Hold The Loans Or “Marketplace”? It Depends
August 1, 2016
At the risk of stating the obvious, the motivation to keep loans on balance sheet or sell them off through a marketplace is related to the type of lending one does. But even then, opinions on the best strategy varies. Is there a winning formula?
Not all online lenders are marketplaces. Some consumer lenders like Affirm, for example, hold all the loans they issue on their balance sheet. Avant, another consumer lender, has either held all or some of the loans on its balance sheet, making it a kind of hybrid.
But for companies like Lending Club, long considered to be the definition of marketplace, their May debacle showed the weakness that model can have, at least with those lending to consumers.
Interest rates, terms and risk profiles associated with businesses are different from those for retail consumers. According to Fora Financial co-founder Dan Smith, this changes the economics of the game since consumer loans are typically longer (3-5 years) compared to business loans where the weighted average term could be as short as under 12 months. This, not only makes consumer lending a lot more capital-intensive it also begs for diversification of sources.
“When I started the business, I had one lender in 2007 and they said they couldn’t work with us. Today, my credit facility has eight different lenders,” said Stephen Sheinbaum, founder of Bizfi which buys future receivables with its balance sheet in addition to running a loan marketplace. “We are undoubtedly seeing a shift from the B2C side. Any model that has sources of funds concentrated in one area is risky.”
Relying on your own balance sheet can lead to handsome returns, sources say. Sheinbaum, said that his company can make twice as much by holding than gains on sale. For companies engaged in consumer lending, that margin can be anywhere between 5 percent to 20 percent depending on borrower profiles and the type of loans, said student lender CommonBond CEO David Klein.
The unit economics of assuming risk can be higher if risk is assessed well. “If you do it well, balance sheet lending provides better unit economics,” said Fora Financial’s Smith. “You have to have the right capital structure, a low cost of capital and need to be able to underwrite effectively so it can scale.”
Smith however warned that this is not prescriptive and consumer lending companies like Lending Club might be forced to take a multi-pronged approach given the barriers to entry and the regulation around balance sheet lending for consumer loans. “There is clearly a more significant regulatory environment to get into on balance sheet consumer lending and that might be a barrier to entry.”
Often referred to as ‘having skin in the game,’ balance sheet lending potentially forces companies to assess risk better and be scrupulous about underwriting. But marketplaces whose prerogative may be seen as trying to make as many loans as possible, will inevitably be scrutinized over perceived conflicts of interest in their underwriting.
There are arguments to be made for each of the models but a better case is made for hybrid models which aims to take the best of both. Klein of CommonBond, said that his company leans heavily on balance sheet at times and the marketplace at other times. “Unless your investors are broad in profile and deep by type, then it is possible for a loan sale purchaser to walk away.” Klein said. “It all comes down to control. If you have more of it, there’s less risk.”
While more consumer lenders gravitate towards hybrid models, Lending Club at the end of Q2 held only 2 percent of the loan volume on balance sheet and CEO Scott Sanborn is very clear about the company operating purely as a marketplace.
“Some of our investors have observed the funding environment and asked: Are you going to become a balance sheet lender, just like a regular bank? Has Lending Club’s business model changed?”
“Let me be very clear: Lending Club is committed to the marketplace model and we do not plan to become a balance sheet or ‘hybrid’ lender. Our mission of connecting borrowers and investors has not changed,” wrote Scott Sanborn in a letter to investors.
The letter reiterated that the limited use of balance sheet does not affect Lending Club’s Notes. And while the company soldiers on, Lending Club’s story has taught many lessons to other lenders.
“In the wake of Lending Club’s news, you realize that if you have a hiccup on the way, it’s good to control some of your capital and assets because if you are truly marketplace, a hiccup in investor confidence can meaningfully change their trajectory,” said Klein who believes that for a pure marketplace player to survive, it needs to have more retail investors than institutional investors.
And there seem to be more people who agree than disagree. “The B2C model of selling 100% to a secondary market will cease and fault,” said Sheinbaum. “If buyers go away, your entire model is jeopardized. In a perfect world you want options. You see whichever way the wind is going and you try to go with it.”
The challenge then is in telling which way the wind will blow and be prepared for a storm.
