Remember Kodak, before it became a crypto currency high flyer?
Kodak thought it was in the business of selling film. They were wrong. Their customers just wanted the pictures and as soon as they could get them digitally, they stopped buying film, suddenly and completely.
Banks…Savings and Loans… thought they were in the community branch business.
Bricks and mortar, a safe, and the occasional free toaster.
But their customers just want high rates on deposits and low rates on loans. They can now get both, online, digitally.
Get the picture?
The Birth of Marketplace Lending
Consumers could not understand why they were paying 13-17% APRs (Annualized Percentage Rates) on their credit cards to banks like Citi or Chase, only to receive sub-1% on their deposits from those same institutions.
It was those frustrations — and a serendipitous confluence of circumstances — that gave rise to marketplace lending and legitimized the first business plans designed to disrupt the banks by changing the pipes that connected borrowers looking for capital and savers looking for a return on capital.
The catalysts for the disruption — the confluence of events — was a combination of factors including:
- Technology (especially mobile tech)
- Changes in online social behavior
The trifecta was cemented after the great financial crisis and provided the foundation for the rise of digital finance.
Consumer credit marketplaces led the way, and the digital finance revolution was underway. Business plans and models quickly emerged aiming at other serious challenges, namely providing access to financing in sectors of the economy that had been abandoned by traditional banks, such as small business lending, or neglected wholesale, such as microfinance.
Many of these models were not so much disruptors as they were enablers. As banks pushed up minimum loan size, swaths of small and micro businesses in the developed world were abandoned by one of their only sources of growth capital: Bank debt.
How Marketplace Lending Works
Generally, the marketplace or platform model involves a borrower, an investor, and a platform.
The platform originates the loans to the borrower and sells that loan to the investor. After finding prospective borrowers, the platforms underwrite them and accept only a handful (5-15% of total applicants) to sell to investors.
In addition to front-end borrower origination and underwriting, the platforms service loans for the investors who bought them.
While most platforms have adopted this agency business model, a few platforms issue loans on balance sheet and either hold all of them for their own account, or sell some of the loans to investors and keep the rest.
Platforms typically charge borrowers a one-time origination fee (e.g., 2%-5%) that gets amortized into the APR, and they charge investors a recurring servicing fee as a function of asset balance at the platform (e.g., 1%/year). Some platforms sell loans at par, while others charge a premium to par.
Different Ways for Investors to Participate
The investor profile in the sector has evolved from the early days to include institutional investors, retail investors, and even banks buying for their balance sheets. Investors can elect one or more ways to participate in the sector.
Buy loans directly from a platform or work with a third-party manager
- Some platforms offer direct access to loans
- Several managers have already built significant followings and strong track records
Buy loans on an active basis or a passive basis or a mix of both
- Active: The investor selects which loans to purchase
- Passive: The investor buys a basket that mirrors a platform’s origination profile
Buy securitized debt, backed by loans
- Several platforms and investors have placed marketplace bonds in the ABS (“Asset Backed Securities”) market
Buy shares of listed funds that purchase loans
- US: A few 40-Act Interval funds have launched since 2015
- UK: Investment trusts
Get indirect exposure by investing through a non-dedicated private investment fund that has made an allocation to the sector
Other considerations for investors include:
- Desiring access to a single sector or to multiple sectors
- Desiring access to a single platform or multiple platforms
Notable Advantages and Disadvantages
- Low correlation to listed securities (held to maturity, short duration)
- Low volatility (short duration, private, non-listed)
- Visibility, since the loans have fixed contractual rents with insight to loss behavior
- Liquidity, since performing loans have high cash generation from principal amortization and cash interest
- Duration tends to be short
- Headline risk for space at both the platform or manager level
- Competition from well-capitalized entrants
- Short duration means high capital recycling into potentially lower coupon assets
- Limited history
Risks and returns
Broadly speaking, investors may realize attractive risk-adjusted returns on a consistent basis if they understand the challenges. These include picking the right platforms, selecting the best credits from those platforms, and understanding the underlying loan’s parameters. For example, prospective investors often mistake headline gross yields for prospective IRRs, which may lead to a gap in expected versus realized returns. In most cases, marketplace loans are sinking balance with principal amortizing at a fast rate (regular way and prepayment). Loan losses is another area that investors sometimes overlook or miscalculate.
