Online Consumer Lenders Stumble, While Online Business Lenders Stay On Their Game
July 8, 2016
Something is happening in the land of marketplace lending, painful setbacks. And it’s mostly on the consumer side.
Avant, for example, plans to cut up to 40% of its staff, according to the Wall Street Journal. Prosper is cutting or has cut its workforce by 28%. For Lending Club it’s by 12% and for CommonBond by 10%. And then there’s Kabbage, whose consumer lending division playfully named Karrot, has been wound down altogether.
Kabbage/Karrot CEO Rob Frohwein told the WSJ that Karrot was put to sleep about three or four months ago, right around the time that it became obvious to industry insiders that the temperature had changed.
Ironically, the person who best summed up the problem is the chief executive of a lender that rivals the ones that are suffering, but has announced no such job cuts of his own. In March, SoFi CEO Mike Cagney told the WSJ “In normal environments, we wouldn’t have brought a deal into the market, but we have to lend. This is the problem with our space.” And that is a problem indeed because the success of these businesses becomes entirely dependent on making as many loans as possible so they can raise more capital to make as many more loans as possible so they can raise more capital. Perhaps the end game of that dangerous cycle is to go public, but the market has gotten a glimpse now of what that might look like, and they’re not very impressed with Lending Club.
The pressure of living up to the expectation of eternal loan growth manifested itself when Lending Club manipulated loan data in a $22 million loan sale to an investor, but it was a problem all the way back to their inception. In 2009, the company founder made $722,800 worth of loans to himself and to family members, allegedly to keep up the appearances of continuous loan growth. It was never found out until last month, seven years later.
That is a perfect example of the vulnerability that SoFi’s CEO spoke of months ago when he said, “we have to lend.” Because if they don’t lend or investors won’t give them money to lend, well then we’d probably see things like massive job cuts, falling stocking prices, and a loss of investor confidence. And that’s what we’re seeing now.
This wave of cuts is not affecting much of the business lending side
Despite the rush to the exits on consumer lending, Kabbage’s CEO is still very bullish on their business lending practice, so much so that they intend to increase their staff by more than 25%.
And in the last month alone, four companies that primarily offer merchant cash advances, have announced new credit facilities to the aggregate tune of $118 Million, one of whom is Fundry which landed $75 Million. Meanwhile, Fora Financial secured a $52.5 Million credit facility in May. Fora offers both business loans and MCAs.
And here’s one big difference between the consumer side and the business side. While online consumers lenders have found themselves trapped on the hamster wheel of having to lend, there is very little such pressure on those engaged in business-to-business transactions. Sure, their investors and prospective investors want to see growth, but only a handful are following the Silicon Valley playbook of always trying to get to the next venture round fast enough, lest they self destruct.
Avant’s latest equity investment, for example, was a Series E round. Prosper and Lending Club also hopped from equity round to equity round, progressing on a track with evermore venture capitalists that were likely betting on the companies going public.
But over on the business side, they’re much less likely to involve venture capitalists. Equity deals tend to be one-offs, major stakes acquired by private equity firms or private family offices, sometimes for as much as a majority share. These deals tend to be substantially bigger, are harder to land, and are less likely to be driven by long-shot gambles. In other words, the motivation is less likely to be driven by the hope that the company can simply lend just enough in a short amount of time to land another round of capital from another investor.
Examples:
- RapidAdvance was acquired by Rockbridge Growth Equity
- Fora Financial sold an undisclosed but “significant” stake to Palladium Equity Partners
- Strategic Funding Source sold a large stake to Pine Brook Partners
- Fundry sold a large stake to a private family office
Business lending behemoth CAN Capital has raised all the way up to a Series C round but they’ve been in existence for 18 years, way longer than any of their online lending peers. Several other of the top companies in the business-to-business space have relied only on wealthy investors that did not even warrant the need for press.
The upside is that these companies are less vulnerable to the whims of market interest and confidence. Having a down month would not trigger an immediate death spiral, where a downtick in loans means less investor interest which means a further downtick in loans, etc.
The margins in the business-to-business side tend to be bigger too, which means it’s the profitability that often motivates investments, rather than pure origination growth potential.
There are outliers, of course. Kabbage, which has raised Series A through E rounds already, admitted to the WSJ that they still aren’t profitable. Funding Circle, which also raised several rounds, disclosed that at the end of 2014, they had lost £19.4 Million for the year, about the equivalent of $30 Million US at the time.
These facts do not mean that either company is in trouble. Kabbage is not limiting themselves to just making loans for instance, since they also have a software strategy to license their underwriting technology to banks like they have already with Spain’s Banco Santander SA and Canada’s Scotiabank. And Funding Circle enjoys government support at least in the UK where they primarily operate. There, the UK government is investing millions of dollars towards loans on their platform as part of an initiative to support small businesses.