Fintech Hearing Summary (7/12/16)
July 13, 2016
A hearing about marketplace lending put on by the House Subcommittee on Financial Institutions and Consumer Credit covered a wide array of topics on Tuesday. From merchant cash advance to business loans to consumer loans, the witnesses tried to help members of Congress understand the circumstances in their respective industries.
Parris Sanz, the Chief Legal Officer of CAN Capital, explained the differences between a receivable purchase and a loan, a distinction that needed to be made in order to answer some of the questions from Missouri Congressman Lacy Clay.
The questions were generally exploratory and broad. For example, Georgia Congressman David Scott wanted to know what made consumer loans different from business loans. Sanz answered by saying that commercial loans power the economy and that their application was for creating jobs and growing businesses. More to the point, he added that these weren’t hobbyists calling themselves businesses because their average customer has been in operation for at least 13 years and does $1 million to $2 million in revenue a year. These are sophisticated users of capital, he said.
Missouri Congressman Blaine Luetkeyemer, who first read comments he obviously disagreed with that were made by CFPB Director Richard Cordray, repeated the question about the differences between the two. Rob Nichols, the CEO of the American Bankers Association, responded by saying that he didn’t believe the lines were blurred. Cordray had previously said that he believed the lines were indeed blurred, which created some fear in the commercial finance community
Where they might be blurred is in regards to data collection as mandated by Dodd Frank’s Section 1071, something that was only touched upon lightly. Ms. Gerron Levi, Director of Policy & Government Affairs, National Community Reinvestment Coalition, said that we don’t know a lot about marketplace lenders because the data isn’t being collected yet.
While there was some skepticism by the Members over how data was being used by fintech companies to make decisions, it appeared to be early days for a lot of the subjects such as the potential for creating a limited federal charter and whether or not these customers are truly underserved or are just being acquired by marketplace lenders because there is a degree of regulatory arbitrage occurring.
The tone of the hearing was overall neutral in nature.
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.
FIRE DRILL IN ILLINOIS: BUSINESS FUNDING COMPANIES TARGETED IN REPRESSIVE BILL
June 30, 2016* Update 6/30 AM: Sen. Jacqueline Collins, D-Chicago is expected to introduce a revised bill today.
** Update 6/30 PM: Reintroduction of the bill has been delayed while they wait for comments from additional parties
Bankers and non-bank commercial lenders – two groups that often disagree – are united in their opposition to financial regulation proposed in Illinois. Both contend that if the state’s Senate Bill 2865 becomes law it could choke the life out of small-business lending in the Land of Lincoln and might set a precedent for a nightmarish 50-state patchwork of rules and regulations.
Foes say the measure was created to promote disclosure and regulate underwriting. They don’t argue with the need for transparency when it comes to stating loan terms, but they maintain that a provision of the bill that would cap loan payments at 50 percent of net profits would disrupt the market needlessly.
Opponents also regard the bill as an encroachment on free trade. “The government shouldn’t be picking winners or losers – the market should be,” said Steve Denis, executive director of the Small Business Finance Association, a trade group for alternative funders.
The states or the federal government may need to protect merchants from a few predatory lenders, but most lenders operate reputably and have a vested interest in helping clients succeed so they can pay back their obligations and become repeat customers, several members of the industry maintained.
“The ability to pay is really a non-issue,” noted Matt Patterson, CEO of Expansion Capital Group and an organizer of the Commercial Finance Coalition, another industry trade group. “I don’t make any money if a borrower doesn’t pay me back, so I don’t make loans where I think there is an inability to pay.”
Outsiders may find interest rates high for alternative loans, but companies providing the capital face high risk and have a short risk horizon, said Scott Talbott, senior vice president of government affairs for the Electronic Transactions Association, whose members include purveyors and recipients of alternative financing. Several other sources said the risks justify the rates.
Besides, a consensus seems to exist among industry leaders that most merchants – unlike many consumers – have the sophistication to make their own decisions on borrowing. Business owners are accustomed to dealing with large amounts of money, and they understand the need to keep investing in their enterprises, sources agreed.
