In spite of ongoing challenges, the marketplace lending industry continues to scale. Perhaps as a testament to the industry’s success, incumbent banks such as Goldman Sachs have begun to encroach on fintech’s turf. The bank’s Marcus platform has offered personal loans to consumers since October 2016. Meanwhile, regulatory uncertainty has only increased with recent rulings providing no clear framework. In spite of this uncertainty, exciting niche opportunities have sprung up to promote financial inclusion in novel ways. The massive potential market for technology-driven financial services has continued to attract diverse capital to this emerging industry.
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The US state-based chartering system has already provided an opening for innovation in financial services. However, many policy groups have discussed opening a “sandbox” at the federal level. In 2016 this took the form of both the Treasury White Paper on Marketplace Lending1 and the Office of the Comptroller of the Currency (OCC) Framework on Responsible Innovation.2 The OCC implemented a fintech charter for qualified businesses which include bank-like activities such as making loans and taking deposits. The stipulations of this include a 3-year business plan with official notification of any changes, as well as capital requirements. Fledgling fintech startups must be nimble to brave business conditions therefore sticking to a business plan may be unrealistic. The charter may also hamstring venture capital fintech investors. Legal experts have speculated that investors may have to prove compliance with the 1956 Bank Holding Company Act to make equity investments in OCC-chartered businesses. If upheld, the burden would effectively prevent VCs from investing in OCC-chartered companies.
The Madden vs. Midland case called into question how usury laws applied to online lenders. So far, nationally-chartered partner banks have shielded online lenders from state usury regulations. In a ruling testing the practice, the court focused on continued bank partnership after origination. The ruling continues to play out as platform-bank partnerships evolve. Meanwhile, the industry follows a tighter standard in the Second Circuit states of New York, Connecticut and Vermont. We look for another circuit court or Congress to “fix” the ruling by backing the longstanding concept of “valid when made,” whereby non-usurious loans remain valid if sold to another party.
Challenge: Platforms need to find steady low-cost sources of capital.
Online lending has faced considerable challenges as the industry continues to mature. Platforms have looked to diversify their sources of capital to avoid reliance on expensive VC equity funding. Mature platforms have looked to raise lending capital from institutional credit investors and select larger ones are using loans to back securitizations. Equity financing events1 dropped to $2.2 billion in deal value across 145 transactions in 2016 down from $5.1 billion across 174 deals in 2015. This pace has continued to trend down in 2017, with 25 deals completed through March, yet SoFi’s $453 million Series G has bumped the total deal value to $754 million.
Securitization has become a widely-practiced method for funding originations among the larger platforms. In the early days of the industry, many online lenders held loans on their balance sheets. Other lenders developed peer-to-peer marketplaces matching retail investors and borrowers. Mature lenders have pivoted away from both the pure balance sheet and the retail peer-to-peer lending models. They have done this by seeking out increased partnerships with institutional investors. Larger lenders have accessed credit markets by securitizing packages of loans. Securitization compounds the larger firms’ comparative advantage from a lower cost of funding. Total marketplace lending ABS issuance in 2016 reached $7.8 billion, up 59% YoY, according to PeerIQ. The securitizations market has seen a virtuous cycle of improved pricing over time. Given an increased sample size of successful issues, investors have bid down yields to be closer in line with similar ABS products.
Challenge: Finding profitability in the mass market
The consumer unsecured marketplace lending segment is the most mature and highest profile. Most of the news flow around online lending has profiled the successes and failures of the major consumer lending unicorns. In the last year we saw Lending Club, Avant and Prosper face high-profile challenges. Instead of an IPO, Prosper has resorted to a major down round to stop the bleeding. The company is raising a $59 million Series E venture round that values the company at $460 million (post-valuation), a steep drop from the $165 million series D raised in 2015 that valued the company at a postval of $1.87 billion. In the year ending December 31, 2016, Prosper’s net losses increased to $118.7 million from $26.0 million in the prior period.
The challenges faced by Lending Club, Prosper and Avant underscore a competitive and commoditized market for mass-market consumer unsecured lending products. In the early days, online lenders differentiated themselves by targeting specific FICO segments. As these lenders have matured many have sought growth by venturing outside of their target FICO demographic. The strategy has made the market more competitive and commoditized. Furthermore, data compiled by Orchard has shown increased charge-offs in more recent vintages. Over time more and more lenders have targeted subprime borrowers and incumbent lenders have relaxed standards to show increased volume for VC backers and potential IPO investors.
Lenders that are able to grow their pie with innovative offerings will find success. Those with moats due to brand, unique offerings and strong relationships with institutions and corporates will continue to experience growth. One example, SoFi, expanded from elite-university student loan refinance to a range of financial services, building a strong moat around its brand of catering to “members.” They target HENRYs - high earners not rich yet - with services such as career counselling and social events. Strong loan performance has led to increasing success with repeat securitizations. For example, recent SoFi student loan issuance gives the platform a 70 to 110 bps funding cost advantage, according to PeerIQ.
Challenge: Competing with publicly traded incumbents As we detailed in our initial 2016 Analyst Report covering Online Lending, SME marketplace lending has the ability to provide a public good. The financial crisis took a toll on small business lending products. Marketplace lenders have stepped in to fill the void left by banks, able to fill the market gap between short-term predatory lenders and banks. Companies like Kabbage and Funding Circle rely on alternative datasets. These include social media data and standardized data imported from accounting software. Impact investors have gotten involved as well. Community Investment Management announced in March 2017 a $100 million commitment to purchase Funding Circle loans. SME lending platforms will be wise to market themselves as agents of job creation and social good. The strategy provides differentiation of their loans from other fixed-income investments since small businesses have accounted for a disproportionate share of job creation even as SME bank credit has dried up.