Business lenders and merchant cash advance companies may not necessarily be on the same venture capital track as many of their consumer lending peers because it is a lot more difficult to perfect and scale small business loan underwriting. Even the most tech savvy of the bunch are examining tax returns, verifying property leases, reviewing corporate ownership documents, and scrutinizing applicants through phone interviews. While this process can be done much faster than a bank, there’s still a very old-world commercial finance feel to it that lacks a certain sex appeal to a Silicon Valley venture capitalist who may be expecting a standalone world-altering algorithm to do all the risk related work so that marketing and volume becomes all that matters. Maybe on the consumer side something close to that exists.
Instead, a commercial underwriting model steeped in a profitability-first mindset makes online business lenders better suited to be acquired by a traditional finance firm, rather than a venture capitalist that is probably hoping to hitch a ride on the join-the-fintech-frenzy-and-go-public-quickly-so-I-can-make-it-rain express train.
Consumer lenders who had to lend and are faltering lately, will now have to figure out something more long term beyond just making as many loans as possible. It might not be something that excites their venture capitalist friends, but it is crucial to building a company that will last a long time.
BRIEF: OnDeck Expands in Denver, Invests $5 million in Office Space
June 16, 2016
OnDeck is expanding its Denver hub.
The online lender inaugurated a new office space worth $5 million, that can accommodate 550 people as it plans to add more to its existing staff there of 170. This is OnDeck’s second biggest hub after New York where it employs 300 people.
The state of Colorado and the Denver Office of Economic Development each gave the company $500,000 in 2012. And in August 2015, OnDeck won an additional $10.4 million in job growth incentive tax credits for creating an additional 400 jobs.
“Our goal is to steadily grow the office and invest more in Denver,” said Noah Breslow, the company’s CEO was quoted as saying in the Denver Post. “Denver is a natural fit for OnDeck.”
States like Colorado and New Jersey are wooing new fintech companies to build and expand their bases in the region. Thanks to the Grow New Jersey Assistance Program, merchant cash advance companies including World Business Lenders and Yellowstone Capital relocated from New York City over across the Hudson to Jersey City in exchange for tax credits. Yellowstone, for instance will earn $3.3 million over ten years in tax credits.
BRIEF: Legend Funding Secures $3 million Debt Facility
June 14, 2016New York City-based merchant cash advance company Legend Funding secured a $3 million debt facility from Houston-based investment investment banking firm Ango Worldwide.
Legend provides working capital financing to businesses in the USA and Canada and the company plans to use the funds for expansion. The deal gets Ango some equity and a seat on the board.
“The merchant cash advance industry is experiencing exciting growth and we felt that the legend management team are strongly positioned to take advance of this opportunity,” said Ango CEO John Carson in a news release.
Balance Letters, Payoff Letters, And Not Letting Go
June 10, 2016
The following is a guest-authored opinion piece on the business financing space
Everyone is struggling to keep their head above the water. Just imagine the scene in the movie Titanic. Currently we are in the scene where they zoom out to show the ship sinking slowly with more people in the water trying to survive than on the ship. “Never letting go” is something everyone is doing and clinging on to whatever floats is the only way to survive. The decline in submissions and quality of funded deals is one aspect that many Funding Companies are realizing. No one is letting go of a piece of their portfolio without a fight.
For many A/B paper (for those who go by the grade system) or the Prime to Sub-Prime, 1st position companies know what I am talking about and it’s time to come clean on the truth and the real perception of why things are the way they are.
You can’t get that payoff letter because that Funding Company does not want to let go of their good paying Merchant. Whether the funding was originated from a Broker or organically, that Business is in bed with that funding company and did not have any intention of breaking a relationship until the option was brought to their attention. Whether this Merchant was solicited by another Broker or the Merchant decided to take it upon themselves to seek additional funding, there is one thing that will most often happen.
As soon as the Funding Company receives a request for a payoff letter or balance letter, they will ask why it is needed or delay the process in releasing one or not give one at all until the Merchant is 100% positive and the reasoning and demand is final. Is there anything wrong with this?
To a Broker? Yes. To a Business Owner? No. As many Brokers will fight and try to justify the circumventing of their Merchants, in this case, this is not circumventing at all. The Business has a contract with the Funding Company and until they have a zero balance, that Funding Company has the right to review their account and offer additional funds or discounts to keep their business. This is how it is with any company. Try calling your cable company to cancel your service. What do they do first? They transfer you to the reconciliation department to try to appease you, offer you free or discounted features, and find out what they did wrong or what company you are switching to. Companies are always trying to improve their service and give their clients the best experience.