In fact, no one has complained of any small-business lending problems in Illinois to state regulators, said Bryan Schneider, secretary of the Illinois Department of Financial and Professional Regulation and a member of Gov. Bruce Rauner’s cabinet.
Regulators should not indulge in creating solutions in search of problems, Sec. Schneider cautioned. “When you’re a hammer, the world looks like a nail,” he said, suggesting that regulators sometimes base their actions on anecdotal isolated incidents instead of reserving action to correct widespread problems.
But the proposed legislation could itself cause problems by placing entrepreneurs at risk, according to Rob Karr, president and CEO of the Illinois Retail Merchants Association, which has 400 members operating 20,000 stores. “It would stifle potential access to capital for small businesses,” he warned.
Quantifying the resulting damage would present a monumental task, but a shortage of capital would clearly burden merchants who need to bridge cash-flow problems, Karr said. Shortfalls can result, for example, when clothing stores need to buy apparel for the coming season or hardware stores place orders in the summer for snow blowers they’ll need in six to eight months, he said.
Restaurant owners and other merchants who rely on expensive equipment also need access to capital when there’s a breakdown or a need to expand to meet competition or take advantage of a market opportunity, Karr observed.
Capital for those purposes could dry up because just about anyone providing non-bank loans to small merchants could find themselves subject to the proposed legislation, including factoring companies, merchant cash advance companies, alternative lenders and non-bank commercial lenders, said the CFC’s Patterson.
Banks and credit unions are exempt, the bill says, but a page or two later it includes provisions written so broadly that it actually includes those institutions, said Ben Jackson, vice president of government relations at the Illinois Bankers Association.
Trade groups representing all of those financial institutions – including banks and non-banks – have joined small-business associations in working against passage SB 2865. “The most important thing is to make sure we’re coordinating with the other groups out there,” the SBFA’s Denis contended. “Actually, Illinois was good practice for the industry in how we’re going to go about dealing with attempts at regulation.”
Patterson of the CFC agreed that associations should coordinate their responses to proposed legislation. “We’ve tried to gather all the affected players in the space and have dialogue with them,” he maintained.
Even though that various associations reacting to the bill generally agreed on principles, their competing messages at first created a cacophony of proposals, according to some. “There was a lot of noise, and I think we’ll all learn from that,” Denis said. “The industry has to learn to speak with one voice to legislators.”
Citing the complexity of dealing with 50 states, 435 members of Congress and 100 senators, Denis said everyone with an interest in small-business lending must work together. “If we don’t, we lose,” he warned.
Many of the groups came together for the first time as they converged upon the Illinois capital of Springfield last month when the state’s Senate Committee on Financial Institutions convened a hearing on the bill. The committee allowed testimony at the hearing from three groups representing opponents. The groups huddled and chose Denis, Jackson and Martha Dreiling, OnDeck Capital Inc. vice president and head of operations.
City of Chicago Treasurer Kurt Summers was the only witness who testified in favor of the bill, according to Jackson. The idea of regulating non-bank commercial lenders in much the same way Illinois oversees lending to individuals arose in Summers’ office, said an aide to Illinois Sen. Jacqueline Collins, D-Chicago. Sen. Collins serves as chairperson of the Financial Institutions Committee and introduced to the bill in the senate.
Sen. Collins declined to be interviewed for this article, and Treasurer Summers and other officials in his of office did not respond to interview requests. However, published reports said Drew Beres, general counsel for Summers, has maintained that transparency, not underwriting, is the main goal. Talbott has met with Sen. Collins and said she’s interested primarily in transparency.
Support for the bill isn’t limited to the Chicago treasurer’s office. Some non-profit lending groups and think tanks back the proposed legislation, opponents agreed. The bill appeals to progressives attempting to shield the public from unsavory lending practices, they maintained.
Politicians may view their support of the bill as a way of burnishing their progressive credentials and establishing themselves as consumer advocates, said opponents of the legislation who requested anonymity. “It’s an important constituency,” one noted. “No one is against small business.”
After listening to testimony at the hearing, committee members voted to move the bill out of committee for further progress through the senate, Jackson said. Eight on the committee voted to move the bill forward, while two voted “present” and one was absent. But most of the senators on the committee said the legislation needs revision through amendments before it could become law, according to Jackson.
