The End of the Beginning
Speaking 75 years ago about the Battle of Egypt, Britain’s first victory of World War II, Winston Churchill famously said, “Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” He knew that one battle could not predict the outcome of the war, but he must have sensed a turning point that presented a different perspective on the future.
Are we seeing an “end of the beginning” in digital finance investing? Has the market matured to the point where early entrants that rode a wave of opportunity are now faltering under the expectations of a more mature market? Can we look ahead to see that new players and larger institutional assets entering the field bring with them a set of greater expectations? We believe the answer to all is an unequivocal “yes.”
We see it most clearly in what we believe is the outsized growth, success, stability, and maturity of several of the platforms with which we invest. What were start-ups just a few years ago, with founders working feverishly in cramped quarters, are now sophisticated organizations with handsome offices staffed with the most sought-after graduates of the world’s top universities and led by senior hires from Fortune 100 companies. Institutionalization and process have become credo.
We also see the end of the beginning in the growing ranks of sophisticated institutional investors committing significant allocations to this space. Insurance companies, pension funds and endowments with well-established expectations of transparency, risk management, and performance have decided that this market has matured to a point of mainstream acceptance.
Maturing markets also attract new, larger players from other fields that pick up the scent of opportunity in a new arena. As digital finance matures, big banks and e-commerce giants will look for ways to participate, whether through organic efforts or through acquisitions. Yet, despite resources, their path to success in digital finance investing is not challenge-free. In our opinion, few might possess the distinct balance sheet model required to succeed, and regulators may not look too keenly on social media giants adding lending and credit to their arsenal of services. Or, the ideal DNA that combines investment savvy and technology expertise may be difficult to nurture and harness.
We welcome the maturing of this market because it validates our initial 2011 thesis that digital finance investing as an investable asset class is here to stay. We saw it coming when we formed our team, honed our investment process, and built a technology engine that is designed to operate in the complex world of digital finance. While we enjoy an occasional look over our shoulder at the efforts of new entrants, our focus remains straight ahead towards the future. While others are exploring areas we have been mining for years, we see opportunities in new sectors of small-balance, short duration, private loans that are converting to digital and becoming available for investment. We also see an evolving expectation among investors for a new experience, one that could provide the real-time access and complete transparency to their investments that they get when they go online to buy a pair of shoes or book a flight.
At HCG, we remain enthusiastic about the next phase of digital finance investing and confident in our ability — and our foresight — to identify opportunities and to take advantage of them. As Gary Oldman might have said…”As long as we have faith in our own cause and an unconquerable will to win, victory will not be denied us.” — Winston Churchill
Macro: The U.S. macroeconomic picture remains supportive. Unemployment is full at 4%, real GDP is growing in the 2-3% range, corporations are enjoying a reduced 21% tax rate, and the housing market is strong. In February, U.S. consumer confidence reached a 17-year high1 while the Institute for Supply Management’s Non-Manufacturing Index is just off a 12-year high2. U.S. home prices continue their steady march higher with the S&P/Case-Shiller national index up 6.4% year-on-year (“yoy”) as of the fourth quarter 20173. Default statistics are benign with revolving consumer credit charge-offs across all U.S. commercial banks at 3.6% as of fourth quarter 20174. Paynet’s Small Business Default Index was at 1.8% at the end of January 2018, roughly flat yoy5. At the end of 2017, the delinquency rate on single-family residential mortgages was 3.5% across all U.S. commercial banks, the lowest level since the end of 20076.
The bond market is getting active: Short-term rates are rising with growth and inflation expectations and in anticipation of further rate hikes by the U.S. Federal Reserve. Since the committee last raised rates on December 14th, one-month LIBOR has climbed 29 bps to 1.78% while the 2-year U.S. Treasury yield has risen 44 bps to 2.26%7,8. The long-end of the curve is also rising, with the U.S. 10-year bond yield up 49 bps to 2.84% over the same period8.