Throughout the years, if the original Funding Company could offer a better rate or term than what the competing offer is, it has always been in the best interest of the Merchant to continue with that original Funding Company. It is NOT in the best interest nor is it ethical to put the Merchant in another position that will hurt the business or “double up” contracts to equal an amount if ONE company cannot adhere to the request. “Stacking” by offering a second position is one thing, squeezing in as many positions is another, and over time it has hurt many 1st position Funding Companies.
Fast forward to now, the rise in funded accounts that have “defaulted” may have fallen victim to the promises of something better. There is no one educating or clearing the air that there probably isn’t something better… but that advice won’t make anyone commissions and those Funding Companies still rely on Brokers to bring in submissions.
There has been no recourse on this issue, rather growth, and those who have paved the way have found their path covered in dirt. Stomping in this path are other funding companies who have adopted practices from veterans but feel the need to set hierarchy to something they can’t control.
So, with that said, who really sets the rules to what is fair when we are all walking on egg shells? The cost of acquiring a customer and the cost of losing one is an expensive and tricky loss. It is safe to say that once a Merchant is stacked- there is no going back. Should ethics rule over the choices and fate of a Business? Should we put more emphasis on realistic expectations before and after a Business is funded?
A simple request for a payoff letter can open a can of worms. The underlying factors of the difficulties companies face in our industry are all brought upon by the decisions we make when working with each Merchant. At the end of the day you have to ask yourself- am I helping or am I hurting the Business?
Transparent Pricing Creates a Level Playing Field, says Kabbage’s Kathryn Petralia
June 7, 2016
Loan matchmaking site Lending Tree has joined the Innovative Lending Platform Association (ILPA) to participate in developing a universal small business lending disclosure system to raise transparency with lenders. It will work closely with the association over a 90-day “national engagement period” to create and implement the SMART Box (Straightforward Metrics Around Rate and Total Cost).
AltFinanceDaily spoke to Kathryn Petralia, cofounder of Kabbage Loans, which is spearheading the association with OnDeck and CAN Capital. Below are the edited excerpts from the interview:
Tell us about how the ILPA came about?
We (OnDeck, CAN Capital and Kabbage) represent the largest non bank lenders. We have collectively lent $12 billion through the course of our businesses and so we thought it will be great for us to make a statement through ILPA. We came from a perspective that there are a lot of different products for small businesses on the market like merchant cash advance, equipment financing, invoice factoring and lines of credit. All of these serve different needs and are ambiguously priced. So we wanted to find some methodology which is transparent to borrowers so they can know the exact price and total cost of borrowing.
We want to keep it open and hope that everyone participates in the disclosure methodology so borrowers can have a clear understanding of the fees they are paying.
What is SMART Box. How does it work?
Different loan products have different fees — some have maintenance fees, some have broker fees, usage fees and so on and they are all structured very differently. It can get very confusing and so we came up with all the products to understand what disclosures would be necessary to know the total cost of borrowing. We’re working with OnDeck and CAN Capital to gather comments and disclose a series of methodologies that will create the ‘Straightforward Metrics Around Rate’ and Total Cost or SMART Box. Those who want to participate will have to disclose it on loan agreements to their customers.
What about disclosures by companies? Would you say the industry needs more regulation on that front?
Kabbage and other companies in the industry are all regulated and go through FDIC audits. We all follow KYC, CIP, FFIEC guidelines that refer to lenders. We all follow these regulations and I would argue vociferously that we are regulated businesses already. All companies are very different and there are a bunch of things happening — states like California, Illinois and New York and CFPB are all taking interest in small business lending and it’s a positive that they recognize the partnership between banks and tech companies. On the general lending side, we have Dodd-Frank and Madden vs Midland which look at lending issues. Some of the regulation is around how loans are sold and some of it is around how they are limited. And on the small business lending side, there is push for more transparency which is the reason we launched ILPA. We wanted to set the standard for what that would look like. And having it done comprehensively is beneficial for us as it gives us a level playing field.
On the consumer lending side, there is transparency but it’s still lacking a comprehensive system that encapsulates the total cost of borrowing. APR is a great metric but the total cost of borrowing must be included.
Give us a snapshot of what the industry looks like to you
All businesses serve different markets, are different in the way they fund their loans and operate in different geographies, so it’s hard to say but in general those who have done a good job at incorporating data and tech and streamlined operative process will have an advantage and will make it through economic turbulence.
What’s your short-term prediction?
Companies that are not well capitalized will have a tough time raising capital in 2016 and we have already been approached by a number of businesses that are looking to sell or find a partnership because they aren’t well capitalized.
Tell us what’s happening at Kabbage?
