Khrom Capital 2015 Letter; Long OnDeck Thesis

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Khrom Capital 2015 letter

March 23, 2016

[drizzle]Dear Limited Partners: In 2015, our Partnership returned 1.4% net of fees and expenses.i On average, we held 7% of our assets in cash throughout this period. For the past five years, the fund has had an average cash balance of 23%.ii

Khrom Capital
Khrom Capital

As our Partners know, our philosophy is not to disclose investment ideas in our letters, in order to prevent commitment bias and to protect our intellectual property. On the other hand, it is valuable for Partners to understand the type of investments Khrom Capital makes. To balance these conflicting goals, we find it prudent to occasionally walk through a particular Khrom Capital investment.

A current investment of ours is in a company called OnDeck, which operates an online platform for small business lending. OnDeck’s story reminds us of Moneyball. (We recommend reading this book or seeing the movie.) Moneybal tells the true story of how scouting for baseball players evolved in the 21st century. It describes the transition that talent scouts made from recruiting players using their personal judgments—which were impaired by cognitive biases and lacked regard for scientific data—to instead employing computer-generated statistical analyses. The first team to implement this change was the Oakland Athletics. Having a fraction of its competitors’ budgets, the Oakland A’s were the League’s underdog. Yet, by beginning to use data analytics to more effectively recruit players, the Oakland A’s catapulted to the playoffs and permanently changed the way Major League front offices do business.

OnDeck brings Moneybal to small business lending. The company has taken advantage of advancements in computing and the proliferation of data to help solve a large problem: deserving small businesses have trouble getting capital. The traditional method requires small business owners, who have limited time to step away from their businesses, to dedicate over 20 hours to the loan application process. 1 Worse, those valuable hours are likely wasted because a majority of small firms (under $1 million in annual revenues) are rejected when they apply for credit.1 For those that do get approved, it usually takes weeks for the funds to arrive, 2 which provides little value for owners with time-sensitive capital needs.

This problem exists partly because banks lack the incentive to make small business loans. Transaction costs to process a $100,000 loan are comparable to a $1 million loan, but with less profit. As a result, banks are less likely to engage in lending at the smallest dollar level. To put this problem in perspective, over half of small businesses surveyed were seeking loans for under $100,000. 2 Furthermore, when banks do review a small business loan application, they frequently shortcut the underwriting process by primarily relying on FICO—the personal credit score of a business owner. As a result, a low FICO score is the top reason for a small business credit denial.1 However, the personal credit score of a pizzeria owner, for instance, is not the best way to predict how many pizzas the business will sell. FICO also does not help an underwriter decide on the appropriate loan size to offer and interest rate to charge each unique pizzeria.

The antiquated process that banks still rely on created the opportunity for OnDeck to disrupt the small business loan market. OnDeck has spent almost a decade building out its OnDeck Score—a credit score for the small business, not the business owner. The OnDeck Score aggregates and analyzes thousands of data elements related to a business that are more predictive of its credit  performance than FICO alone. 3 This allows OnDeck to more accurately underwrite small businesses’ financial performance. Since a majority of this process is also computer automated, 4 it enables the company to profitably approve loans under $100,000. Small business owners can now complete an online application within an hour from the convenience of their offices and receive funding the same day.

OnDeck’s technology was developed by an impressive team, led by its CEO, Noah Breslow. Noah graduated from MIT with a BS in Computer Science and Engineering and received an MBA with Distinction from Harvard—an ideal educational background for the leader of a financial technology (fin-tech) company. More importantly, among the competitor CEOs whom we spoke with, Noah stands out as the most capable. We took the time to get to know Noah, and his qualities match what we look for in CEOs. He sticks to a clearly defined goal: make OnDeck the best in the world at delivering credit to small businesses. When necessary, he takes short-term pain to achieve this long-term objective. As a recent example, he reduced the company’s reliance on a distribution channel that brought OnDeck significant business, but that did not best serve the company’s customers in the long-run. Noah drives innovation to keep OnDeck ahead of its competitors: his team just pioneered the concept of “OnDeck-as-a-Service” (which we discuss further below). He is highly ambitious and greatly believes in the future of OnDeck, with virtually all of his net worth invested in the company.

In addition to OnDeck’s strong management, the company itself has competitive advantages that should enable it to win a big portion of a very large market. As the largest online small business lender, it benefits from the positive feedback loop of its data gathering. The more loans that OnDeck’s algorithm underwrites, the more data it receives on loan performance, the more it can improve the algorithm’s predictability, the more its underwriting advantage increases versus smaller competitors, the more loans it can underwrite, the more data it receives on loan performance, and so on in a virtuous cycle.

The company’s scale also drives increasing operating leverage. As an online lender, much of the company’s costs are fixed, resulting in a lower cost per loan with each additional loan it makes. Not only does this help build OnDeck’s position as the lowest cost producer, its scale allows it to maintain its lead by being able to invest more into R&D than its smaller competitors.

As a result, OnDeck can now underwrite the widest credit spectrum compared to its competitors, which gives it a cost advantage in acquiring customers. Most lenders to small business are clustered at either end of the credit spectrum—from subprime to prime—and offer only one or two products. OnDeck, on the other hand, has advanced its credit model to a point where it can now underwrite a short duration loan to a

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