Part 3: Initial Diligence

*This post is a part of a series of posts we have written. To start from the beginning, click [HERE].

As investors, the best way for us prepare for an initial meeting is to have read an entrepreneur’s materials ahead of time and get beyond the generic “tell me what you do,” questions.

If in a meeting, if we are asking:

• How big is the market?
• How much does it cost to originate a loan?
• What are the terms on your loan and average size?

We have failed.

Our goal is to have received an entrepreneur’s deck ahead of time, and discussed internally before taking the meeting.

There are exceptions. In the event that we are taking the meeting to be helpful (which we often do depending on the source), we may not have all the information in advance. But by the time we’re diving in, in person meetings should be used for “analyzing information,” not “sharing information.”

If you are nervous about sharing information, you should send an NDA ahead of the meeting to be signed by the potential investor to make sure you can share information freely.

[Here is a template for a sample NDA] if you’d like to use this one.

In Venture Capital, it is rare that investors will sign an NDA. The reasons are as follows:

• Ideas are not that important, the importance is around execution.
• There is not a lot of “IP” in the earliest stages of a company
• VC’s get pitched ~1000+ deals per year. Most of those companies will overlap with something else seen. If they sign your NDA, and then invest in a similar company because they like the angle or the entrepreneur better, they could get screwed.

But in lending, it’s more common for NDA’s to get signed, and you should be good with the one we link to in this blog.

The information we look for in those introductory materials are as follows:

Question 1| What problem are you solving?

Are you lending to an underserved borrower base? If you are making unsecured consumer loans to people who can receive a loan on LendingClub, we’re likely not interested. We cannot figure out why we’d have an “edge” over sophisticated lenders competing with us, often with cheaper sources of capital.

So the problems we like to find are ones where:

• A borrower base has been ignored
• A new borrowing base exists that hadn’t existed before
• People have been mispricing loans to borrowers who have been traditionally taken advantage of for one reason or another.

Question 2 | Why Does the Problem Still Exist?

Most good opportunities have been taken advantage of. So we want to answer the “Why Now?” question. What secret insight does the founder have that no one else had before, or what exists about the world that had never existed before, making the opportunity newly available?

Some things that could change about the world include:

1. A new technology invented an asset previously non-existent. And we can now lend against it. Lending against Bitcoin would be a good example of that. Bitcoin never existed before, but now that it does, it serves as a lendable opportunity likely inefficient because of a lack of capital in the space.
2. Technology helped reduce origination or underwriting costs, allowing for a lender to make small loans formerly impossible to make. A $150 loan made over 10 days has traditionally been hard to make manually because at a 25% interest rate only yields $1.02 of revenue. Paying someone to make that loan is impossible, but using technology to make the loan is newly affordable.
3. Unique access to a borrower not formerly available: this often happens when a lender integrates with a marketplace, a platform, an e-commerce website, or some unique way to have access to borrowers other lenders may not have access to.

In any case, we need to understand why the opportunity still exists, and receive some believable explanation.

Question 3 | Why is the Lending Opportunity Outsized from a Risk-Reward Profile Than Normal?

If you are making an unsecured consumer loan, we want to understand why the default rates of the loans you are originating will be much lower than market, yet why your yields will either be as high as market, or better.

A couple of the ways to reduce default rates from what is traditionally market is to either:

• Use a new data point to underwrite the borrower, that other lenders don’t use, to better assess credit quality
• Have a unique repayment mechanism that allows us to receive money owed to the borrower, before the borrower receives it

A couple of ways your yields can be higher than market are usually around having unique access to a borrowing base either through:

• A unique origination channel — or in other words, having a captured audience of borrowers who find it easier to take a loan from you than anyone else
• To have access to a data point other people don’t have, so you can originate a loan others cannot
• The ability to help support the borrower, during the loan servicing process, to ensure the borrower can pay back.

Our strategy, in short, is super simple and obvious: Give capital to lenders who make a higher yield on the loans they originate, while incurring a lower default rate.

Genius, right?

Question 4 | Are You Going to be Good at Originating the Loans?

This has become an increasingly important part of our underwriting process. Many companies pitch amazing credit risks with loan products that are incredibly interesting to the investor, but that they cannot convince any borrowers to bite on.

This makes a lot of sense. In a really obvious example, let’s imagine:

I am making 25% APR loans to prime borrowers. As the investor, I’m very interested in doing this. As the borrower, I’m thinking “NFW.”