We have two businesses – the direct lending business which we are trying to grow and the second is the platform business where we have seen sustained growth, with existing partnerships with ING in Europe, Santander in the UK and Scotia Bank in Canada. More partnerships are in the offing – both domestically and in Latin America.
It’s Time to End the Phrase ‘Marketplace Lending’ – Because it’s Insane
May 19, 2016
Nobody knows what “marketplace lending” means, including me. That’s kind of ironic considering AltFinanceDaily is for the most part a publication dedicated to it. In fact, the cover of the March/April issue featured a big yellow robot sporting a name tag that actually said, “Hello, my name is Marketplace Lending.” Even the letter I penned that introduced readers to the issue used the phrase not once, not twice, but FIVE TIMES.
The FDIC basically defined it as encompassing all types of financing that include the practice of pairing borrowers over an online platform. Eager to be hip to the industry’s newest lingo, I got on board, and unfortunately perpetuated something that makes almost no sense.
Many companies operating under the marketplace lending umbrella don’t even know that they’ve been lumped into it. It’s become a media buzzword, something to help the simple masses understand so that they will click on a news headline without worrying if the content will only be geared toward the financially savvy.
Imagine shopping for a loan at a supermarket, but ONLINE, and voilà, marketplace lending!
But there are virtually no online platforms that work like that. The simplest explanation to describe a dizzyingly diverse industry is the most incorrect one. Lenders set rates and terms, borrowers don’t choose exactly what they want from a virtual shelf and put them in an imaginary shopping cart. There are however, portals where prospective borrowers can review different offers from different lenders in an Expedia-like environment, but this is really just Online Lead Aggregation 2.0, not a new-age system of lending.
Of course, some adopters of the phrase will point out that the marketplace was supposed to refer to the investor side, not the borrower side. It is investors that can shop for loans or notes that they want to invest in. Indeed, on platforms like Lending Club and Prosper, investors can select individual notes with terms befitting their desires and place them in an online shopping cart for purchase. Behold, the marketplace!
But what if you didn’t deal with retail investors hand-selecting $25 notes at a time? Notably, some online platforms that sell their loans to institutions in giant pools by the thousands or millions believe that such activity constitutes a marketplace because somebody is buying what they’re selling. And so long as somebody is selling something to somebody else at some point, the whole thing might as well be a marketplace. And even if it’s not, referring to it as such anyway will garner more press, attract more investors, and boost valuations.
I mean, would a site like TechCrunch be more likely to write about a FinTech Marketplace Lender or a generic financial company that sold a batch of loans to a bank?
I can tell you firsthand that if a press release submitted to us used the term “marketplace lender” instead of “finance company,” we’d at least check it out, or at least we used to. These days, we are becoming numb to its overuse.
Peer-to-Peer lending was an awesome term and it was descriptive too. Everybody could understand it. But then those platforms had to go and start selling their loans to Wall Street instead of peers and come up with something else to still sound trendy, techie, and disruptive. There’s nothing trendy of course about selling loans to financial institutions. It is a quintessential boring business activity of Wall Street. It is the opposite of disruptive, except in the events where all the loans go bad and the entire economy collapses like in 2008.
The FDIC specifically said that marketplace lending can encompass unsecured consumer loans, debt consolidation loans, auto loans, purchase financing, real estate loans, merchant cash advance, medical patient financing, and small business loans. This wildly diverse list, which even includes a non-loan product, will obviously have platforms in every category where people or businesses can get paired with a source of funds via the Internet. It’s 2016. It’d be weird if you couldn’t search for financing online. You can do everything else on the Internet. Just because a search happens online shouldn’t mean that the resulting options should be thrown together in some special broad category of lending and then be judged according to what all the other sectors do.
None of this is said to diminish the technological feats that many platforms have achieved. People and businesses can access capital in much faster and more convenient ways than ever before. Their growth and success is America’s economic gain. Jobs have been created and borrowing costs reduced. Hooray, perhaps, for marketplace lending.
The problem is merely the characterization that anyone lending to anyone else these days must also be a marketplace. That makes no sense.
Who will be the first to stop the madness?
Stairway to Heaven: Can Alternative Finance Keep Making Dreams Come True?
April 28, 2016
The alternative small-business finance industry has exploded into a $10 billion business and may not stop growing until it reaches $50 billion or even $100 billion in annual financing, depending upon who’s making the projection. Along the way, it’s provided a vehicle for ambitious, hard-working and talented entrepreneurs to lift themselves to affluence.
Consider the saga of William Ramos, whose persistence as a cold caller helped him overcome homelessness and earn the cash to buy a Ferrari. Then there’s the journey of Jared Weitz, once a 20 something plumber and now CEO of a company with more than $100 million a year in deal flow.