The legislative session was scheduled to end May 31. If the bill didn’t pass by then it could come up for consideration in a summer session if the General Assembly chooses to have one, Jackson said. If it does not pass during the summer, it could come to a vote during a two-week “veto session” in the fall or in an early January 2017 “lame duck session.” Unpassed legislation dies at that point and would have to be reintroduced in the regular session that begins later in January 2017, he noted.
Although time is becoming short for the proposed legislation, it’s a high-profile measure that could prompt action, particularly if amendments weaken the rule for underwriting, Jackson said. The Illinois General Assembly sometimes passes important legislation during lame duck sessions, he said, noting that a temporary increase in the state sales tax was enacted that way.
Whatever fate awaits SB 2865, some in the alternative funding business have suspected that the bill came about through an effort by banks to push non-banks out of the market. But cooperation among groups opposed to the proposed legislation appears to lay that notion to rest, according to several sources.
“I don’t get that impression,” Denis said of the allegation that bankers are colluding against alternative commercial lenders. “I think this shows banks and our industry can get together and share the same mission.”
Talbott of the ETA also counted himself among the disbelievers when it comes to conspiracy theories against alternative lenders. “I’d say that’s a misreading of the law and not the case,” he said. “Traditional banks oppose this because it would effectively reduce their options in the same space.”
The interests of banks and non-banks are beginning to coincide as the two sectors intertwine by forming coalitions, noted Jackson of the state bankers’ association. A number of sources cited mergers and partnerships that are occurring among the two types of institutions.
In one example, J.P. Morgan Chase & Co. is using OnDeck’s online technology to help make loans to small businesses. Meanwhile, in another example, SunTrust Banks Inc. has established an online lending division called LightStream.
At the same time, alternative funders who got their start with merchant cash advances and later added loans are contemplating what their world would be like if they turned their enterprises into businesses that more closely resembled banks.
And however the industries structure themselves, the need for small-business funding remains acute. Banks, non-banks and merchants agree that the Great Recession that began in 2007 and the regulation it spawned have discouraged banks from lending to small-businesses. The alternative small-business finance industry arose to fill the vacuum, sources said.
That demand draws attention and could lead to bouts of regulation. Although industry leaders say they’re not aware of legislation similar to Illinois SB 2865 pending in other states, they note that New York state legislators discussed small-business lending in April during a subject matter hearing. They also point out that California regulates commercial lending.
Many dread the potential for unintended results as a crazy quilt of regulation spreads across the nation with each state devising its own inconsistent or even conflicting standards. Keeping up with activity in 50 states – not to mention a few territories or protectorates – seems likely to prove daunting.
But mechanisms have been developed to ease the burden of tracking so many legislative and regulatory bodies. The CFC, for instance, employs a government relations team to monitor the states, Patterson said. The ETA combines software and people in the field to deal with the monitoring challenge.
And regulation at the state level can make sense because officials there live “close to the ground,” and thus have a better feel for how rules affect state residents than federal regulators could develop, Sec. Schneider said.
Easier accessibility can also keep make regulators more responsive than federal regulators, according to Sec. Schneider. “It’s easier to get ahold of me than (Director) Richard Cordray at the Consumer Financial Protection Bureau,” he said.
Also, state regulators don’t want to take a provincial view of commerce, Sec. Schneider noted. “As wonderful as Illinois is, we want to do business nationwide,” he joked.
State regulators should do a better job of coordinating among themselves, Sec. Schneider conceded, adding that they are making the attempt. Efforts are underway through the Conference of State Bank Supervisors, a trade association for officials, he said.
At the moment, state legislatures and federal regulators have small-business lending “squarely on their agenda,” the ETA’s Talbott observed. The U.S. Congress isn’t paying close attention to the industry right now because they’re preoccupied with the elections and the presidential nominating conventions, he said.
The goal in Illinois and elsewhere remains to encourage legislators to adopt a “go-slow approach” that affords enough time to understand how the industry operates and what proposed laws or regulations would do to change that, said Talbott.
At any rate, the industry should unite in a proactive effort to explain the business to legislators, according to Denis. “We need to work with them so that they understand how we fund small businesses,” he said. “That’s the way we can all win.”
