Reality, not Perception
What a difference a year makes! Around this time in 2016, some were penning the obituary for digital finance investing, given the challenging fund-raising environment for FinTech and an aggressive widening of credit spreads on the sector’s asset-backed bonds. Combined with other negative headlines during the year, a perception emerged that this sector may not have the muscle to continue to exist.
Fast forward to the reality of an active first few months of 2017 that saw four transactions alone attract $1.7 billion into the sector: SoFi’s and FundingCircle’s equity raises of $500 million1 and $100 million2, respectively, and two record-setting marketplace asset-backed bond issuances for $1.1 billion3…
…and Prosper secured a $5 billion financing program4 from a host of high profile investors, providing further validation for the marketplace model.
For an industry that has been battling negative perception, the reality is that there is strong financial commitment to both the digital loan originators’ capital structure – debt and equity – and to the loans being originated on those platforms. We believe the sector has the muscle to thrive.
Lendit 2017, SFIG Vegas, and Context Marketplace Summit. Three recent conferences featured digital finance investing. We moderated two interesting panels, one on allocation to alternative lending and one on credit underwriting. At Lendit 2017, HCG was nominated for “Fund Manager of the Year – 2016”5. The reality we saw at the conferences is one of a maturing sector that is attracting the attention of investors of all profiles.
The U.S. banking sectors’ management teams offer insights into the overall U.S. credit cycle6. While the Partnership operates in the digital loan space, the traditional U.S. banking sector is still the heart of today’s U.S. credit economy, and we monitor it closely. Our takeaways from the banking sectors’ recent quarterly earnings events, 2017 guidance and outlooks on the credit cycle, especially with respect to future pricing (i.e., loan coupons and APRs) and loss expectations, are:
- Revolving consumer credit continues to grow. The trillion-dollar revolving unsecured consumer credit market grew 6.2% yoy7 with the fourth quarter showing the highest year-on-year growth rate of 2016. Based on bank commentaries and Federal Reserve surveys on lending, we believe some banks have started to tighten underwriting and credit availability, particularly on the new loan marketing front, as we may have just seen the peak in competitive loosening.
- Losses, or net charge-offs, should increase. Losses should increase towards the long term historical average loss rates for consumer credit. Banks generally have been slow to tighten the credit funnel arguing that loans are still accretive despite higher expected loss rates. Note that digital loan platforms saw the deterioration in loss rates occur earlier and many reacted faster by tightening underwriting in 2016. For example, LendingClub revised its credit underwriting policy several times over the past 9 months to exclude approximately 15% of prime borrowers that had qualified pre-revisions8.
- Stated coupons on consumer credit should rise. Credit card rates, which are the consumer credit pricing baseline, are floating rate. As the Fed raises rates, consumer credit pricing naturally follows in lockstep. We expect digital loan platforms to raise fixed rate coupons in due course.
- Small-business optimism and business confidence is rising in their outlook for the economy. In a recent survey by Wells Fargo and Gallup, small business owners’ confidence reached highs not seen since 2007, with 45% reporting increased revenues yoy, and 79% expecting better financing performance in 2017.9
- Home buyer demand is holding steady in the face of rising mortgage rates. Several bank executives commentary was relatively sanguine, noting that activity had slowed down but was still positive. Recent data from the National Association of Realtors and the Mortgage Bankers Association reinforce this view that the market should continue to grow, albeit at a more moderate pace in 2017 vs 2016.10
The OCC’s proposed FinTech SPNB, or Special Purpose National Bank, charter: comments from industry participants…and rocks from the States. While FinTech players offered constructive feedback, several states11 and members of Congress were vocal about their differences with the OCC’s approach. Our view is that legislation with broader sponsorship and buy-in will need to be introduced. Stay tuned.
LendingClub and Square reported fourth quarter earnings. The two publicly-listed digital loan platforms in our ecosystem underscored real improvements in financial health manifested by improved operating cash flow12, strong available cash balances13, and healthier loan origination volumes14. Notably at LendingClub, banks purchased 31% of total platform originations (second highest level during the past 8 quarters)15, and 2017 guidance is $40-55 million in Adjusted EBITDA. Square guided to $30 million of 2017 Adjusted EBITDA and implied a $1 billion origination run-rate for Square Capital. For more details, please see each company’s release (click here for LendingClub, here for Square).
2 “Peer-to-peer Funding Circle bags $100 million despite industry hiccups and Brexit”, CNBC, Jan 12, 2017.
3 “SoFi rides rally with new student loan securitization”, Reuters, Feb 2, 2017; and “Online Lending Platform Kabbage Announces $525 Million Securitization Transaction for new Facility to Enable Expansion of Large Business Products”, CrowdFundInsider, Mar 8, 2017.
4 “Prosper Inks $5 Billion Loan-Buying Deal With Investors Including Soros, Jefferies”, The Wall Street Journal, Feb 27, 2017.
5 HCG’s nomination was not based on the performance of any HCG private fund clients
6 4Q16 earnings releases, conference call transcripts and earnings presentations for JPM, COF, BAC, C, DFS, SYF
7 FED G.19, Revolving Unsecured Consumer Credit through January 2017
8 LendingClub 8-k: June 7, 2016; October 14, 2016; March 9, 2017
9 “Small-business optimism at post-recession high: Survey”. American Banker. March 13, 2017.
10 “February New Home Purchase Mortgage Applications Increase 2.2% yoy”. MBA. March 14, 2017.
11 Conference of State Bank Supervisors response to the OCC’s proposed SPNB Fintech charter. January 13, 2017 12 Operating Cash Flow is defined as EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization.
13 Cash balance is defined as cash on hand, excluding restricted cash, and short-term securities
14 Originations are defined as the amount of loans sold through the platforms. During 4Q16, LendingClub originated about $2 billion and Square Capital originated about $250 mm.
15 LendingClub 4Q16 Results presentation, available on the LendingClub website
We believe the digital finance investment sector has the muscle to thrive