Their careers are only the beginning of the success stories. Jared Feldman and Dan Smith, for example, were in their 20s when they started an alt finance company at the height of the financial crisis. They went on to sell part of their firm to Palladium Equity Partners after placing more than $400 million in lifetime deals.
The industry’s top salespeople can even breathe new life into seemingly dead leads. Take the case of Juan Monegro, who was in his 20s when he left his job in Verizon customer service and began pounding the phones to promote merchant cash advances. Working at first with stale leads, Monegro was soon placing $47 million in advances annually.
Alternative funding can provide a second chance, too. When Isaac Stern’s bakery went out of business, he took a job telemarketing merchant cash advances and went on to launch a firm that now places more than $1 billion in funding annually.
All of those industry players are leaving their marks on a business that got its start at the dawn of the new century. Long-time participants in the market credit Barbara Johnson with hatching the idea of the merchant cash advance in 1998 when she needed to raise capital for a daycare center. She and her husband, Gary Johnson, started the company that became CAN Capital. The firm also reportedly developed the first platform to split credit card receipts between merchants and funders.
BIRTH OF AN INDUSTRY
Competitors soon followed the trail those pioneers blazed, and the industry began growing prodigiously. “There was a ton of credit out there for people who wanted to get into the business,” recalled David Goldin, who’s CEO of Capify and serves as president of the Small Business Finance Association, one of the industry’s trade groups.
Many of the early entrants came from the world of finance or from the credit card processing business, said Stephen Sheinbaum, founder of Bizfi. Virtually all of the early business came from splitting card receipts, a practice that now accounts for just 10 percent of volume, he noted.
At first, brokers, funders and their channel partners spent a lot of time explaining advances to merchants who had never heard of them, Goldin said. Competition wasn’t that tough because of the uncrowded “greenfield” nature of the business, industry veterans agreed.
Some of the initial funding came from the funders’ own pockets or from the savings accounts of their elderly uncles. “I’ve met more than a few who had $2 million to $5 million worth of loans from friends and family in order to fund the advances to the merchants,” observed Joel Magerman, CEO of Bryant Park Capital, which places capital in the industry. “It was a small, entrepreneurial effort,” Andrea Petro, executive vice president and division manager of lender finance for Wells Fargo Capital Finance, said of the early days. “A number of these companies started with maybe $100,000 that they would experiment with. They would make 10 loans of $10,000 and collect them in 90 days.”
That business model was working, but merchant cash advances suffered from a bad reputation in the early days, Goldin said. Some players were charging hefty fees and pushing merchants into financial jeopardy by providing more funding than they could pay back comfortably. The public even took a dim view of reputable funders because most consumers didn’t understand that the risk of offering advances justified charging more for them than other types of financing, according to Goldin.
Then the dam broke. The economy crashed as the Great Recession pushed much of the world to the brink of financial disaster. “Everybody lost their credit line and default rates spiked,” noted Isaac Stern, CEO of Fundry, Yellowstone Capital and Green Capital. “There was almost nobody left in the business.”
RAVAGED BY RECESSION
Perhaps 80 percent of the nation’s alternative funding companies went out of business in the downturn, said Magerman. Those firms probably represented about 50 percent of the alternative funding industry’s dollar volume, he added. “There was a culling of the herd,” he said of the companies that failed.
Life became tough for the survivors, too. Among companies that stayed afloat, credit losses typically tripled, according to Petro. That’s severe but much better than companies that failed because their credit losses quintupled, she said.
Who kept the doors open? The firms that survived tended to share some characteristics, said Robert Cook, a partner at Hudson Cook LLP, a law office that specializes in alternative funding. “Some of the companies were self-funding at that time,” he said of those days. “Some had lines of credit that were established prior to the recession, and because their business stayed healthy they were able to retain those lines of credit.”
The survivors also understood risk and had strong, automated reporting systems to track daily repayment, Petro said. For the most part, those companies emerged stronger, wiser and more prosperous when the crisis wound down, she noted. “The legacy of the Great Recession was that survivors became even more knowledgeable through what I would call that ‘high-stress testing period of losses,’” she said.
ROAD TO RECOVERY
The survivors of the recession were ready to capitalize on the convergence of several factors favorable to the industry in about 2009. Taking advantages of those changes in the industry helped form a perfect storm of industry growth as the recession was ending.
They included making good use of the quick churn that characterizes the merchant cash advance business, Petro noted. The industry’s better operators had been able to amass voluminous data on the industry because of its short cycles. While a provider of auto loans might have to wait five years to study company results, she said, alternative funders could compile intelligence from four advances within the space of a year.
