynamic” lending. Truly a best of all worlds where the capital markets meet a truly disrupting underwriting and allocation model.
I am an optimist by nature, so I will dismiss the worst case scenario. After all, how can things get worse than what led to 2008/09 – famous last words, I know. I believe in the intersection between Neutral and Best Case based on level of excellence of various Digital Alt Lenders.
As such my investment thesis – which may vary from one geography to another though – is to back a team that will offer the following array:
– Proprietary distribution channels via the right partnerships
– Team to have included the right capital markets and lending expertise as early as possible to mitigate risk
– A certain level of secret sauce to exhibit a higher degree of discipline than other platforms (read sound underwriting framework) again to mitigate risk
– Focus on niche assets. Read no undifferentiated consumer lending, no undifferentiated SMB lending as the first wave of platforms have been built to a certain extent on a lack of focus and valuations are sky high. Much more interested in differentiation asset class wise and riches in niches.
– Marketplaces that contemplate also owning a piece of the action. First because skin in the game breeds discipline. Second because there is meaningful value to be extracted from owning the right debt at the right time.
– If not in the US, then focus on Digital Alt Lenders in South East Asia, Europe, Africa, China, Latin America.
Getting back to the secret sauce, which is an open ended question for me. Can superior data analytics, a superior credit model powered by machine learning by a long lasting competitive advantage? What say you?