Don’t Look Now, But The US Treasury is Staring At Marketplace Lending
June 24, 2016
The US Department of Treasury is concerned about marketplace lending. Again.
The Financial Stability Oversight Council which was established per Dodd Frank to monitor excess risks to the financial system by bank and nonbank financial entities categorized marketplace lending as one in its annual report.
Concerned by the quick proliferation of nonbank lenders, the FSOC said that new financial products, its delivery mechanism and the business practices involved although contribute to “efficient” financial intermediation, the technology-backed underwriting models pose credit risk.
“Marketplace lending is an emerging way to extend credit using algorithmic underwriting which has not been tested during a business cycle, so there is a risk that marketplace loan investors may prove to be less willing than other types of creditors to fund new lending during times of stress,” the report said, worrying about the possible erosion of lending standards.
The Treasury however recognizes that the threat is still moderate but is still cautious.
“Financial regulators will need to continue to be vigilant in monitoring new and rapidly growing financial products and business practices, even if those products and practices are relatively nascent and may not constitute a current risk to financial stability.”
This is not the first time marketplace lending industry has garnered attention from authorities. Last month, (May 10th) the Treasury released a white paper titled “Opportunities and Challenges in Online Marketplace Lending” listing the risks associated with data and modeling techniques and the new data model being untested through a complete credit cycle.
The CFPB is also turning its attention towards small business lenders. Bloomberg reported that the agency wants to collect credit data in small business lending.
However, there are some who believe that regulating the lending industry cannot have a one-size-fits-all solution, nor does it need one. Thomas Weinberger, partner at Schulte Roth and Zapel is less inclined to believe that this will affect different market segments. “Marketplace lending has a self correcting system where if default rates go up, investors won’t buy,” he said. “The discipline is enforced by the capital.”
The Unsung Disruption in Online Lending – Stacking, Litigation and Questionable Debt Negotiators
June 22, 2016
Give a small business two options, a low APR 3-year business loan and a short term loan with a high factor rate, and you’ll find advocates for each product arguing over which is better and why. We’ve been led to believe that it’s one versus the other, that one is good and one is bad, and that’s all there is to the story. Entire business models have been developed along the lines of this thinking, algorithms deployed and merchants funded, along with narratives framed in the mainstream media about why one system is superior to others.
But to hear the men and women in the phone rooms tell it, when given a choice between one funding option or the other, small businesses are often choosing both at the same time. Reuters said that stacking is the latest threat to online lenders, and in many ways they’re right. The practice isn’t new of course, the tendency for merchants to take on multiple layers of capital (often times in breach of other contracts) has been a central cause of tension between funding companies for the last few years. But the reason the story is bubbling over into traditional news media now as the latest threat, is because opponents of stacking assumed that the practice would be eradicated by now. There was this false sense of hope that government agents in black suits would show up one day unannounced after hearing that a merchant had taken a third advance or loan despite having not yet satisfied the obligations of the previous two. And when that didn’t happen, some of the models heralded as better for the merchant started to show cracks. What happens to the forecasts when the merchants priced ever so perfectly for a low rate long term loan go and take three or four short term loans almost immediately after? Back in October, Capify CEO David Goldin argued that long dated receivables were already dangerous to a lender regardless because the economy could turn south. “You’re done. You’re dead. You can’t save those boats. They are too far out to sea,” he told AltFinanceDaily.
Sue everyone?
When it comes to disruption, nothing has changed the game as much as stacking, and companies must prepare for the likelihood that it could be around forever. That means forming a long-term business model that is equipped to deal with this practice. Several lawsuits have been waged in an attempt to generate case law to deter it, including one filed last year in Delaware by RapidAdvance against a rival. Patrick Siegfried, assistant general counsel of RapidAdvance told the Wall Street Journal last fall, “we’re doing it to establish the precedent,” he said. “This kind of thing is happening more and more.” At the time, a motion to dismiss the case entirely was pending. RapidAdvance since won that motion but only by a hair and with a judge that was very reluctant to move the case forward.