Return drivers include:
- Gross yield: generally, marketplace loans are fixed rate
- Default/Charge-off rates: Dynamic
- Servicing fees paid to the originator: Fixed rate
- Prepayment rates and reinvestment pace: Dynamic
For a levered approach, add:
- Leverage levels
- Cost of leverage
Some risks include:
- Existential risk: Risk that the originator winds down and there is either no backup servicing strategy or the backup servicing strategy fails
- Charge-off rates end up being materially higher than expected
- Asset/liability mismatch for levered structures
- Manager risk, primarily conflicts of interest
Thousands of marketplace lenders have sprung up over the years, and, as is the case with early participants in many new industries, most of these startups will not survive once VC funding dries up. The rationalization process started in early 2016, with several smaller platforms closing shop or selling to larger, better capitalized competitors.
Future leaders in this industry will likely share several essential attributes. For example, they may:
- be well-capitalized or have a clear path to profitability
- demonstrate consistent underwriting prowess
- consolidate their leadership positions
A potential short list of winners and future leaders would include:
Source: Company Websites, Crunchbase; data through December 2017, unless otherwise noted.
Zopa: Marketplace lending has its roots in the UK, with the founding in 2005 of Zopa, a consumer only marketplace lender. Zopa has raised about $110 million in venture capital from several firms including Bessemer, Benchmark, Balderton, Wellington, Augmentum, Wadhawan, and Northzone.
Prosper: In 2005, Prosper, a U.S. “peer-to-peer” consumer lending platform closed its $7.5 million Series A round led by Accel. Since then, Prosper has raised $412 million in venture capital from marquee investors, including Fidelity, Meritech, QED, Omidyar, DraperFisher, Crosslink, Sequoia, Francisco Partners, Credit Suisse, Target Global and FinEx Asia. From inception through December 2017, Prosper has originated over $10 billion in consumer loans.
OnDeck: In 2006, OnDeck Capital was founded in New York City. Unlike Zopa and Prosper, the firm makes loans exclusively to small businesses. From its Series A through to its last pre-IPO round, OnDeck raised about $190 million in venture capital and growth equity from RRE Ventures, First Round Capital, IVP, and Tiger Global. The company completed its IPO in December 2014, raising $200 million. From inception to December 2017, OnDeck originated over $7 billion in small business loans. OnDeck is one of the established leaders in small business digital loans.
GreenSky: Founded in 2006, Greensky’s platform was launched to make it easy for businesses of all sizes to offer credit to customers with a paperless point-of-sale solution. The company raised $350 million in equity capital from venture investors and banks including Fifth Third Bank, TPG, DST Global, QED Investors, Iconiq Capital and Wellington Management. Since inception through December 2017, the company has originated over $10 billion.
CreditEase: In 2006, CreditEase was founded and today is one of the leading Fintech conglomerates in China specializing in finance and wealth management. In 2012, CreditEase launched Yirendai which has grown into one of China’s leading online consumer finance marketplaces. Since its founding and including Yirendai’s 2015 IPO, CreditEase has raised $95 million in equity capital including venture investors KPCB and IDG Capital Partners. From inception through September 2017, CreditEase / Yirendai has originated over RMB 60.5 billion (at September 2017 fx, this is over $9.1 billion).
LendingClub: In May 2007, Prosper’s main competitor was born with a $2 million angel round. LendingClub proceeded to raise almost $400 million in venture capital and growth equity from another list of marquee investors, including Norwest, Canaan, Morgenthaler, Foundation, Union Square Ventures, KPCB, Google, DST, Blackrock, Sands Capital, and T. Rowe Price. LendingClub completed its IPO in December 2014, raising $860 million. As with Zopa and Prosper, LendingClub’s platform business is built around unsecured consumer loans, but in 2014 LendingClub launched a small business loan product and in 3Q16 LendingClub announced the launch of an auto refinancing loan product. From inception through September 30, 2017, LendingClub has originated over $30 billion in loans, most of them consumer, making them the de facto marketplace leader, even though they were not the first to launch.
Auxmoney: In 2007, Auxmoney was founded to match borrowers with private savers and institutional investors across Europe, with a focus on Germany. Since its series A round, Auxmoney has raised $242 million in equity capital from well-known investors such as Aegon, Index Ventures, Union Square Ventures, Foundation Capital, Partech Ventures, Seven Ventures and Crosslantic Capital. From inception through December 2017, Auxmoney has originated nearly EUR $600 million (at Dec 2017 fx, this is over $700 million).