That data found a home in the industry around the time the recession was ending because funders were beginning to purchase or develop the algorithms that are continuing to increase the automation of the underwriting process, said Jared Weitz, CEO of United Capital Source LLC. As early as 2006, OnDeck became one of the first to rely on digital underwriting, and the practice became mainstream by 2009 or so, he said.
Just as the technology was becoming widespread, capital began returning to the market. Wealthy investors were pulling their funds out of real estate and needed somewhere to invest it, accounting for part of the influx of capital, Weitz said.
At the same time, Wall Street began to take notice of the industry as a place to position capital for growth, and companies that had been focused on consumer lending came to see alternative finance as a good investment, Cook said.
For a long while, banks had shied away from the market because the individual deals seem small to them. A merchant cash advance offers funders a hundredth of the size and profits of a bank’s typical small-business loan but requires a tenth of the underwriting effort, said David O’Connell, a senior analyst on Aite Group’s Wholesale Banking team.
The prospect of providing funds became even less attractive for banks. The recession had spawned the Dodd-Frank Financial Regulatory Reform Bill and Basel III, which had the unintended effect of keeping banks out of the market by barring them from endeavors where they’re inexperienced, Magerman said. With most banks more distant from the business than ever, brokers and funders can keep the industry to themselves, sources acknowledged.
At about the same time, the SBFA succeeded in burnishing the industry’s image by explaining the economic realities to the press, in Goldin’s view.The idea that higher risk requires bigger fees was beginning to sink in to the public’s psyche, he maintained.
Meanwhile, loans started to join merchant cash advances in the product mix. Many players began to offer loans after they received California finance lenders licenses, Cook recalled. They had obtained the licenses to ward off class-action lawsuits, he said and were switching from sharing card receipts to scheduled direct debits of merchants’ bank accounts.
As those advantages – including algorithms, ready cash, a better image and the option of offering loans – became apparent, responsible funders used them to help change the face of the industry. They began to make deals with more credit-worthy merchants by offering lower fees, more time to repay and improved customer service. “The recession wound up differentiating us in the best possible way,” Bizfi’s Sheinbaum said of the changes.
His company found more-upscale customers by concentrating on industries that weren’t hit too hard by the recession. “With real estate crashing, people were not refurbishing their homes or putting in new flooring,” he noted.
Today, the booming alternative finance industry is engendering success stories and attracting the nation’s attention. The increased awareness is prompting more companies to wade into the fray, and could bring some change.
WHAT LIES AHEAD
One variety of change that might lie ahead could come with the purchase of a major funding company by a big bank in the next couple of years, Bryant Park Capital’s Magerman predicted. A bank could sidestep regulation, he suggested, by maintaining that the credit card business and small business loans made through bank branches had provided the banks with the experience necessary to succeed.
Smaller players are paying attention to the industry, too, with varying degrees of success. Predictably, some of the new players are operating too aggressively and could find themselves headed for a fall. “Anybody can fund deals – the talent lies in collecting the money back at a profitable level,” said Capify’s Goldin. “There’s going to be a shakeout. I can feel it.”
Some of today’s alternative lenders don’t have the skill and technology to ward off bad deals and could thus find themselves in trouble if recession strikes, warned Aite Group’s O’Connell. “Let’s be careful of falling into the trap of ‘This time is different,’” he said. “I see a lot of sub-prime debt there.”
Don’t expect miracles, cautioned Petro. “I believe there will be another recession, and I believe that there will be a winnowing of (alternative finance) businesses,” she said. “There will be far fewer after the next recession than exist today.”
A recession would spell trouble, Magerman agreed, even though demand for loans and advances would increase in an atmosphere of financial hardship. Asked about industry optimists who view the business as nearly recession-proof, he didn’t hold back. “Don’t believe them,” he warned. “Just because somebody needs capital doesn’t mean they should get capital.”
Further complicating matters, increased regulatory scrutiny could be lurking just beyond the horizon, Petro predicted. She provided histories of what regulation has done to other industries as an indication of the differing outcomes of regulation – one good, one debatable and one bad.
Good: The timeshare business benefitted from regulation because the rules boosted the public’s trust.
Debatable: The cost of complying with regulations changed the rent-to-own business from an entrepreneurial endeavor to an environment where only big corporations could prosper.
Bad: Regulation appears likely to alter the payday lending business drastically and could even bring it to an end, she said.
Still, regulation’s good side seems likely to prevail in the alternative finance business, eliminating the players who charge high fees or collect bloated commissions, according to Weitz. “I think it could only benefit the industry,” he said. “It’ll knock out the bad guys.”
Is That a Bird, a Plane or a Recession in the Wings?