Much of the competition in the SME arena comes from publicaly traded POS payments providers Paypal (NAS: PYPL) and Square (NYSE: SQ). Both companies leverage their data to offer credit solutions. Small businesses repay based upon a percentage of sales, enabling greater flexibility. As platforms mature, increased data leads to a virtuous cycle. Tighter spreads emerge from the increased accuracy of data-driven models. Scale becomes a huge advantage given the value of larger sample sizes in pricing alternative credit. Commercial lending has yet to have its own Madden vs. Midland moment, however, New York state has considered amending small business usury laws. Further, revenue-based financing, increasingly popular for asset-light businesses, would face risks given sliding rates.
Analytics & Data
Challenge: Using data to promote inclusive finance
Best practices from marketplace lending will spread to traditional lending and the multi-trillion-dollar ABS market. Most marketplace lending platforms have developed their own proprietary models. Alternative data such as education and job title from social media creates an edge over the data sets used by credit bureaus. Standalone platforms like Nova have pitched credit models as a means to social inclusion. The company has integrated international data into a portable credit scoring system to allow immigrants and expats access to credit. The company is able to partner with online lenders to open up the 42 million foreignborn residents in the US as a whole new target market. The Brookings Institution found that immigrant access to credit lags behind that of the native-born population. The gap exists until the individual has been in the country for over 30 years, or moved to the US before the age of 16. Once creditworthy immigrants have access to capital when they move, this will disproportionately accelerate growth as the immigrant community in the US has a long history of entrepreneurial activity.
Challenge: Building sustainability amidst a soft landing
At the turn of the millennium, China lacked the infrastructure of credit bureaus, credit scoring, and even credit cards. As a result, an ecommerce and online lending ecosystem developed alongside traditional financial infrastructure. Only recently has the Chinese market offered consumer credit cards and developed credit bureaus and scoring models. However, existing financial institutions have limited data and thus closely monitor rates and delinquency. Small loans are not available in the incumbent financial system due to high cost and lack of data. Ecommerce and
manufacturing titans such as Alibaba and Foxconn emerged in the recent boom. These companies have extensive datasets on their middle-class clients and small business suppliers, and have begun to leverage their access to capital markets on behalf of their suppliers, clients and customers. Due to limited credit bureaus, customer acquisition costs for lenders are high. Thus, existing clients with long track records of transactions can be a lucrative client type. For manufacturing businesses, technologies like blockchain allow them to provide financing for suppliers. Platforms like Dianrong even utilize blockchain for tracking supply chains as well as capital flows around the world.
The massive population and rapid growth in the economy combined with an immature banking sector has stoked the growth of marketplace lending giants. Yirendai has become the closest thing to a household name in the West after a completed US IPO in December 2015, and shares have more than doubled since the offering. Moreover, public scandals at competing Chinese marketplace lenders have induced volatility in public shares. However, Yirendai is only the 12th largest Chinese marketplace lender by volume.1 While Yirendai went to the US public markets, its larger competitors have partnered or aligned themselves with corporate behemoths. Lufax, for example, raised $1.2 billion with a $18.5 billion postval from Ping An Insurance and others.
Concerns have emerged over China’s massive expansion in credit. Some wonder if the titanic economic boom leaves online lenders vulnerable to failure. Low barriers to entry have left the Chinese marketplace lending industry overcrowded. According to a report in February 2017 by the Beijing Bureau of Financial Work, there are 4,856 P2P lenders in China. The report makes the audacious claim that nine out of ten will fail this calendar year. These platforms popped up after governmental agencies began to encourage the practice in 2011. Regulators have since changed their tune. Newly proposed rules require platforms to establish formal partnerships with the formal banking sector, however, banks remain reluctant to partner with P2P lenders. Those that can meet SOE criteria will survive while the rest will fail without official blessing.
Charge-offs have increased in recent vintages as platforms sacrificed loan quality in order to meet quotas to drive increased equity funding rounds. The return to more sustainable origination rates in 2016 should ameliorate some of the growing pains in terms of loan performance issues experienced during the boom of 2015.
Select Company Profiles
Location: San Francisco, CA | Year Founded: 2013 | Capital
Raised to Date: $209.3M |
First Funding Date: November 2013 | First Funding Amount: $11.2M
Latest Funding Date: November 2016 | Latest Funding Amount: $100M |
Latest Funding Post- Valuation: $670M
Description: The company provides a platform for alternative mortgages including shorter duration loans for investment properties. In turn, LendingHome provides an opportunity for investors to participate in the market for senior secured, collateralized mortgage loans.
Location: Atlanta, GA | Year Founded:2006| Capital
Raised to Date:$410M|
First Funding Date: December 2014 | First Funding Amount: $350M |
Latest Funding Date: September 2016 | Latest Funding Amount: $50M |
Latest Funding Post- Valuation: $3.6B |
Description: GreenSky provides financing solutions for individuals with strong credit to finance big-ticket purchases. The company partners with retailers to offer these services to their customers. The company began with items such as furniture and home improvement products, but has since moved into segments such as elective surgery.
Location: Palo Alto, CA |Year Founded:2015|
Capital Raised to Date:$11.4M| First Funding Date: January 2015|
First Funding Amount: $3.0M | Latest Funding Date: September 2016 |
Latest Funding Amount: $8.4M | Latest Funding Post- Valuation: $31M |
Description: Point operates a home equity marketplace for minority stakes in single-family real estate. The company is developing a marketplace to enable homeowners to diversify their wealth by selling some of the equity in their homes without taking on any additional debt.
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