Kabbage: In 2009, Kabbage was founded to provide a new and automated way to lend money to small businesses. The company has raised $489 million in venture capital and growth equity from marquee investors SoftBank, BlueRun Ventures, Mohr Davidow Ventures, Thomvest Ventures, Reverence Capital Partners, the UPS Strategic Enterprise Fund, ING, Santander InnoVentures, Scotiabank and TCW/Craton. Since inception through December 2017, the company has originated over $4 billion in small businesses loans.
RateSetter: In 2010, RateSetter was founded in the UK to provide a consumer platform to match borrowers and savers. In 2014, RateSetter expanded to Australia building on its success in the UK. Since its founding, the company has raised $65 million in growth equity from investment fund managers including Woodford Investment Management, Artemis and Five V Capital. Since inception through December 2017, the company has originated over $3 billion in consumer loans globally (mainly in the UK and Australia).
FundingCircle: Founded in 2011, FundingCircle has established itself as the go-to small business marketplace lender in the UK and an important competitor in the US. The company has raised $373 million in venture capital and growth equity from marquee investors Index, Accel, Union Square Ventures, DST, Temasek, and Blackrock. Since inception through December 2017, the company has originated over $5 billion in small business loans globally (mainly in the UK and the US).
SoFi: In August 2011, another future giant was born. SoFi was founded to facilitate peer-to-peer student loans, and has raised a total of ~$2 billion in venture capital from Baseline, Discovery Capital, Third Point Ventures, Silver Lake and Softbank ($1 billion in September 2015). The company has started to offer other products, including consumer loans, to its ecosystem of borrowers. From inception through December 2017, SoFi has originated over $25 billion, most of which are student loans.
SocietyOne: In 2011, SocietyOne began as one of the pioneers of P2P lending in Australia, aiming to provide consumers with better loan options than banks and attractive returns for savers. Since its founding, SocietyOne has raised $55 million in equity capital from investors such as Beyond Bank, News Corp, Seven West Media, Consolidated Press Holdings, Reinventure Group and Global Founders Capital. From inception through December 2017, SocietyOne has originated over AUD $350 million (at Dec 2017 fx, this is over $260 million).
CommonBond: Founded in 2011, CommonBond began with the goal of using marketplace lending to lower the cost education financing. Since its founding, CommonBond has raised $79 million in equity capital from investors such as Neuberger Berman, Social Capital, Tribeca Venture Partners, Victory Park Capital, August Capital and Nelnet. From inception through October 2017, CommonBond has originated over $1 billion.
LendingHome: LendingHome was founded in 2013 to service the “fix-to-flip” residential mortgage sector, a niche abandoned by the banks post Dodd-Frank. The company has raised about $160 million in venture capital from Ribbit, Foundation, First Round Capital, and Renren. From inception through December 2017, the company has originated over $1.75 billion in secured residential mortgages. LendingHome is the de facto leader in the digital real estate lending sector.
Square Capital: Square Capital is an offshoot of Square, Inc, the publicly-listed payment processor. Born as a pilot project in 2014, Square Capital is quickly becoming a market leader in unsecured small business digital loans. Per Square’s 3Q17 conference call, annual run rate originations are estimated to be $1.2 billion.
The primary global platforms listed in the prior table have originated an aggregate $112 billion in consumer, small business, and real estate loans since inception. While a staggering sum for an industry that was born ten years ago, in the context of market share, this number is still small. The total US household credit stack is approximately $13 trillion broken down into $9.5 trillion of housing debt, $1 trillion of revolving consumer credit, $1+ trillion auto, and $1.5 trillion student loans. Small business debt is estimated at $1.5 trillion.
We believe there is still a long way to go.
We believe that the trend toward digitalization is inevitable and that most, if not all, loans will ultimately be digitalized. We are already seeing further inroads to both massive markets, such as student loans, and tertiary segments like litigation finance.
In the case of Kodak, film was an unnecessary and very expensive layer between the photographer and the images they wanted to produce. There are still many, many layers of intermediaries and institutions living off the aforementioned $13 trillion. Digitalization, enabled by further generations of technology and encouraged by accelerated global regulation will continue to erode those layers.
(Since many of our younger readers may in fact not remember Kodak, we offer this: Once the dominant player in film and photography, Kodak was an American institution. “A Kodak Moment” was the commonly accepted phrase for a special event that deserved to be recorded. Slow to adapt to the inevitable shift to digital photography, the company, founded in 1888, filed for Chapter 11 bankruptcy protection in 2012.)
HCG has been a pioneer in digital finance investing since 2012. We believe that foresight, the ability to look ahead at critical issues around evolving fintech, credit underwriting, regulation and financing markets, is essential to effectively navigating the challenges and opportunities of this nascent industry.