April 26, 2016
The R-word has been rearing its ugly head with more frequency in recent months, propelled by falling stock prices, higher borrowing rates and the dollar’s ascent.
While a recession—typically defined as a fall in GDP in two consecutive quarters—is far from certain, it would most definitely be a double whammy for an industry that many believe is already ripe for a pullback due to multiple years of unfettered growth. Indeed, many funders have experienced great success riding on the coattails of the long-running favorable market. Some industry participants fear these funders are masking loss rates behind strong volume—a particularly problematic strategy if the volume were to taper off due to an economic downturn.
“It’s no different than what happened in the housing market in 2008,” says Andrew Reiser, chairman and chief executive of Strategic Funding Source Inc. in New York. If and when a recession occurs, several industry participants expect there will be a culling of the weakest firms. They say inexperienced and less-diverse funding companies are particularly at risk, as are MCA funders that don’t keep close tabs on their business dealings. They also believe that venture capital funding will be even harder to come by and regulation will rain down more heavily on the industry.
RISK FACTORS THAT SPELL TROUBLE IN RECESSIONARY ENVIRONMENT
For a variety of reasons, Glenn Goldman, chief executive of Credibly, a New York-based small business lending platform, believes that fewer than 50 percent of the funders today are prepared to weather a recession. Many don’t have strong data science and risk management, for example. Some newer platforms also don’t have the seasoned management to help guide them appropriately, he says.
Another red flag is when funders rely too heavily on a single source of funding. Goldman points back to 2008 when the commercial paper market disappeared. Companies that had on balance-sheet funding capacity were able to weather that storm because they weren’t exclusively relying on commercial paper or securitization, he says.
Goldman believes the prudent way to manage an alternative funding business is to utilize a combination of on-balance sheet financing, whole loan sales and securitization. “If the market moves sideways and you rely only on a single source of funding, you are at risk. It’s an incredibly obvious statement, but it becomes more acute when the economic environment comes under pressure,” he says.
Notably, there are very few sizable alternative funders who successfully survived the last big recession, meaning there are hundreds of companies now doing business in this space that don’t have years-worth of data to help them make more prudent underwriting decisions. Strategic Funding, for example, had the highest loss rate in its history in the third quarter of 2008 and has used its wealth of data to learn from past mistakes. “There’s no doubt that it is critical to be able to correlate events with history,” Reiser says.
Funders are also going to have to batten down the hatches when it comes to their underwriting standards. “Just because someone paid you back yesterday doesn’t mean he’s going to pay you back tomorrow,” Reiser says. “You have to be right more often in a recessionary environment.” Indeed, liquidity for originators and investors will become even more critical in a recession.
“Liquidity is king,” says David Snitkof, chief analytics officer and co-founder of Orchard Platform, a New York-based technology and data provider for marketplace lending. He points out the large number of companies that went belly-up in the last big recession for lack of liquidity. “The more that participants in this market are able to diversify their capital structure, diversify their funding sources and work with multiple providers, the better off they will be,” he says.
Another challenge will be for funders that haven’t had their servicing and collection capabilities adequately stress tested, Snitkof says. These firms should consider working with an outside provider to help them scale their collections as necessary. In this way, a company that needs additional resources can scale up pretty quickly without disrupting operations.
THE P2P OUTLOOK
To be sure, all types of companies fall under the alternative funding umbrella and each will have its own special challenges in a recession. In the P2P space, for example, having a diverse investor base and a sound credit model will become increasingly important. Peter Renton, an investor and founder of Lend Academy, an educational resource for the peer-to-peer lending industry, predicts that some of the newer P2P platforms will struggle more in a recession. That’s because they haven’t had as much time to accumulate and interpret borrower data and adapt their models accordingly.
Lending Club, for example, has gone through many iterations of its credit model over its multiple years in business, and it’s much better than it was even five years ago, says Renton, who had around $37,000 invested with Lending Club as of the third quarter of 2015. “The best data that anyone can get is payment history with your existing borrowing base,” he says.
Particularly in a recession, P2P players need to be extra careful about maintaining strict underwriting standards. Marketplaces may have to tighten their borrowing standards to lend to more solid companies, so the likelihood of defaults isn’t as great. So, for instance, if their standard was once borrowers with a FICO score of at least 640, they could up it to 660, Renton says.
Platforms also have to make sure they have enough investors to satisfy their borrowers, which is why having a diverse investor base is so important. In a recession if you have three hedge funds and that’s your entire investor base, they could all go away. By contrast, if a platform has five thousand individual investors, they aren’t all going away. You may lose 10 percent or 20 percent of them, but if you still have four thousand investors, you can still have your loans funded, Renton explains.