Last October, MyBusinessLoan.com, LLC, also known as Dealstruck, sued five companies at once, a mix of lenders and merchant cash advance companies after one of their borrowers defaulted, allegedly because of actions carried out by the co-defendants. They were greeted with several motions to dismiss for failure to state a claim.
Even if these funding companies don’t win, simply letting the world know that they’ll sue rivals for stacking can act as a deterrent. But it’s an expensive tactic, especially when some defendants are more than happy to litigate the claims. Litigation is definitely an underrated cost of doing business for online lenders and merchant cash advance companies. In one recent case, a merchant challenged the legitimacy of a contract with Platinum Rapid Funding Group, a company whom they sold a portion of their future receivables to. The merchant asked the judge to recharacterize the contract to a loan so that they could try to use a criminal usury defense. The judge refused in a well-written decision that called the merchant’s attempt to do that “unwarranted speculation.” But even with the precedent of a favorable ruling, countless merchants have attempted to come up with strategies to wriggle their way out of their agreements, sometimes with ample legal counsel at their side.
Debt negotiators and questionable characters
Stacking has become a cost of doing business, but something else is creeping in as well. An entire cottage industry of “debt negotiators” has set their sights on online lenders and merchant cash advance companies, and at times these self-professed business experts don’t even realize there’s a difference between the two. One MCA funder told altfinancedaily earlier this week that a merchant in default claimed to be represented by Second Wind Consultants, a debt restructuring firm that lists one Don Todrin as the CEO on their website. Not mentioned among Todrin’s accolades is that he is a disbarred attorney who pled guilty to federal bank fraud charges in 1994, according to an old report by the Boston Globe, after he filed at least nine false financial statements to acquire $1.4 million in loans.
Another purported debt negotiation firm, who has the irked the ire of merchant cash advance companies, is apparently trying to assert affiliation to a native American tribe and invoke tribal immunity in response to lawsuits against them, according to court filings in New York State.
And only three weeks ago, an attempted class action against a merchant cash advance company failed because each named class representative had waived its right to participate in a class action in exchange for business financing. The initial action, before being moved to federal court, was brought by a merchant represented by an attorney who had just been reinstated to practice law, following a long suspension for pleading guilty to identity theft.
On top of it all, there are merchants themselves that act in bad faith, with some preying on the perceived vulnerabilities of an online-only experience. In the November/December 2015 issue of AltFinanceDaily Magazine, attorney Jamie Polon said some applicants don’t even own businesses at all, they just pretend to. “They’re not just fudging numbers – they’re fudging contact information,” he told AltFinanceDaily. “It’s a pure bait and switch. There wasn’t even a company. It’s a scheme and it’s stealing money.”
Weeding out bad merchants is a job for the underwriting department but for the good merchants seemingly deserving of those 3-5 year loan programs, the future is not as easy to predict as it once was. They might stack regardless, no matter how favorable the terms are. And given that government agent ninjas aren’t likely to drop down from the sky to stop them any time soon, many funding companies are faced with hard choices. Are the initial forecasts still valid? Is it economically feasible to turn the client away for additional funds because they breached their original agreement, all while the cost to acquire that customer in the first place was really high? Do you sue your rivals, make them look bad in the press, or lobby for regulations that will hurt them? How do you handle the new breed of debt negotiators who use the same UCC lead lists as lenders and brokers?
Sure, things like marketing costs are going up and the capital markets are less inviting than they used to be. But once loans and deals are funded, making sure those agreements are lived up to can take time, resources, and undoubtedly a lot of lawyers. And realistically, these issues aren’t likely to change any time soon. Help, in whatever relief form some are hoping for, is not on the way. How’s that for disruption?
Taking Stock of China’s Changing Fortunes in Fintech
June 21, 2016
It’s been called the Wild West of the financial world, and it appears the sheriff is finally headed to town.
Chinese fintech, the P2P practice of connecting borrowers to lenders via the Internet, was supposed to bring much-needed competition and efficiency to the country’s outsized, government-run banking system, turning a sizable profit for a visionary group of investors in the bargain. Investors weren’t the only ones that stood to benefit from the boom. With large Chinese banks choosing to lend primarily to mammoth, state-owned corporations, the country’s small business community was similarly poised to profit.