Unsurprisingly, with this rise in rates typically comes a demand for banks to pass on higher rates to depositors. According to the latest FDIC data, the national rate on small balance, 12-month CDs has risen to 32 bps9. Yields on short duration, high quality corporate bonds (BBB or better), have climbed to 2.95%, the highest levels seen since 200910. These levels start to have far-reaching consequences on capital allocation decisions generally, and fixed income allocations specifically.
Upward movements in benchmark yields should put a floor on the pricing of private credit opportunities; in fact, we believe that private credit should start to see pricing move up. Until recently, platform pricing was largely a function of one originating platform’s competitive positioning against other platforms. Traditional fixed income assets were not a competitive consideration for platforms as short-term rates were too low to compete for investor demand. Going forward, as rates continue to rise, other short-duration assets – CDs, money market funds, short-term sovereign notes – could offer investors an alternative yield, increasing pressure on platforms to raise borrower rates.
Higher loan rates should not serve as an impediment to platform origination growth. Platforms will continue to offer borrowers a strong value proposition on both cost of funds and customer service levels relative to their traditional loan competitors. One example is credit card rates in the U.S., which as a consequence of Dodd-Frank, raise existing borrower interest rates in step with changes in short term rates. Consequently, according to the U.S. Fed, rates on interest-bearing credit cards rose 138 bps yoy through November, 201711, with 1-month Libor increasing 73 bps over the same period.
Digital finance asset-backed bonds are in demand. On the securitization front, issuance and pricing remains robust. Consumer and marketplace loan ABS issuance was $2.2 billion in the first quarter of 2018, up 28% yoy according to data provider Finsight. On pricing, spreads on senior tranches have averaged about 60 bps year-to-date over comparable swaps, roughly 85 bps tighter than the average in 2017 for similar notes12. On the student loan side, SoFi recently completed an offering that included more than $1 billion in collateral – another “first” by a digital finance originator13.
Originating Platforms: We believe the beginning is behind us, and we are entering phase 2 of an established asset class. FinTech firms, established banks and technology giants are positioning themselves to capture what we believe to be the broad El Dorado opportunity that is digital finance. Most objectives and strategies are common and converge: reducing cost and maximizing efficiency, delivering an outstanding customer experience and finally, maximizing profitability and return on equity. FinTech companies are offering the digital version of services that were historically traditional bank services – digital loans, digital investment advice, and digital banking – while also focusing on streamlined operations, lower headcount, and profitability. For example, over the past several months, we have seen LendingClub generate positive operating income14, OnDeck achieve profitability during the fourth quarter15, SoFi reduce staff and recruit a high-profile CEO16 and Funding Circle generate positive cash flow in 2017 ahead of its planned IPO17. On the other hand, many weaker platforms are no longer going concerns.
At the same time, a few large banks are investing to catch up and introduce equivalent and competitive digital offerings. Perhaps the best preview of the traditional bank moving into FinTech can be seen at Goldman Sachs. In April 2016, the renowned global investment bank formed GS Bank, an Internet-based savings bank18 and then acquired GE Capital Bank, assuming about $16 billion in deposits19. These noteworthy strategic moves were followed later that year with the launch of Marcus, an originator of digital consumer loans. It seems that Goldman recognized the trend of digitalization of small-balance private credit and proceeded to build a viable competitor in the digital finance space. From launch through December 2017, Marcus has originated $2.3 billion20 in consumer loans – compared to over $33 billion21 at LendingClub over 11 years and over $25 billion22 at SoFi over 7 years. What is the latest move memorializing Goldman’s commitment to a digital finance strategy? GS Bank is being rebranded as Marcus23. More recently, other banks have revealed plans to hop on board the digital trend: Barclays launched a digital loan effort24, while reports indicate Citi is considering a digital loan program launch25.
Yet, despite the convergence in service offerings, there is at least one notable area of divergence: the balance sheet. Banks are a balance sheet heavy business model that rely on deposits to fund their loans whereas most FinTech companies are asset-light operating companies that have shown little interest in adopting balance sheet models26. This is largely driven by a wide gap in valuation multiples – technology operating companies enjoy lofty multiples while banks do not. Consequently, FinTech companies do not rely on deposits as their primary funding source and have to seek external funding from specialist digital finance investors. In our opinion, this creates opportunity for investment managers specializing in digital finance, and particularly managers that are focused on optimizing their cost of capital. Moreover, we believe that effectively managing both the cost of and sources of capital in a rising rate environment will be critical for success over the next few years for both digital finance originating platforms as well as investors.