As a less obvious example: We’ve seen a ton of lenders try to do the following:

• Lend to hospital patients who have high deductible plans, and whom suddenly have to undergo a non-elective procedure. These emergency expenses can be difficult to pay for, and so hospitals often work out repayment plans with their patients. The problem is, hospitals are really bad at servicing these “payment plans” and so have a lot of bad receivables.
• The loan product essentially offers to originate and service loans on behalf of the hospital in exchange for a discount (say a 15% discount). The lender then offers patients a repayment plan at a 15% interest rate, creating a 30% yielding product.

This would seem like a good opportunity, right? There is a proprietary origination channel, a new event (high deductible plans are more popular now) that makes the problem suddenly exist, and a high yield (30%) because of the hospital discount.

The problem is, originating the loans is hard. The person explaining the loan product is the admin in the waiting room, who often doesn’t know all the details of the loan product and cannot be paid to promote it.

So you have an unmotivated workforce originating a complicated loan product to a borrower in distress.

For us — we not only need to understand whether or not the loan product is attractive to the investor, but why it’s also attractive to the borrower (often because it’s their best option). We then want to understand the mechanisms to market the product in a way that is believable.

In some cases, lenders do not spend as much time doing diligence on the origination process because they charge something called a “maintenance fee.” This is a fee charged to the Online Lending Platform, forcing them to pay interest on some percentage of the capital whether or not they’ve made loans.

In some cases we charge this too, however our goal is to not force our investees to pay us interest with revenue they are not earning, so we’d rather catch this problem early.

Question 5 | Will You Be Around to Service the Loans?

Lenders often look at the assets or the loans being originated, and feel that if:

• The assets are in a bankruptcy remote vehicle, even if the originator/servicer goes out of business the debt capital will be secured.

This is true, as long as upon bankruptcy there is a backup servicer in place, and that backup servicer is actually good at servicing the loans. There are a few primary backup servicers that most funds use (and most LP’s like to see). (A backup servicer is a business that services loans in the event that the primary servicing company, such as an online lender, goes out of business.

However, in the event of a crisis or a new recession, the backup servicer is likely to get over stretched with requests for help and may not have enough bandwidth for all of its clients.

Further, if the loans are complicated to repay, it may turn out that the Online Lender had a unique ability to collect on the loans.

For that reason, we look for loans that have an automated repayment mechanism, that even in a bankruptcy of the Online Lender, and our backup servicer not being adequate, we feel confident we can get paid back.

What is Your Barrier To Entry?

We want to have relationships with companies where we can invest for 3–5 years (if possible), and maintain our yields. What we do not want to see happen is:

One of our companies find a unique niche, start originating at a high yield, and then as more and more competitors come into the space, force the lender to stretch its credit box or bring down its price point.

We are looking to understand what competitive advantages the company will have not just in the beginning, but over time.

As written in my last post, these often come from either:

• Switching costs
• Observing a difficult data point to access
• Ability to effectuate the borrower

Underwriting Materials

Another one of the more obvious items we’d want to see, is insight into the underwriting process. What data points are you using to underwrite loans and make credit decisions with?

We want to know:

• What information you collect
• Whether or not you have a rules based system for making a loan
• How you bucket different types of borrowers (all receiving different priced loans)
• Who at the company is allowed to make these decisions
• How exceptions are handled
• Any underwriting manuals available
• And anything else relevant to the process

In order for us to understand if the loans are made at a higher yield than what is market, we need to understand, with granularity, who the borrower is and what their risk would normally be in the context of a traditional investment.

Sometimes this is briefly discussed in opening materials, and provided in greater detail later on in the process.

The In-Person Meeting

Our meeting in person is typically used to analyze all of this information provided beforehand. The main thing we can’t receive before a meeting is our opinion of the management team. Our first meeting is the beginning of the relationship process. It’s our chance to hear how management thinks about the materials sent over, corner cases, their own backgrounds, how their backgrounds led them to the current opportunity, and how they divide roles and responsibilities.

We often know management teams for months (or even years!) before we lend to them, because no matter how bullet proof legal docs can get, how each party handles themselves when things go sideways determines whether problems get resolved efficiently, or expensively.

The agenda for the meeting is to analyze the materials outlined above, but the underlying denominator behind all of that, is to begin deciding whether or not we can see working with the people across the table.

Continued in our next post is a [Deeper Look on Diligence].

For the Full Series of Posts, Please See Below:

(1) Part 1: An Intro to Online Lending (LINK)

(2) Part 2: An Intro on How To Source Deals [LINK]

(3) Part 3: Initial Diligence [LINK]

(4) Part 4: Deeper Diligence [LINK]

(5) Part 5: Structuring The Deal [LINK]

(6) Part 6: Building a Credit Model [LINK]

(7) Part 7: Monitoring Your Investment [LINK]

(8) Part 8: Conclusion [LINK]