That’s exactly how it played out for a while. Buoyed by bullish expectations, fintech startups with good marketing skills attracted large numbers of investors. This resulted in nearly a decade’s worth of easily amassed capital, dizzying returns in high interest rate bearing vehicles, and little in the way of meaningful regulation. Before you could say “Alibaba”, roughly one fifth of the world’s largest fintech firms hailed from China, with ZhongAn, an online insurance group backed by the e-commerce titan’s founder, Jack Ma, topping the list.
It was indeed the Wild West, but there was trouble on the horizon.
The twin villains irrational exuberance and negligent oversight eventually flipped the script, and China’s fintech sector has been reeling ever since. Returns derived from investing “captive capital” into funds that returned high spreads started drying up. Payment companies came under fire for questionable practices that at least one investment research firm, J Capital Research, likened to a Ponzi scheme. Doubt set in, followed by panic. Capital began flowing out of the country instead of into it, with investors that could head for the exit door doing just that.
By the end of 2015, nearly a third of all Chinese fintech lenders were in serious trouble, according to a recent article in the Economist, “trouble” being defined as everything from falling returns to halted operations to frozen withdrawals.
A few brave souls stuck to their guns, wrangling over how to make their finance models more sustainable for the long haul. Other so-called industry leaders simply skipped town. Literally. Enter “runaway bosses” into your preferred web search engine and the hits keep coming. According to the same Economist article, the delinquent bosses of some 266 fintech firms have fled over the past six months alone. It’s a worrying trend that pessimists say represents yet another nail in the coffin of China’s so called “Era of Capital.”
I wouldn’t be so sure.
Emerging trends will always be susceptible to periods of protracted volatility. It’s how industry leaders – and government officials – respond to such crises that lays the groundwork for what happens next. Now, the “maturation” process has begun in China. Unfortunately, to date it’s happened exclusively in the form of mass consolidation, with the state sector swooping in and taking over what was up until now a strictly private sector trend.
The Chinese government’s fondness for consolidating its interests is no state secret of course, but it would be a mistake for it to use the failings of the fintech sector to reassert the dominance of the country’s state-owned banking sector. The reason for this is straightforward enough. Big banks aren’t usually the biggest allies of small business, and every economy needs a robust small business sector in order to thrive.
Where could the Chinese government look for guidance? Not the US, unfortunately. If anything, the fintech market in America suffers from too much regulation. Everyone knows there’s no friendlier country on the planet for budding entrepreneurs than the US, and you certainly don’t have to look far to find examples of fast-growing American fintech success stories. You could go so far as to argue “disruptive innovation” in the financial sector is in our DNA, from the rise of Western Union to the emergence of giant credit card companies like Visa and Mastercard to the recent arrival of game changers like Lending Club, OnDeck and Venmo.
And yet, ask any fintech startup CEO about the thicket of regulation he or she has to routinely navigate in order to figure out which agencies have jurisdiction over, or which laws apply to, the various aspects of their businesses. Better yet, don’t. The alphabet soup of regulatory bodies they will be obliged to list – the SEC, the Fed, FINRA, OCC, FDIC, NCUA, CFPB, etc. – will put you both to sleep. The point is that these days the US lags behind other regions of the world in creating the environment the fintech industry needs to flourish. (One discouraging example: In the United States, the licenses needed to become a money services business (MSB) have to be acquired on a state-by-state basis; in the European Union, a single license is all it takes to do business in Berlin, Paris, Madrid, and Rome.)
Making finance safer is one thing, but blinding business with an unusually harsh regulatory spotlight isn’t the answer.
Why does it matter if the fintech sector goes belly up in China, the US, or anyplace else? To reiterate: Fintech isn’t some passing trend or get-rich-quick scheme. It’s one of the essential engines that drives small business development. According to the site VentureBeat.com, the World Economic Forum recently reported that a healthy fintech industry could close a $2 trillion funding gap for small businesses globally. You could drive a healthy uptick in the global GWP through a gap that size.