Technology operating companies likely came to this same conclusion: stick to being operating companies. After years of investing to build a digital loan effort, in February 2018, press reports indicated that Amazon did an about face and reoriented its digital finance strategy – named Amazon Lending – to look more like an operating company than a balance sheet company. Specifically, those reports noted that Amazon is planning to partner with Bank of America Merrill Lynch to provide loans to merchants in order to reduce risk and increase capital availability27. Rather than take on the banks, Amazon is now on the cooperation path, whereby it marries its operating prowess with the balance sheet of BofA – and potentially JPMorgan and Capital One on the consumer side for checking accounts28. Similarly, Paypal, a FinTech pioneer, recently opted to sell a portfolio of about $6.8 billion in consumer credit receivables from its balance sheet, an amount that represented almost 20% of their current assets at the time, to Synchrony Financial29. Again, we believe technology firms will continue to choose the operating model.
Outlook: We expect that the robust macro backdrop of the next 12 months will continue to push inflation expectations higher, and short-term rates will continue to rise. We predict that the established digital finance platforms will increase borrower rates to capture some of the recent and expected moves in short rates. We expect to see more esoteric private credit opportunities migrate to digital offerings, and we expect some new digital finance opportunities to emerge that will warrant our attention. For example, new startups are proposing business models that integrate digital loans collateralized by cryptocurrency, potentially offering new avenues of value creation that were heretofore nonexistent. We expect to see what we believe are compelling digital loan opportunities in new geographies, including emerging markets. Lastly, we anticipate evaluating new leverage opportunities, especially on the fixed rate side. HCG remains at the forefront of many of these emerging opportunities, and is excited about the outlook for the digital finance space.
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2. Institute for Supply Management Non-Manufacturing Index. March 5, 2018.
3. S&P CoreLogic Case-Shiller Home Price Indices. February 27, 2018.
4. Board of Governors of the Federal Reserve System. Charge-off Rate on Credit Card Loans, All Commercial Banks. February 22, 2018.
5. Paynet Small Business Default Index. January 31, 2018.
6. Board of Governors of the Federal Reserve System. Delinquency Rate on Single-Family Residential Mortgages, All Commercial Banks. February 22, 2018.
7. ICE LIBOR. March 13, 2018.
8. U.S. Department of the Treasury. March 13, 2018.
9. Federal Deposit Insurance Corporation. March 12, 2018.
10. ICE Benchmark Administration Limited (IBA), ICE BofAML US Corporate 1-3 Year Effective Yield. March 13, 2018.
11. Board of Governors of the Federal Reserve System, Commercial Bank Interest Rate on Credit Card Plans, Accounts Assessed Interest. January 8, 2017.
12. Finsight. March 13, 2018.
13. SoFi Press Release. January 25, 2018.
14. LendingClub 2017 10-K filing. February 22, 2018.
15. OnDeck Fourth Quarter and Full Year 2017 Financial Results. February 13, 2018.
16. SoFi Press Release. January 23, 2018.
17. PTMNTS.com. March 12, 2018.
18. TechCrunch. April 25, 2016.
19. Goldman Sachs Press Release. April 18, 2016.
20. Goldman Sachs Presentation to Credit Suisse Financial Services Conference. February 13, 2018.
21. LendingClub’s 2017 10-K filing. February 22, 2018.
22. SoFi’s Twitter feed. October 26, 2017.
23. American Banker. November 3, 2017.
24. American Banker. November 21, 2017.
25. Global Capital. February 26, 2018.
26. While some firms have chosen to pursue a bank license – e.g. Zopa, Square, and others – we believe that this will only be a part of their funding strategy, rather than the entirety.
27. CNBC Article. February 14, 2018.
28. Wall Street Journal. March 5, 2018.
29. Paypal Press Release. November 16, 2017.
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The maturing of this market validates our thesis that digital finance investing as an investable asset class is here to stay