One way to do well even in a recessionary environment is for P2P players to tweak their credit model to be more restrictive so their default rates are lower. “If your default rates are only 3 percent and your competitors are at 6 percent, you’re going to get more business,” Renton says.
Certainly, alternative funding companies can get into trouble if they don’t act early enough when they see a change in activity and economic performance, says Ron Suber, president of Prosper Marketplace, a P2P lender based in San Francisco. Funders need to be able to nimbly adjust their pricing, risk models and expected default rates as needed. “Every marketplace will see a change in borrower behavior as unemployment increases and there are economic declines. Therein lies the question: what does the marketplace do?” Prosper, for instance, recently raised rates on loans, telling investors it had increased its estimated loan loss rates and therefore was updating the price of loans to reflect increased risk. Understanding risk and pricing loans accordingly is always important, but even more so in a shaky economic environment. “You always have to stay on top of it,” Suber says.
MANY MCA FUNDERS AT HIGH-RISK IN RECESSION
If a recession strikes, some observers believe the risk to certain MCA funders will be particularly acute. That’s because new players have entered the MCA space over the past several years, and a sizable number of them don’t have a good handle on their business. Higher default rates could force many of them to shutter operations. Certainly merchants especially those with bad credit—will need more access to capital during a recession and MCA is a natural place for these businesses to turn. But MCA funders have to do a better job of adjusting for risk and keeping adequate records if they hope to weather an economic downturn, says Yoel Wagschal, a certified public accountant in Monroe, New York, who has worked with a number of struggling MCA funders. “A small recession could lead to big failures if you don’t take the right steps,” he says.
To avoid business-threatening issues, Wagschal recommends that MCA funders take steps now to develop stronger underwriting systems to vet merchants better. He believes it’s more prudent to do fewer deals with higher rated merchants than to continue taking on risky businesses as customers. If they see more defaults are coming in, funders should also consider raising their factor rates, he says. Another option is to halt new funding for three to four months to re-energize the business. “It’s much harder to make money than to lose money,” he notes.
If they don’t already have them—and many don’t—MCA funders also need to invest in a good accounting system that can flag their profits, losses and defaults on a real-time basis. This information allows funders to make swift decisions about the business so they can take necessary steps at the right time, he says. “You don’t wait for months, or year end, to analyze all the facts. You might have already lost your business and lost your money because money is just turning around so quickly.”
UNCERTAINTY ABOUNDS FOR VENTURE CAPITAL INVESTMENT
Existing funders won’t be the only ones to struggle in a recession; the well of venture capital funding for new entrants could easily dry up as well,like it did in the last big recession. That’s not to say VC firms will lose interest entirely, but new funders will have to work even harder to get noticed. “There are so many originators, for any new entrants, the bar gets higher and higher to prove that you have something truly unique,” says Snitkof of Orchard Platform. Reiser of Strategic Funding already sees this scenario playing out. “I don’t think the market [lately] has been very favorable to our space,” he says, noting the dearth of exit strategies that have made it riskier for VC firms to invest. “It’s always easy to get in; it’s hard to get out,” he says.
GET READY FOR MORE REGULATORY ACTION
Industry watchers also believe the alternative funding industry will become more heavily regulated in a recession and its aftermath.
Reiser points to all the additional restrictions placed on the mortgage industry in the wake of the housing market bust in 2008. At a time when the housing market was restricting, you had more compliance placed on it as well. “I think you’ll have more compliance in our industry too. That’s just another cost that will have to be absorbed,” Reiser says.
In a recession, there’s more likelihood that harm can come to customers and that will drive regulatory action as well, he adds.
THE ART OF MAKING TOUGH DECISIONS
If the economy turns south, many alternative funders will be forced to make tough underwriting decisions. It can be hard if your analysis of data tells you that things are going to turn downward and your competitors don’t take the same stance, says Stephen Sheinbaum, founder of Bizfi, a New York-based online marketplace.
In that case, funders have to decide whether they are willing “to tighten and pivot while the rest of the players in the space are going full steam ahead,” he says. “That’s where you have to have some conviction and trust your data and do the right thing.”
Of course, even as the rest of the economy is faltering, recessionary times can also be a boon for enterprising companies. For example, the 2008 recession turned out to be positive for Bizfi, which at the time was called Merchant Cash and Capital. Using housing starts, consumer spending and other data, the company correctly predicted the economy was going to take a severe turn downward. It therefore made tweaks to its underwriting guidelines, moving into certain industries and away from others it deemed riskier. “Change can be hard, but it can be for the better,” Sheinbaum says.
Indeed, alternative funders that embrace new opportunities can be successful even in a broad economic downturn. “It’s about having the foresight to be able to discern good from bad and just being really disciplined about it,” says Snitkof of Orchard Platform.
