We’ve started seeing a lot of companies in the alternative lending space, and I’ve actually stopped calling them “lending” platforms because often rather than originating loans these companies are purchasing and selling off “assets” such as produce (as ProducePay does) or smartphones (as PayJoy does).
And the space is exciting. LendingClub, OnDeck, SoFi, CommonBond, Prosper etc have all proven that there is a real market of both borrowers and investors. Investors are looking for yield while borrowers are looking for access to capital that was either previously cumbersome, expensive or simply unavailable.
To be honest, I expect the rise of these platforms to continue for a while. It’s doubtful the fed is going to hike rates any material degree, capital will continue to be cheap, equity will continue to be expensive, emerging economies are not as sexy as they once were and it’s maybe the hardest time in decades to find a place to put money. That drives innovation (some really good and some really desperate/bad).
And there are a ton of populations and demographics who have not had access to capital markets. This is for a number of reasons but the two biggest are:
- they needed amounts of capital too small for brick and mortar financiers to efficiently originate and service
- their credit has been hard to assess
These alternative financing platforms have allowed lenders to:
- efficiently originate loans in a cost effective way by marketing themselves online and using computers to assess credit quality
- evaluate alternative data sets/look at new types of information to price loans
- avoid a lot of the regulatory scrutiny traditional banks have to deal with
And the market is enormous — so just because we’ve seen a couple of successes it doesn’t mean there won’t be new billion dollar + companies that emerge. But there is a lot of noise and a lot of “me too” companies and I’ve begun using the following filters to weed through the companies we’ve seen in the space:
(1) Does this platform have a unique way of originating deals? I see too many companies that start off by going after the low hanging fruit (pursuing borrowers they already have direct access to, semi-protected distribution channels, etc.). But in these cases there is often no proprietary way to create real defensibility at scale unless the founder has direct access to an entire industry). Some companies are able to create defensibility by offering software platforms that their distribution partners use to manage inventory, their staff, or loan applications and receivables. To the distribution partners these platforms feel like SaaS applications and ripping them out would cause a lot of brain damage. This distribution strategy is similar to the one Zenefits has and I’m a big fan.
(2) Market size is another huge issue. Too many people come in thinking about how big a number “$1 billion is.” But if you’re only taking 100 bps off of $1B then you’re really looking at a market size of $10m (total available revenue). Niche businesses often have unique marketing/sales strategies, structural barriers and secrets that can be exploited. But they are rarely have potential for venture scale. We look for companies that are targeting ~$50B markets or greater.
(3) There are some spaces that are really enormous and might have unique ways of approaching a borrower base — but are really crowded. Real estate is one of those industries. SMB lending and consumer lending are others.
(4) What is the rate of return to debt investors? How does this compare to other comps? Is there interest rate risk? (will this company be attractive once investors aren’t totally starved for yield?) Often founders spend so much time trying to achieve a low costs of capital in the beginning that they never end up making their first loan. The first lenders on a platform have to either earn incredible terms for taking on “new platform risk” or know that their allocation will be able to scale over time and that they can get right of first refusal in the future. Often that first debt capital will need to be juiced with warrants or equity rights. If the debt capital isn’t attractive enough to early private investors, the company is likely to struggle. Sometimes loan sizes are small enough that a company can use equity capital to make the first loans and keep them on the balance sheet, but this is expensive and doesn’t scale.
(5) Management teams are always important, and this is especially true in alternative financing businesses. The good news is that a lot of the founders of these companies are pretty bright. Most come out of business school, from credit card companies, hedge funds, private equity firms, etc.
The most attractive types of founders, though, are the ones who know their customers intimately well. Raising debt capital is hard, but hiring a CFO who comes from a strong credit background is pretty doable. Finding early customers and creating loyalty over time to avoid total commoditization is probably the hardest part of building an alternative financing platform and a founder who has the “domain expertise” to do so is most attractive IMO.