This brings us back to China. Chinese regulators may be tempted to capitalize on the country’s fintech troubles to reassert their influence, but they should strongly resist the urge. Instead, they might focus their efforts on taking steps to create a healthy ecosystem for the country’s fintech sector, one with regulatory controls that are clear, efficient, and properly implemented. Transparency will be key. One of the things American fintech companies do right is publishing essential information about those seeking loans, including their credit history, employment status, and income. This is to ensure that the investors putting up the money know what they’re getting into. It’s a critical confidence-builder, and China’s fin-tech model will need to be similarly transparent if it wants to succeed.
I happen to believe that it will succeed, and that it will continue to attract big money. The case could be made that it’s already happening. In December 2015, Yirendai, the consumer arm of P2P lender CreditEase, became the first Chinese fintech firm to go public on an overseas exchange, listing on the NYSE with a valuation of around $585 million. In January of this year, Lufax, a platform for a range of products, including P2P loans, completed a fundraising round that valued the company at $18.5 billion, setting the stage for a highly anticipated IPO.
Both companies pride themselves on their transparency protocols and risk controls.
The bottom line is this: No financial sector benefits from descending too far into a Wild West of laissez-faire everything, and China’s regulators were right to ride to the rescue. They would do equally well not to strong arm the sector’s brightest leaders. The country should strive to create a safe, healthy environment for third-party service providers to prosper and grow. If they do, it won’t just be investors in mobile transactions and digital currencies who benefit.
China’s entire economy will.
Starting an ISO Shop? Here’s What You Need to do Differently
June 17, 2016
It’s not news that commercial finance brokers are hurting and some are even calling it quits. The industry that didn’t ask for more than a phone and a sharp sales acumen from anyone wanting to start an ISO shop is now stifled with competition. The low barriers to entry that welcomed new companies is causing a seismic shift in the way brokers do business. While some are ready to leave, most are still grappling with the changing times.
What’s different about the business now? Almost everything, some say. Gil Zapata who runs a four year old ISO shop, Lendinero, says clients were desperate for money when he started. However he doesn’t think of the competition as fierce but just messy. “There are brokers and ISOs entering and clogging up the system,” he said, “They are obviously fly-by-night and get pulled into it thinking the industry is a fast money maker but it’s really not.”
Competition did what competition does, drove prices and commissions down, costs up and hacked the product. For instance, daily payment ACH loans strongly tied to historical cash flow history didn’t exist. Neither did fancy verbiage for them. The onslaught of online lenders that entered the industry didn’t help either.
OnDeck started selling term loans, which had some similarities to other daily payment products, said Chad Otar, founder of New York-based MCA company Excel Capital Management. “ISOs, on their part have to be careful while pitching these products to clients, explain the contract clearly to avoid penalty.”
The competition has also led to loan stacking, much to brokers’ and lenders’ contempt. And the online lending ilk of Lending Club, Prosper and OnDeck cannot escape it either. Last week, (June 10th), Reuters ran an article calling stacking the latest threat to online lenders where “soft credit inquiries” and “patchy reporting” results in multiple lenders making loans to the same borrower, diminishing the ability to pay.
“Deals become impossible to structure and it becomes difficult for lenders to keep clients on the books when there are second and third names,” said Zapata. The proliferation of loan products that succeeded as a result of competition was a double edged sword. While there are more products to be sold, there are not enough borrowers to lend to.
From a funder’s perspective, that means acquiring and retaining a customer on price rather than an ongoing relationship. “The increased competition has led to commoditization of the MCA,” said Sol Lax, CEO of New York-based business funder Pearl Capital. “It was an exotic financial instrument 5 years ago and the ability to set up shop was restricted. That has changed.”
The ISOs are increasingly reliant on renewals, thanks to the high marketing costs. “A real differentiating factor is whether an ISO syndicates, their default rate, and their renewal rate. All of it is intertwined so that ISOs need to view their business more like investors and less like brokers,” Lax said.
So what would ISOs have done differently? Otar says he would have started an industry coalition similar to the Innovative Lending Platform Association. “I would have tried to pull a Godfather and formed a coalition with other companies and self regulate.”
For Zapata, doing things differently would have meant finding an early backer. “If I had to do this over, I’d have a good investor behind my back,” he said. “Find someone who knows the business and have a good game plan. If you don’t have deep pockets, your chances are minimal.”
